5-2a Money Market
The money market is similar to the bicycle market or the computer market, in that there is a supply and a demand for
money. Instead of the price for money being money, the price paid for money is the interest rate. Another distinction
between the money market and other markets is that the supply is a vertical line. Because the FED determines what
the Money Supply is, the quantity supplied does not increase with the price—so it doesn’t follow the law of supply.
Instead, the money supply in effect, determines the interest rate.
The demand for money is also a little different from other markets. It is made up of two different demand curves
added together. First the transaction demand for money is what we require to make transactions everyday. When we
buy gas or lunch, we demand money to make the transaction. This demand is independent of the interest rate and is
also a vertical line. Then there is the ‘asset’ demand for money. This demand is inversely related to the interest rate.
When interest rates are high, we invest our money to make more of it, we don’t hold it as an asset. When interest
rates are low, we hold on to it and wait for something to do with it. That’s why the asset demand curve is downward
sloping. So the total demand for money curve is downward sloping and follows the law of demand.
The intersection of the supply and demand determines the nominal interest rate.
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