Money Market Equilibrium

Learning Objectives

1. Explain the demand for money and its determining factors.

2. illustrate the difference between shifts and movements along the demand curve for money.
3. Explain how quantity of money supplied changes through open market operation and the
demand deposits multiplier.
4. Understand how the money market reaches equilibrium and how interest rate adjust to state
of equilibrium.
5. Explain how interest rate affect total spending and the whole economy.
6. Illustrate how monetary policy works to affect real GDP.
The Demand for Money

 An individual’s quantity of money demanded is the amount of wealth that the individual choose to
hold as money, rather than as other assets.
 People choose either to use money to purchase goods and services or put their money in bonds
which earns interest. There are three variables to be considered in making this decision:
1. The price level. A rise in the price level, increase the amount of money people will hold to
make their purchases.
2. Real income. As nominal income increases, with price level remains unchanged, purchasing
power or real income increases and so will the number of pesos spend for the particular period.
Again, people will hold more of their wealth in the form of money.
3. The interest rate. Interest rate payments are what people give-up as they choose to hold money
– the opportunity cost of money. The higher the interest rate, the greater the opportunity cost of
holding money. Thus, a rise in the interest rate decreases quantity demanded for money
 The economy’s quantity of money demanded is the amount of total wealth in the economy
that all households and businesses, together, choose to hold as money rather than bonds.
 The demand for money in the economy depends also on price level, real income, and
interest rate. In particular,
a) a rise in price level will increase demand for money;
b) a rise in real income (real GDP) will increase the demand for money; and,
c) a rise in the interest rate will decrease the quantity of money demanded.
The Money Demand Curve

 The money demand curve shows the inverse relationship between total quantity of money
demanded in the economy at each interest rate, holding other factors (price and real
income) unchanged.
 Figure 5.1. shows that as long as the other influences on money demand don’t change, a
drop in interest rate--which lowers the opportunity cost of holding money—will increase
the quantity of money demanded.
Figure 5.1. The Demand for Money
Shifts in the Money Demand Curves

 It is assumed earlier that other factors (price and real income) are held constant, so that as
rate of interest increases, quantity of money demanded decreases.
 As these other factors change, the money demand curve will shift. Shifts and movements
along the money demand curve are compared in Figure 5.2.
Figure 5.2. Shifts and Movements Along the
Money Demand Curve
The Supply of Money

 As mentioned in the previous chapter, money supply is composed coins, papernotes and
demand deposits that are in circulation.
 The BSP is tasked to control the money supply to ensure stable macroeconomy. It uses
open market operations to inject or withdraw reserves from the banking system and relies
on the demand deposit multiplier to do the rest.
 The money supply curve is a line showing total quantity of money in the economy at each
interest rate (see Figure 5.3)
 As the monetary authorities decide to increase money supply by purchasing bonds to
inject reserves into the banking system, the money supply curve shifts rightward by a
multiple of the reserve injection (depending upon the deposit or money multiplier).
 Figure 5.3. illustrate a rightward shift of the money supply curve. Originally, the money
supply is 500 B regardless of the rate of interest. But monetary authorities decided to inject
more reserves to banking system amounting to 20B by purchasing bonds. With a required
reserve ratio (rrr) 10%, the demand deposit multiplier is equal to
m = 1/.1 = 10 - this is the number of times injection of reserve
increases
So the change in quantity of money supplied is
Change in MS = (Total reserves injected)(m)
Change in MS = (20B)(10)
Change in MS = 200B
Figure 5.3. The Money Supply Line
Equilibrium in the Money Market

 Putting together the money demand and money supply, we find the equilibrium interest
rate in the economy.
 Equilibrium in the money market occurs when the quantity of money people are actually
holding (quantity supplied) is equal to the quantity of money they want to hold (quantity
demanded). People are satisfied holding the money that they are actually holding.
 Figure 5.4 illustrates money market equilibrium. At point E, quantity of money demanded
equals quantity supplied at 6% interest rate. At a higher interest rate, say 9%, there is
excess supply of money and interest would fall. At a lower interest rate such as 3%, there
would be excess demand for money, and the interest rate would rise.
Figure 5.4. Money Market Equilibrium
How the market reaches equilibrium?

