Question

Draw a graph showing equilibrium in the money market. Carefully label all curves and axes, and explain why the curves have the slopes that they do.

Short answer

Answer: The primary elements of the money market graph include the money demand curve (L), the money supply curve (M), and the interest rate (i) and quantity of money (M) on the axes. The money supply curve (M) is vertical because the money supply is determined by the central bank and is a fixed amount, independent of the interest rate. The money demand curve (L) is downward-sloping because, as the interest rate (i) increases, people tend to save and invest their money, resulting in a decrease in the quantity of money demanded.

Step-by-step solution

Draw the axes

Begin by drawing horizontal and vertical axes to represent the market for money. Label the horizontal axis as "Quantity of Money (M)" and the vertical axis as "Interest Rate (i)."

Draw the money supply curve

Draw a vertical line that represents the money supply (M). This line should be parallel to the vertical axis because the money supply is determined by the central bank and is a fixed amount, meaning its slope is 0. Label this line as "M."

Draw the money demand curve

Now, draw a downward-sloping curve that represents the money demand (L). This curve should slope downwards from left to right because as the interest rate (i) increases, people are more likely to save and invest their money, which decreases the demand for money. Label this curve as "L."

Identify the equilibrium point

Find the point of intersection between the money supply curve (M) and the money demand curve (L). This is the equilibrium point in the money market, where the quantity of money demanded is equal to the quantity of money supplied.

Explain the slopes of the curves

The money supply curve (M) is vertical because it is determined by the central bank and is a fixed amount, independent of the interest rate. The money demand curve (L) is downward-sloping because, as the interest rate (i) increases, people tend to save and invest their money, resulting in a decrease in the quantity of money demanded.

Key concepts

Money Supply Curve

The money supply curve is a graphical representation that shows the total amount of money available in an economy at various interest rates. In the context of money market equilibrium, the money supply curve is typically depicted as a vertical line on a graph where the horizontal axis represents the quantity of money and the vertical axis represents the interest rate.

The vertical nature of the money supply curve indicates that the total amount of money supplied in the economy is fixed in the short run and does not change with different interest rates. This assumption holds true because the money supply is primarily controlled by the central bank through various monetary policy tools.

Essentially, the money supply is set independently of the market's interest rate, hence its vertical slope, which corresponds to a slope of 0. The central bank can increase or decrease the money supply by conducting open market operations, adjusting reserve requirements, or varying the discount rate. These actions can shift the money supply curve to the right (increase in money supply) or to the left (decrease in money supply).

Money Demand Curve

The money demand curve, in contrast to the money supply curve, is downward sloping. This reflects the inverse relationship between interest rates and the quantity of money people wish to hold. When we plot the money demand curve on a graph with the interest rate on the vertical axis and the quantity of money on the horizontal axis, we see a clear trend: as interest rates increase, individuals and businesses are less inclined to hold money because it becomes more costly to forego interest-bearing assets.

The downward slope of the money demand curve indicates that at higher interest rates, people prefer to save or invest their funds rather than hold liquid cash. Conversely, when interest rates are low, cash holdings are typically higher because there is less opportunity cost in not investing that money. Factors affecting money demand include income levels, price levels, and changes in economic activity.

The interaction of the money supply and money demand curves determines the market interest rate, with the equilibrium occurring at the point where the two curves intersect.

Interest Rate

The interest rate serves as a crucial component in the money market, acting as the price of borrowing money. It is determined by the equilibrium between the money supply, set by the central bank, and the money demand from consumers and firms.

Higher interest rates typically induce people and businesses to save more and borrow less, leading to a decrease in the quantity of money demanded. Conversely, lower interest rates encourage spending and borrowing, increasing the demand for money. The equilibrium interest rate is the level at which the intention to save or lend balances with the intention to borrow or spend, aligning with the money supply determined by the central bank.

It's important to note that the interest rate is not solely affected by the money market but also interacts with other financial markets and macroeconomic factors. However, understanding its role within the context of money supply and demand is fundamental for students grappling with economic principles.

Central Bank Policy

Central bank policy is a key influencer of the money supply and, by extension, the overall economic activity. Through its monetary policy actions, a central bank can adjust the money supply to target specific economic objectives, such as controlling inflation or stimulating growth.

Common tools used by central banks include open market operations, where they buy or sell government securities to influence the money supply; adjusting the discount rate, which is the interest rate at which commercial banks can borrow from the central bank; and changing reserve requirements, which sets the amount of funds banks must hold in reserve and not lend out.

When a central bank wants to lower interest rates to stimulate economic activity, it increases the money supply by purchasing government securities, lowering reserve requirements, or reducing the discount rate. Conversely, to combat inflation, the central bank may decrease the money supply by selling securities, raising reserve requirements, or increasing the discount rate. These policies affect the position and slope of the money supply curve, thereby impacting money market equilibrium.