Question

Equilibrium interest rate is achieved in the money market when aggregate demand for real monetary assets equals the supply of real monetary assets.
a. Write down the condition required for equilibrium in the money market using real quantities of monetary assets.
b. The aggregate real money demand function is given as L(R, Y). For a given level of income, real money demand decreases as interest rate increases. Explain why L is
negatively related to interest rates. How is the real income related to the aggregate real money demand?
c. Briefly state the effect of an increase in the nominal money supply on the interest rate, for a given price level.

Answer 1

a) The money market is defined as the interaction among the various institutions through which money is supplied to individuals, firms, government and other bodies that demand money. A money market is said to be in equilibrium at an interest rate which is determined by the interaction of money demand(MD) and money supply(MS). When MD=MS, money market is at equilibrium level. As we know that money supply is constant, the shifts in the demand for money determine the increase and decrease in the interest rates.

Lets illustrate with the help of the following diagram. The money supply is constant represented by the vertical line. Suppose it is held at 200 billion dollars. When the MD curve intersects the MS curve at point E, interest rate is determined. Here it is 10%. There will be disequilibrium in the economy if rate of interest is either higher or lower than 10 %. If interest rate is higher (say 12%), there is excess money supply. This will mean that the people are not holding money as required by the monetary authority. If interest rate is lower (say 8%), there will be excess demand. People will prefer to sell off their bond or other financial holdings to obtain greater quantity of money at the lower rate of interest.

b) In simple words we can state that interest is the price for money. By applying the law of demand, if interest is higher, then the demand for money will be lower. Hence, L and interest rates have an inverse relationship.

An increase in real income causes an increase in the demand for transactions. This causes an upward shift in the Money demand curve.

c) This can be best explained with the help of the following diagram:

  

In the above figure, when the quantity of money increases from M1 to M2 , the M2 curve intersect the MD curve at E'. This leads to a fall in rate of interest from i to i’ . In this case we move down on the curve. Thus, when the money demand curve or curve of liquidity preference is given, an increase in the supply of money decreases the rate of interest.