MONEY MARKET

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The demand for money has two components: transactional demand and asset demand.

Transactional demand (Dt) is money kept for purchases and will vary directly with GDP.

Asset demand (Da) is money kept as a store of value for later use. . Asset demand varies inversely with the interest rate, since that is the price of holding idle money.

Total demand for money will equal quantities of money demanded for assets plus that for transactions. The demand curve for money illustrates the inverse relationship between the quantity demanded of money and the interest rate.

 

The supply of money is a vertical line, suggesting the quantity of money is fixed at a level largely determined by the Fed.

Equilibrium in the money market exists when the quantity demanded of money equals the quantity supplied.

In the above graph, it shows an equilibrium of the money market at interest rate of 6%, and quantity of money at 600 billions. The vertical curve indicates the money supply decided by the Federal Reserve.

At any interest rate above the equilibrium rate, there is an excess supply of money. At any interest rate below the equilibrium rate, there is an excess demand of money.

Fed can influence the market interest rate by adjusting the money supply. If the money supply increases (moving the vertical curve in the above graph towards the right), the interception point will demonstrate a lower interest rate in the market. If the money supply decreases  (moving the vertical curve in the above graph towards the left), the interception point will  demonstrate a higher interest rate. Therefore, market's interest rate is closely related to the monetary policy of the Fed. 

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