Money Market Graph with Demand, Supply and Equilibrium

Money market graph shows the money market demand and supply forces and equilibrium of the money market.

What is money market?

Money market presents two major forces. They are actual supply of money and actual demand of money.

What is the interest rate on money market graph?

Money supply and money demand is decided by the interest rate

The supply of debt instruments on money increases as the interest rate rises. The existence of these tools allows for the “supply” of money to be captured. So, there is a positive relationship between the interest rate and money supply.

In contrast, because borrowing money is more costly when interest rates are high, demand generally declines, balancing the market. So, there is a negative relationship between the interest rate and money supply.

Money demand

Households, businesses, and governments that use money as a medium of trade and a store of value are the sources of the demand for it. According to the law of demand, as interest rates rise, less money is demanded since storing money has an opportunity cost associated with it. In other words, money is less useful as a store of value when interest rates are higher. On the other hand, when interest rates decrease, the demand for money is increasing. As a result of the high money demand, the real output of an economy rises.

Let’s understand the concept of money demand using an example.

Assume that you have $2500 in your hand. You can invest these money in bonds or spend these money to buy consumption goods. If you invest these money in bonds, you will receive 10 percent interest income at the end of year. You cannot invest your all money in bonds. They you do not have any money to spend and you have to be in hungry. On the other hand, if you spend all of these money to buy consumption goods, you do not receive any interest income. So, you decide trade off between two options. As examples, you spend $1000 and you invest $1500 in bonds.

Interest rate is a direct factor that determine the demand of money. If the interest rate is high, people spend less money and invest more money on bonds. So, they decrease demand for money. If the interest rate is low, people spend more money and invest less money on bonds. So, they increase demand for money.

Finally, we can decide there is a negative relationship between the money demand and interest rate. Following money demand curve shows the negative relationship between interest rate and money demand.

Money supply

The money supply curve shows the relationship between the quantity of money supplied and market interest rate. A county’s money supply curve is a vertical line. It is not an upward or downward curve. Because the money supply is not depend on the interest rate. The money supply of a country is determined by the size of the money base and the money multiplier. The size of the money base is typically decided by the nation’s central bank. Keep in mind that the money base consists of both currency in circulation outside of banks and reserves in vaults. To alter the money base, for instance, central banks might change the reserve requirements.

The following graph shows the money supply of a country.

Money market graph – equilibrium

Any market reaches equilibrium when the amount supplied and demanded are equal. Prices change until the market is balanced. This is also true of the money market. Here, the nominal interest rate is similar to the price of the curve (vertical axis).

The following money market graph shows the money market demand and supply forces and the equilibrium of the money market. The horizontal axis of the money market shows the quantity of money and the vertical axis shows the nominal interest rate. When money demand equals the money supply, money market equilibrium is occurred (at point E1).

According to the following money market graph, when the nominal interest rate is higher than the equilibrium interest rate, the money supply exceeds the money demand. So, the nominal interest rate is decreasing and then people increase the demand for money. Finally, the money market comes to the equilibrium point.

On the other hand, as mentioned in the following money market graph, when the nominal interest rate is lower than the equilibrium interest rate, the money demand exceeds the money supply. So, the nominal interest rate is increasing and then people decrease the demand for money. Finally, the money market comes to the equilibrium point.