1. The Money Market (Supply and Demand for Money)
Money Demand
What is it? MD is our demand for liquidity
it is our demand to keep some of our wealth in our wallets, purses, and checking accounts
it is NOT a request for higher wages at work
The Demand for Money: Two Components There are two sources of money demand or two reasons why do we want to hold M1 money in our wallets, purses, and in our checking account, instead of putting it in the back to earn interest. They are the (1) transactions demand and the (2) asset demand. The (3) Total demand for money (keeping money in our wallets and not in our savings account where they can earn interest) then is the transactions demand plus the asset demand. 1

2. Demand for Money
Transactions Demand – medium of exchange demand; directly related to changes in nominal GDP
Transactions Demand for Money
Definition: We keep M1 money in order to buy things
It is the demand for money as a medium of exchange
Transactions demand and nominal GDP
directly related: when GDP increases the transactions demand for money also increases (shifts to the right).
the main determinant of transactions demand is nominal GDP
Transactions demand and interest rates
we'll assume that they are unrelated, so on a graph the transactions demand looks like:

3. Demand for Money cont.
Asset Demand – store of value demand; inversely related to the interest rate
Asset demand
Definition: we keep some money so that we can spend it later
the demand for money as a store of value
What determines how much money (M1) we keep in our wallets, purses, and checking accounts?
The problem with holding money: is that you are not earning interest on it
Asset demand and interest rates are inversely related
if interest rates are high, people will keep less in their pockets and more in their savings accounts (and in other interest earning assets)
if interest rates are low, people will keep more money in their pockets, because they are not losing much and it is more convenient
According to this graph, if interest rates on savings accounts are 10%, the quantity of money that we STORE in our wallets and checking accounts will be zero. Note: we would still keep some to buy things (transactions demand).

4. Demand for Money cont.
Total Money Demand – transaction + asset directly related to nominal GDP
Total Money Demand
Total MD = transactions demand + asset demand
Graphically: The black vertical D1 is the transactions demand and the black, downward sloping D2 is the asset demand. If we add them together we get the blue total demand for money.

5. The Demand for Money
At any given time, people demand a certain amount of liquid assets (money) for everyday purchases
The Demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded
1. What happens to the quantity demanded of money when interest rates increase?
Quantity demanded falls because individuals would prefer to have interest earning assets instead
2. What happens to the quantity demanded when interest rates decrease?
Quantity demanded increases. There is no incentive to convert cash into interest earning assets 8

6. Nominal Interest Rate (ir)
The Demand for Money
Inverse relationship between interest rates and the quantity of money demanded
Nominal Interest Rate (ir)
20% 5% 2%
DMoney
Quantity of Money
(billions of dollars) 9

7. What happens if price level increase? Nominal Interest Rate (ir)
The Demand for Money
What happens if price level increase?
Money Demand Shifters
Changes in price level
Changes in income
Changes in taxation that affects personal investment
Nominal Interest Rate (ir)
20% 5% 2%
DMoney1
DMoney
Quantity of Money
(billions of dollars) 10

8. This is called Monetary Policy.
The Supply for Money
The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED)
Interest Rate (ir)
SMoney
The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy
This is called Monetary Policy.
20% 5% 2%
illustrates the money market. It combines demand with supply of money. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest.
If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds. Bond prices rise, and lower market rates of interest result
The equilibrium interest rate then is where the MS an MD graphs cross
We will make a simplifying assumption that the supply of money is set by Federal Reserve policy, and is therefore shown graphically as a vertical line.
Adjustments to a Decrease in the Supply of Money — When the supply of money decreases (shifts to the left) the interest rate goes up.
Adjustments to an Increase in the Supply of Money — When the supply of money increases (shifts to the right) the interest rate goes down.
Adjustments to a Decrease in the Demand for Money — When the demand for money decreases (shifts to the left) the interest rate falls.
Adjustments to an Increase in the Demand for Money — When the demand for money increases (shifts to the right) the interest rate goes up.
DMoney
200
Quantity of Money
(billions of dollars) 12

9. What would happen if there were a decrease in the Supply of Money from SM to SM’? If you stay at the old interest rate of i˳ when the supply of money falls, then the demand for money will exceed the supply of money. What would you do if you were running a bank and more people came in demanded money than there were coming in and supplying money? Wouldn’t your natural reaction be to increase the interest rate in the hope that the higher interest rate would decrease the demand for money? Remember that at a higher interest rate, the asset demand for money will be less. As the interest rate goes up, the demand for money and the supply of money will eventually come into equilibrium again at a higher interest rate, say i*. 

10. Why are there so many interest rates?
Our previous discussion referred to the interest rate as though there was only one in the economy. The reality is that there are many interest rates. The interest rate on your credit card is different than the interest rate for a car loan, which is different than the rate you might be charged on a home loan. Let’s consider four factors that will influence the interest in any given situation.
Term or maturity
Shorter term loans have a lower i
Longer term loans have a higher i
Risk
Riskier loans have a higher i
Safer loans have a lower i
Liquidity
Liquid loans have a lower i
Illiquid loans have a higher i
Administrative Costs
Loans that have a high cost to administer have a higher i
Loans that have a low cost to administer have a lower i