Difficulty: Intermediate | Prerequisites: Part 1 of these notes (money demand), Chapter 10 (money supply and the Fed's tools).
Big picture: Part 1 covered why people demand money. This section brings in the money supply (set by the Fed) and shows how the two together determine the equilibrium interest rate. The key skill here is predicting what happens to the interest rate when the Fed acts (open-market operations, reserve requirements, discount rate) or when the economy changes (GDP moves, prices change). Nearly every exam question in this section is a "what happens to the equilibrium interest rate when X occurs?" scenario.
Source: Principles of Macroeconomics, Case/Fair, 8e – Chapter 11, Section 11.2
Tags: equilibrium interest rate, money market equilibrium, money supply curve, excess demand for money, excess supply of money, Fed policy, open-market operations, reserve requirement, discount rate, interest rate determination
The equilibrium interest rate is where money demand equals money supply. When there is excess demand for money, people sell bonds, bond prices fall and the interest rate rises. When there is excess supply, people buy bonds, bond prices rise and the interest rate falls. The Fed shifts the money supply curve through open-market operations, the reserve requirement and the discount rate.
Equilibrium interest rate
The interest rate at which the quantity of money demanded equals the quantity of money supplied. At this rate, firms and households are satisfied with the amount of money they hold. Think of it as the "market-clearing price" for holding money.
Excess demand for money
A situation where, at the current interest rate, people want to hold more money than is available. They sell bonds to get cash, which pushes bond prices down and the interest rate up. In simple terms, there is a shortage of money and rates will rise.
Excess supply of money
A situation where, at the current interest rate, people are holding more money than they want. They buy bonds with the surplus, pushing bond prices up and the interest rate down. In simple terms, there is a surplus of money and rates will fall.
Money supply curve
A vertical line on the money market diagram, because the Fed sets the quantity of money independently of the interest rate. Shifts left or right only when the Fed changes policy or conditions change the money multiplier.
Open-market operations
The Fed's buying and selling of government securities. Buying securities injects reserves into the banking system (money supply shifts right, interest rate falls). Selling securities drains reserves (money supply shifts left, interest rate rises).
Required reserve ratio
The fraction of deposits banks must hold as reserves. Raising it reduces the money multiplier and shifts the money supply curve left (interest rate rises). Lowering it does the opposite.
Discount rate
The interest rate the Fed charges banks that borrow reserves directly from it. Raising it discourages borrowing and contracts the money supply (shifts left). Lowering it does the opposite.
The money supply curve is vertical (the Fed fixes it).
The money demand curve slopes downward (higher interest rates reduce the quantity of money demanded).
Where they cross is the equilibrium interest rate.
Interest rate too high (above equilibrium): quantity of money supplied exceeds quantity demanded. People have more money than they want, so they buy bonds. Bond prices rise, and the interest rate falls back toward equilibrium.
Interest rate too low (below equilibrium): quantity of money demanded exceeds quantity supplied. People want more money than exists, so they sell bonds. Bond prices fall, and the interest rate rises back toward equilibrium.
An increase in aggregate output (GDP), the price level or transaction volume shifts money demand right → equilibrium interest rate rises (money supply unchanged).
A decrease in GDP, the price level or transactions shifts money demand left → equilibrium interest rate falls.
Important: when money demand shifts along a fixed money supply, the equilibrium quantity of money does not change (the supply curve is vertical). Only the interest rate adjusts.
The Fed buys government securities → money supply shifts right → interest rate falls and equilibrium money holdings increase.
The Fed sells government securities → money supply shifts left → interest rate rises and equilibrium money holdings decrease.
The Fed lowers the reserve requirement → money supply shifts right → interest rate falls.
The Fed raises the reserve requirement → money supply shifts left → interest rate rises.
The Fed lowers the discount rate → money supply shifts right → interest rate falls.
The Fed raises the discount rate → money supply shifts left → interest rate rises.
When both supply and demand shift in the same direction on the interest rate, the outcome is clear. When they push in opposite directions, the effect on the interest rate is ambiguous.
Money supply decreases AND GDP increases → both push the interest rate up → rate definitely rises.
Money supply decreases AND GDP decreases → supply effect pushes rate up, demand effect pushes it down → ambiguous.
Money supply increases AND GDP decreases → both push rate down → rate definitely falls (decrease in required reserve ratio + decrease in aggregate output, for instance).
Money supply increases AND GDP increases → supply pushes rate down, demand pushes rate up → ambiguous.
A surplus in the money market (excess supply) can be eliminated by the Fed decreasing the money supply, or by an increase in money demand (higher GDP, higher prices).
