MacroeconomicsI_working_version (1)

70
Chapter 7
7.7. The Money Market
The money market consists of the demand for money and the supply of money. The point
of intersection of the curves determines the equilibrium interest rate.
i
MS
i 0
M*
MD
M
Figure 7.7 Equilibrium in the money market.
Figure 7.7 shows the equilibrium situation in the money market. The money supply curve
is vertical, showing its independence on the interest rate. The position of this curve is
determined by changes in money stock, which are exogenous. The total quantity of money
and altering money supply (such as M1) is in the option of the central bank. The position
and the slope of the money demand curve are determined by the transaction and asset
demand for money. The point of intersection determines the equilibrium rate of interest i 0 .
Let’s examine the changes in equilibrium in the money market. The left part of Figure 7.8
portrays the influence of increasing economic activity on the money market equilibrium.
Assuming the supply of money unchanged. A rise in GDP will induce rise in demand for
money. The money demand curve shifts to the right until the new point of equilibrium E’ is
reached. As a result the equilibrium interest rate rises. With money supply unchanged a rise
in demand for money, cannot increase in equilibrium. The interest rate must rise until its
effect on demand exactly offsets the positive effect of rising GDP. In the right part of the
figure, the effect of an exogenous increase in money supply is depicted. The curve of
money supply shifts to the right until the new point of equilibrium E’. It lowers the
equilibrium interest rate.