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Money and Financial Assets Review for AP Economics (page 3)

By — McGraw-Hill Professional
Updated on Mar 2, 2011

The Money Market

The central bank, having established a given level of money supply circulating in the economy, allows us to incorporate a vertical money supply (MS) curve with a downward sloping money demand curve to complete the money market. John Maynard Keynes developed the theory of liquidity preference, which postulates that the equilibrium "price" of money is the interest rate where money supply intersects money demand. Just like any market, if the price is below equilibrium (a shortage) the price must rise, and if the price is above equilibrium (a surplus) the price must fall. Money demand can increase if more transactions are being made, but the real focus of the rest of this chapter is on changes in money supply. Equilibrium is shown in Figure 16.2.

The Money Market

"How Is the Money Market Different from the Market for Loanable Funds?"

" This is an important question. Know the difference." —AP Teacher

Tough question, we'll take it in two and a half parts. I'm sure the first is much more helpful, the second much more esoteric and the half is going to earn you the graphing points.

  1. Breadth of scope
  2. The supply of loanable funds, which varies directly with the interest rate, comes from national saving. The supply of money is more inclusive than just saving; it includes currency and checking deposits. A $100 bill in your wallet would fall into the money supply curve, but not into the supply of loanable funds. The demand for loanable funds comes from investment demand. The demand for money includes the money used for investment, but also for consumption (transaction demand) and for holding as an asset (asset demand). So basically the money market, both on the supply and the demand side, is broader, and more inclusive, than the market for loanable funds. The price (a.k.a. the interest rate) appears to be the same in both markets, and is the result of …

  3. Different philosophies
  4. We don't want to delve too much into the Keynesian versus Classical philosophical debates because they are quite unlikely to appear on your AP Macroeconomics exam. It can seem a little confusing to show the interest rate as the "price" in both the market for loanable funds and the market for money. The reason that both markets are presented here, and in your textbook, is that they represent fundamental differences in macroeconomic philosophies.

    • Classical economists believe that the price level is flexible and long-run GDP adjusts to the natural rate of employment. For any level of GDP, the interest rate adjusts to balance the supply and demand for loanable funds and the price level adjusts to keep the money market in equilibrium.
    • Keynesian economists believe that the price level is sticky. For any price level, the interest rate adjusts to balance the supply and demand for money and this interest rate influences aggregate demand and thus the short-run level of GDP.
    • Bottom line here: the two different ways of looking at the interest rate are the result of two different ways of looking at the overall economy and the difference in the longrun (Classical) and short-run (Keynesian) views of the economy…. and 1/2. Graphing

    While it appears that the same interest rate is graphed on the vertical axis of both the loanable funds and money market graphs, they are not in fact the same. It is correct to label the vertical axis of the money market with a nominal interest rate and the vertical axis of the loanable funds market with the real interest rate. Changes in the money market can be viewed as short-term changes and therefore the role of expected inflation is negligible. For long-term decisions like investment and saving, the price of investment, or return on saving, does depend upon expected inflation and so it makes sense to focus on the real rate of interest when making long-term plans. Here's a way to keep it straight: "Loanable funds are REAL-ly fun."

Changes in Money Supply

When we talk about monetary policy, we are really talking about money supply policy. The tools used to expand or contract the money supply are discussed later in this chapter, but it's useful to see what is happening in the money market when the money supply increases or decreases.

An Increase in the Money Supply

Like the market for any commodity, when the supply increases, there exists a temporary surplus at the original equilibrium price. The money market is no different. At the original interest rate of 10 percent, the supply of money is $1000. Now the Fed increases the money supply to $1500. In Figure 16.3, you can see that at 10 percent, there is now a surplus of money.

Changes in Money Supply

With surplus money on their hands, people find other assets, like bonds, as places to put the extra money. As more people increase the demand for bonds, the bond price rises, and this lowers the effective interest rate paid on the bonds.

How does this work?

A bond is selling at a price of $100 and promises to pay $10 in interest. The interest rate = $10/$100 = 10 percent. But if the price of the bond is driven up to $125, the same $10 of interest actually yields only $10/$125 = 8.0 percent. With lower interest rates available in the bond market, the opportunity cost of holding cash falls and the quantity of money demanded increases until MD = $1500. An increase in the money supply therefore decreases the interest rate.

A Decrease in the Money Supply

If the Fed decides to decrease the supply of money from $1000 to $500, there is a shortage of money at the 10 percent interest rate. A shortage of money sends some bondholders to sell their bonds so that they have money for transactions. An increase in the supply of bonds in the bond market decreases the price and increases the rate of interest earned on those assets.

How does this work?

If the original price of the bond is $100, promising to pay $10 in interest, the interest rate is 10 percent. If the price falls to $90, the same $10 of interest now yields $10/$90 = 11.1 percent. Higher interest rates on bonds increase the opportunity cost of holding cash and so the quantity of money demanded falls until the interest rate rises to the point where MD = $500. This adjustment is seen in Figure 16.4.

Changes in Money Market

Review questions for this study guide can be found at:

Money, Banking, and Monetary Policy Review Questions Review for AP Economics

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