A shortage in the money market (excess demand) can be eliminated by an increase in money supply, a decrease in GDP, or a decrease in the price level.
No new formulas in this section, but the diagram logic is critical:
Money supply: vertical line. Shifts left/right with Fed actions.
Money demand: downward-sloping curve. Shifts left/right with changes in Y (GDP), P (price level) or volume of transactions.
Equilibrium: intersection of the two. Read the interest rate off the vertical axis and the quantity of money off the horizontal axis.
When central banks announce interest rate decisions, they are describing the outcome of open-market operations. If the Fed wants to lower its target rate, it buys government securities on the open market, which injects reserves, increases the money supply and pushes the equilibrium interest rate down. Every mortgage rate, car loan rate and credit card rate in the economy traces back, at least in part, to this mechanism.
Students often think excess demand for money pushes interest rates down. The opposite is true: excess demand means people sell bonds to get cash, which drives bond prices down and interest rates up.
Students sometimes believe that when demand shifts right along a vertical supply curve, both the interest rate and the quantity of money rise. Only the interest rate changes; the quantity of money stays the same because the supply is fixed.
Students confuse the direction of the money supply shift with the Fed's action. Remember: the Fed buying securities increases the supply (shifts right); selling decreases it (shifts left). The word "sell" and the word "shrink" both start with "s", which can help.
Students mix up the discount rate (what the Fed charges banks) with the equilibrium market interest rate. They are related but distinct.
⚠️ Be very comfortable reading money market diagrams. Most exam questions give you a figure and ask what happens at a given interest rate (surplus or shortage?) or what causes a movement between labelled points.
⚠️ Know the three Fed tools and which direction each shifts the money supply: open-market purchases (right), selling securities (left), raising reserve requirement (left), lowering reserve requirement (right), raising discount rate (left), lowering discount rate (right).
⚠️ Combined-shift questions are common. If both curves shift in the same direction on the interest rate, the effect is definite. If they push in opposite directions, the answer is "ambiguous" or "indeterminate."
⚠️ When money demand shifts but money supply is fixed, only the interest rate changes, not the equilibrium quantity of money.
True or false: An excess demand for money drives interest rates down.
False. It drives them up.
If the Fed buys government securities, the money supply shifts ________ and the interest rate ________.
Right; falls.
True or false: An increase in the price level, ceteris paribus, will increase the equilibrium interest rate.
True.
If both the money supply and GDP decrease, the effect on the equilibrium interest rate is ________.
Ambiguous (indeterminate).
At the equilibrium interest rate, firms and households are ________ with the amount of money they are holding.
Satisfied.
Q: At an interest rate above equilibrium, is there an excess demand or excess supply of money? What do firms and households do?
A: There is an excess supply of money. Firms and households buy bonds with the surplus cash, pushing bond prices up and the interest rate down toward equilibrium.
Q: At an interest rate below equilibrium, what happens?
A: There is an excess demand for money. People sell bonds to obtain cash, pushing bond prices down and the interest rate up toward equilibrium.
Q: The Fed sells government securities on the open market. What happens to the money supply curve and the equilibrium interest rate, ceteris paribus?
A: The money supply curve shifts left. The equilibrium interest rate rises.
Q: GDP increases and the Fed simultaneously sells government securities. What is the effect on the equilibrium interest rate?
A: Both changes push the interest rate upward (demand shifts right, supply shifts left), so the interest rate definitely increases.
Q: A decrease in the required reserve ratio and a decrease in aggregate output occur simultaneously. What happens to the equilibrium interest rate?
A: Both push the interest rate down (supply shifts right, demand shifts left), so the interest rate definitely decreases.
Q: An increase in the price level causes the money demand curve to shift right. If money supply is fixed, what happens to equilibrium money holdings?
A: They do not change. The money supply is vertical, so only the interest rate rises; the quantity of money stays the same.
Q: If there is a surplus in the money market, how can the Fed eliminate it?
A: By decreasing the money supply (selling government securities, raising the reserve requirement, or raising the discount rate).
Q: If there is a shortage in the money market, what are three ways it can be eliminated?
A: An increase in the money supply, a decrease in GDP, or a decrease in the price level.
The equilibrium interest rate determined here feeds directly into planned investment spending (Chapter 12). When the interest rate falls, planned investment rises, which increases aggregate expenditure and output through the multiplier. This is the transmission mechanism of monetary policy: Fed action → interest rate → investment → GDP. Understanding this section is essential for the aggregate demand/aggregate supply model later in the course.
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