David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 19 Interest rates and monetary transmission
An excess demand for money must be exactly matched
by an excess supply ofbonds. Otherwise people are planning
to hold more wealth than they actually possess.
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'ti r "
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L' L0
Real money balances
LL'
An excess demand for money at the interest rate r1 in
Figure 19 .1 bids up the interest rate to its equilibrium level
r0• With excess demand for money, there is an excess supply
of bonds. To make people want more bonds, suppliers of
bonds offer a higher interest rate. 2 People switch from money
to bonds. The higher interest rate reduces both the excess
supply of bonds and the excess demand for money. At
the interest rate r0, money supply equals money demand.
Bond supply equals bond demand. Both markets are in
equilibrium. People wish to divide their wealth in precisely
the ratio of the relative supplies of money and bonds.
From now on, we examine the implicit market for money.
However, any statement about the money market is also
a statement about the bond market.
With a given real income, LL is the demand schedule
for real money balances. A reduction in the real money
supply from L0 to L' moves the equilibrium interest rates
from r0 to r ' to reduce the quantity of money demanded
in line with the fall in the quantity supplied. With a given
supply of real money L0, an increase in real income shifts
the demand schedule from LL to LL'. The equilibrium
interest rates must increase from r0 to r'. Higher real
income tends to increase the quantity of real money
demanded and higher interest rates are required to
offer this, maintaining the quantity of real money
demanded in line with the unchanged real supply.
Figure 19.2
Equilibrium interest rates
Changes in equilibrium
A shift in either money supply or money demand changes
equilibrium in the money market (and the bond market).
These shifts are examined in Figure 19.2.
A fall in the money supply
Suppose the central bank lowers the money supply. For
a fixed price level, lower nominal money reduces the
real money supply. Figure 19.2 shows this leftward shift
in the supply curve. Real money falls from L0 to L'. The
equilibrium interest rate rises from r0 to r'. A higher
interest rate reduces the demand for real money in line with the lower quantity supplied. Hence a lower real
money supply raises the equilibrium interest rate. Conversely, a rise in the real money supply reduces the
equilibrium interest rate.
A rise in real income
Figure 19.2 shows real money demand LL for a given real income. A rise in real income increases
the marginal benefit of holding money at each interest rate, raising real money demand from LL to LL'. The
equilibrium interest rate rises to keep real money demand equal to the unchanged real supply L0• Conversely,
a fall in real income shifts LL to the left and reduces the equilibrium interest rate.
More competition in banking
Figure 19.2 also draws money demand LL for a given interest rate paid on bank deposits. Holding this rate
constant, a rise in bond interest rates r raises the cost of holding money and reduces the quantity of money
demanded. This implies the economy moves up a given demand curve LL.
2 A bond is a promise to pay a given stream of interest payments over a given time period. The bond price is the present value of
this stream of payments. The higher the interest rate at which the stream is discounted, the lower the price of a bond. With an
excess supply of bonds, bond prices fall and the interest rate or rate of return on bonds rises.
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