3.5.5 Demand and supply of money (HL only) Notes

Determining Interest Rate

The interest rate is determined in the money market through the equilibrium of the demand and supply of money.

1. As observed in the diagram above, the:
   1. X-axis measures the quantity of money
   2. Y-axis measures the interest rate
2. At the equilibrium, the interest rate is at $i_1$ and the quantity of money demanded is at $Q_1$.
3. The money supply is vertical (and is always vertical), as it is fixed at a level determined by the central bank.
4. Now we can view the inverse relationship between the rate of interest and the quantity of money where: as the rate of interest falls, the quantity of money demanded increases.

Demand for Money

The demand for money refers to the desire to hold money rather than investing it.

1. As observed in the diagram presented above, the demand curve for money ($D_{money}$) is downwards sloping.
2. This is because:
   1. If the interest rates are higher (there is high return on savings):
      1. Individuals have less incentive to hold on to cash.
      2. Therefore, the quantity demanded for money will decrease.
   2. If the interest rates are lower (there is low return on savings):
      1. Individuals have less incentive to keep their money in the bank, and they are incentivised to spend it.
      2. Therefore, the quantity demanded for money will increase.

Supply of Money

1. Mentioned before, the supply of money is fixed by the central bank.
2. However, if the central bank decides to change the supply of money, the supply curve will shift, hence affecting the interest rate.

1. Observed in the diagram above:
   1. Initially, the supply of money is $Sm_1$ and demand for money is $Dm_1$, the interest rate is $i_1$, and quantity of money demanded is at $Q_1$.
   2. If the supply of money is increased, the supply curve will shift to the right, to $Sm_2$, where the interest rate decreases to $i_2$, and quantity of money demanded increases to $Q_2$.
   3. If the supply of money is decreased, the supply curve will shift to the left, to $Sm_3$, where the interest rate increases to $i_3$, and quantity of money demanded decreases to $Q_3$.