Changes in money market equilibrium, Macroeconomics

Changes in Money Market Equilibrium

A shift in either the supply curve for money or the demand curve for money will alter the equilibrium position in the money market (and the bond market). These shifts are examined in Figure.

A Fall in the Money Supply: Suppose the central bank reduces the money supply, either by undertaking an open market sale of securities to reduce the money monetary base or by taking steps to make banks increase their cash reserve ratios and reduce the value of the money multiplier. Given our assumption that the price level is given, this contraction in the nominal money supply will also reduce the real money supply. Figure shows this as a leftward shift in the supply curve. The real money stock falls from L0 to Lé. The equilibrium interest rate rises from r0 to ré. It takes a higher interest rate to reduce the demand for real balances in line with the lower quantity supplied. Hence a reduction in the real money supply leads to an increase in the equilibrium interest rate. Conversely, an increase in the real money supply reduces the equilibrium interest rate. It takes a lower interest rate to induce people to hold larger real money balances.

Figure: A fall in real money supply

1696_changes in equilibrium.png

Increase in Real Income: In Figure we draw the demand curve for real balances LL for a given level of real income. As we explained in Figure, an increase in real income increases the marginal benefit of holding money at each interest rate, and increases the quantity of real balances demanded. Hence in the figure we show the money demand schedule LL shifting to the right, to LL", when real income increases. Since people wish to hold more real balances at each interest rate, the equilibrium interest rate must rise from r0 to r" to keep the quantity of real supply L0. Conversely, a reduction in real income will shift the LL schedule to the left and reduce the equilibrium interest rate.

Figure : An increase in demand for real balances

1951_changes in equilibrium1.png

To sum up, an increase in the real money supply reduces the equilibrium interest rate. A lower interest rate reduces the attractiveness of bonds and induces people to switch from bonds to money. It is necessary to induce people to hold the higher real money stock. An increase in real income increases the equilibrium interest rate. A higher interest rate offsets the tendency of higher real income to increase the quantity of real money balances demanded, and thus maintains the demand for real balances in line with the unchanged supply.

Posted Date: 9/18/2012 6:40:14 AM | