EXPLANATORY NOTES:

Use the money market model to explain how interest rates are determined.

A. The Demand and Supply for Money

The money market model shows how the interaction of the demand and supply for money
determines the short-term nominal interest rate. The demand for money curve slopes downward
because when nominal interest rates on financial assets are low, the opportunity cost of holding
money is low and the quantity of money demanded is high; when interest rates are high, the
quantity demanded of money demanded will be low.

B. Shifts in the Money Demand Curve

Changes in variables other than the interest rate cause the demand for money to shift. The two
most important of these variables are real GDP and the price level.

C. Equilibrium in the Money Market

Assuming that the Federal Reserve is able to set the supply of money at the level it chooses, the
money supply curve is a vertical line and changes in the nominal interest rate have no effect on
the quantity of money supplied. Equilibrium in the money market occurs where the money
demand curve crosses the money supply curve. In the short run the Fed can cause a decline in the
short-run nominal interest rate by increasing the money supply, but long-term interest rates play
a more important role in the financial system than short-term interest rates.

Practice Questions:

1) In the liquidity preference framework, demonstrate graphically the effect of a decrease in the
money supply. Indicate on the graph the excess demand or excess supply of money. Explain the
process of adjustment that results in a change in the equilibrium interest rate, and the direction of
the change in rates.
Answer: The graph should show the money supply curve shifting to the left. At the original rate,
excess supply is the difference between the demand curve and new supply curve at the original
equilibrium interest rate. To adjust, individuals sell bonds, driving bond prices down and interest
rates up until the new equilibrium rate is attained.
2) Economists recognize that interest rates are typically procyclical, meaning that interest rates
increase during economic expansions and decline during recessions. Real income and generally
inflation rise and fall with the economy. Using the liquidity preference model of interest rates,
give three reasons why interest rates are procyclical.
Answer: The answer should explain that the income, price-level, and expected inflation effects
would all increase interest rates during an expansion and decrease them in a recession.

3) Draw a graph of the money market. Show the effect on the money demand curve, the money
supply curve, and the equilibrium short-term nominal interest rate of each of the following:

a. The price level increases.

b. The Fed increases the money supply at the same time that the price level falls.
a. An increase in the price level shifts the money demand curve to the right, from MD1 to
MD2, raising the interest rate, from ii to i2.

b. The increase in the money supply by the Federal Reserve shifts the money supply curve
to the right from, MS1 to MS2, and the fall in the price level shifts the money demand
curve to the left, from MD1 to MD2, lowering the interest rate, from ii to i2.