How Is Interest Determined in the Money-Market Model?
Monetary policy
What you will learn
- In the simplified money market, equilibrium balances desired money holdings with a given supply.
- Apply the model to an original scenario and justify its limits.
Essential definitions
- Money demand
- The desired holding of liquid money balances at each interest rate.
- Liquidity preference
- The preference for holding readily spendable balances rather than less liquid interest-bearing assets.
Why hold money?
Money provides immediate spending power. People hold it for transactions, as a precaution against unexpected bills, and when they prefer liquidity to other assets. The speculative motive concerns choices between money and assets such as bonds when returns or prices are uncertain.
The diagram puts the nominal interest rate, in percent, vertically and the money quantity, in currency units, horizontally. Money demand slopes down: a higher return on interest-bearing assets raises the opportunity cost of holding non-interest-bearing balances. Trace this relationship while holding income and the price level constant.
Read equilibrium and a supply change
In this model, the monetary authority supplies a fixed quantity, drawn as a vertical line. Its intersection with money demand is E1. If money supply rises, the vertical line moves right. At the old interest rate people hold more money than they want and seek assets such as bonds. Higher bond prices correspond to lower yields.
The new intersection E2 has a lower interest rate. A supply contraction reverses that chain. More income or a higher price level can instead raise transaction demand and shift money demand right. At fixed supply the equilibrium rate rises. A rate change alone is movement along demand, not a reason to shift it.
Solve an illustrative equilibrium
Let Md be money demanded in billions of currency units and r the interest rate measured in percent, so r = 4 means 4%. Suppose Md = 120 − 10r. The coefficient 10 means each one-percentage-point rate rise reduces desired balances by 10 billion. Ms denotes the supplied quantity in the same units.
Set Md equal to Ms to solve equilibrium. Supply of 80 gives 80 = 120 − 10r, so r = 4%. Supply of 90 gives r = 3%. This equation illustrates the model rather than reproducing every number in the interactive diagram. Modern policy often targets an interest rate and accommodates reserve demand; state the fixed-supply assumption when using this explanation.
Hypothetical worked application
- Set Md = Ms: 120 − 10r = 80.
- Rearrange 10r = 40, giving r = 4%.
- At Ms = 90, 10r = 30 and r = 3%.
The hypothetical monetary expansion lowers equilibrium interest by 1 percentage point.
Money market and the interest rate
MD: i = 10 − 0.05M. MS₁ = 80, i₁ = 6%; MS₂ = 100, i₂ = 5%. Equilibria are computed from the plotted money-demand equation.
Money demand falls as the opportunity cost of holding money rises. In the textbook model, a larger money supply lowers the equilibrium interest rate; an increase in money demand with supply fixed raises it.
How to draw it and model assumptions
- Nominal interest rate (%) vertically, money quantity horizontally.
- Draw downward MD and vertical MS₁, MS₂.
- Project the initial E1 and new E2 intersections to label i₁ and i₂.
Nominal interest rate and nominal money stock; income and price level fixed when money supply changes. A stylized fixed-money-supply model, distinct from a central bank implementing an interest-rate target.
Apply and evaluate
- The fixed-supply diagram is a simplification; implementation through a policy-rate target may operate differently.
Common misconceptions
- Higher interest produces movement along money demand; higher income can shift money demand.
Knowledge check
At fixed money supply, how does higher transaction demand affect the interest rate?
Real-world application
Monetary easing during the pandemic
15 March 2020: The US Federal Reserve lowered the federal funds target range to 0–0.25% in its emergency policy announcement.
Model application: lower rates can support consumption and investment by reducing financing costs. Near-zero rates also illustrate the limited room for conventional further cuts. Restrictions on production and low confidence can weaken the spending response, so a rate cut is not a guarantee of an immediate recovery.
Federal Reserve, FOMC statement ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
Loans create deposits
14 March 2014: The Bank of England explains that commercial-bank lending creates matching deposits and that banks do not mechanically multiply a fixed stock of central-bank money into loans.
Use a balance sheet: the bank gains a loan asset and a deposit liability. The borrower gains a deposit and a debt, not free net wealth. Profitability, credit risk, capital, liquidity and monetary policy constrain the process. The simple reserve-ratio story is a conditional model, not a universal description of banking.
Bank of England, Money creation in the modern economy ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
What to remember
In the simplified money market, equilibrium balances desired money holdings with a given supply. More supply lowers the rate; greater money demand raises it, with other conditions unchanged.
Completion is your own reflection on learning, not a test score. Syllabus references: 3.5.05.
Sources and applications
Lessons in this section
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