 As mentioned earlier, people choose between holding money or bonds. If they choose to
hold less money than they currently holding, then, they must want to hold more in bonds
than they are currently holding—an excess demand for bonds. So, when there is excess
supply of money in the economy, there is also an excess demand for bonds.
 As the public continue to demand for bonds which make them scarcer, the price of bonds
will rise.
 To summarize, a higher interest rate than its equilibrium value means excess supply
of money and excess demand for bonds. The public would continue to buy bonds,
making it scarcer, hence, an increase in price of bonds.
Bond Prices and Interest Rates

 The interest rate earned on bond depends on the price of bond. The higher the price of
bond, the lower the interest rate. Or the more you pay for any bond, the lower your rate of
return, or interest rate, will be.
 When the price of bonds rises, the interest rate falls; when the price of bonds falls, the
interest rate rises. For example, buying a bond at price Php800.00 with a payback of
Php1,000.00 after a year earns an interest rate of 25% (=200/800 x 100). But as price
increases to Php900.00 and still promises a payback of Php1000.00 after a year earns only
11% (=100/900 x 100).
Interest Rate Adjusts to State of Equilibrium

 Figure 5.4a illustrates how a higher interest rate (i.e. 9%) than equilibrium will eventually
go down in response to the action of the public of buying more and its effect on bonds
prices. The process will continue until there is no more excess supply of money, and an
excess demand for bonds or equilibrium(at 6% interest rate).
 Figure 5.4b shows how a lower interest rate (i.e. 3%) than equilibrium will adjust as the
public tends to sell bonds which causes price of bonds to fall and interest rate to rise until it
reach equilibrium at 6%.
Figure 5.5a Higher Interest Rate than
Equilibrium
Figure 5.5b
BSP Influences Interest Rate

 The BSP can change the equilibrium interest rate in the money market by changing the
money supply.
 Specifically, it conducts open market purchases to increase money supply. With the
excess money supply and excess demand for bonds, public will buy bonds which results to
higher price of bonds and a lower interest rate.
 It can raise interest rate as well, through open market sales of bonds. This causes supply
of money to decrease. With the excess demand for money and excess supply for bonds,
public tries to sell bonds which bids price of bonds down and interest rate up.
How does interest rate affect spending?

 A lower interest rate stimulates business spending on plant and equipment. Interest rate,
being the cost of borrowing, investors are encouraged to borrow funds to finance
investment projects at a lower interest rate. (the opportunity cost of the firm’s funds when
spent on plant and equipment).
 A firm deciding whether to spend on plant and equipment compares the benefits of the
project—the increase in future income—with the costs of the project. Lower interest rate
means lower costs, so more projects will be pushed through.
How does interest rate affect the economy?

 Interest rate also affects consumption spending on consumer durables like cars, furniture,
television set, etc. Consumers often borrow to buy these items. For example, lower
interest rate charged by banks offering car loans will encourage purchase of new cars, the
most expensive consumer item. The more expensive the item is, the more sensitive it is to
changes in interest rate.
 In summary, an increase in money supply, the interest rate falls, and spending on plant
and equipment, new housing, and consumer durables (especially cars) increase.
Alternatively, as money supply decreases, the interest rate rises, and spending on the above
items fall.
How monetary policy works?

 Monetary policy refers to controlling money supply to influence interest rate, spending and
eventually real GDP .
 Figure 5.6a illustrates how easy money policy, specifically open market purchases, works
to increase real GDP. More open market purchases of bonds increases money supply and
lowers interest rate. At a lower interest rate, more autonomous consumption (a) and
planned investment (Ip). As a result, real GDP improves depending upon the size of the
multiplier.
 Figure 5.6b illustrates the opposite. An open market sales reduces real GDP.
How easy money policy works?
How tight money policy works?