IB DP Economics - Unit 3 - Demand and supply of money-Study Notes - New Syllabus

Demand and Supply of Money — Determination of Equilibrium Interest Rates

The rate of interest in an economy is determined through the interaction of:

• Demand for money
• Supply of money

The money market explains how equilibrium interest rates are established.

Interest rates play an important role in influencing:

• Consumption
• Investment
• Saving
• Aggregate demand
• Economic growth

The Money Market

The money market is the market where the demand for money interacts with the supply of money.

The equilibrium interest rate is determined where:

Money demand = Money supply

Demand for Money

Demand for money refers to the amount of money people wish to hold rather than use for spending or investing.

People demand money mainly because money is needed for transactions and financial security.

Motives for Holding Money

According to Keynesian theory, there are three main motives for demanding money:

• Transactions motive
• Precautionary motive
• Speculative motive

1. Transactions Motive

People hold money to carry out everyday purchases of:

• Goods
• Services

The transactions demand for money depends mainly on:

• Level of income
• Level of economic activity

Relationship with Income

As income increases:

• People buy more goods and services.
• Demand for money increases.

Income ↑ → Transactions demand for money ↑

2. Precautionary Motive

People also hold money for unexpected situations such as:

• Medical emergencies
• Unexpected expenses
• Income uncertainty

Higher income usually increases precautionary money demand.

3. Speculative Motive

People may hold money instead of financial assets if they expect:

• Bond prices to fall
• Interest rates to rise in the future

The speculative demand for money depends mainly on interest rates.

Relationship Between Interest Rates and Speculative Demand

When interest rates are low:

• People may expect rates to rise later.
• Bond prices may fall in the future.
• People prefer holding money instead of bonds.

Result:

• Money demand increases.

Inverse Relationship Between Interest Rates and Money Demand

The overall demand for money usually has an inverse relationship with interest rates.

Interest rate ↑ → Demand for money ↓

Interest rate ↓ → Demand for money ↑

Why Higher Interest Rates Reduce Money Demand

Higher interest rates increase the opportunity cost of holding money.

People may prefer to hold:

• Bonds
• Savings accounts
• Financial assets

instead of holding cash.

Supply of Money

Money supply refers to the total quantity of money available in the economy.

The supply of money is mainly controlled by the central bank through monetary policy.

Characteristics of Money Supply

In many economic models, the money supply is shown as fixed at a given point in time.

This means the money supply curve is vertical.

Why the Money Supply Curve is Vertical

The central bank determines the quantity of money supplied independently of interest rates.

Therefore:

• The money supply does not automatically change when interest rates change.

Equilibrium Interest Rate

The equilibrium interest rate occurs where:

Demand for money = Supply of money

At equilibrium:

• The amount of money people wish to hold equals the amount supplied.

Money Market Equilibrium

If:

Money demand > Money supply

there is excess demand for money.

This pushes interest rates upward.

Why Interest Rates Rise

People sell financial assets to obtain money.

Bond prices fall and interest rates rise.

If Money Supply Exceeds Money Demand

If:

Money supply > Money demand

there is excess supply of money.

People use excess money to buy financial assets.

Bond prices rise and interest rates fall.

Graphical Interpretation 

In the money market diagram:

• The vertical axis shows interest rates.
• The horizontal axis shows quantity of money.
• The money demand curve slopes downward.
• The money supply curve is vertical.

The intersection determines equilibrium interest rates.

Shifts in Money Demand

The demand for money may shift because of changes in:

• Income
• Economic activity
• Price level
• Consumer expectations

Increase in Money Demand

If money demand increases:

• The money demand curve shifts right.
• Interest rates rise.

Example:

Higher national income increases transactions demand for money.

Decrease in Money Demand

If money demand decreases:

• The money demand curve shifts left.
• Interest rates fall.

Shifts in Money Supply

The central bank may change money supply through monetary policy.

Increase in Money Supply

If the central bank increases money supply:

• The money supply curve shifts right.
• Interest rates decrease.

Result:

• Borrowing and investment may increase.

Decrease in Money Supply

If the central bank reduces money supply:

• The money supply curve shifts left.
• Interest rates rise.

Result:

• Borrowing and spending may decrease.

Importance of Interest Rates

Interest rates affect:

• Consumption
• Investment
• Saving
• Exchange rates
• Aggregate demand

Therefore, equilibrium interest rates are important for overall economic stability.

Liquidity Trap

A liquidity trap occurs when interest rates are extremely low and people prefer holding cash instead of financial assets.

In this situation:

• Expansionary monetary policy may become less effective.

Comparison of Changes in the Money Market

Summary of Money Demand Motives

Key Ideas:

• Interest rates are determined by demand and supply of money.
• Money demand has transactions, precautionary, and speculative motives.
• Money demand usually has an inverse relationship with interest rates.
• The central bank controls money supply through monetary policy.
• Equilibrium interest rates occur where money demand equals money supply.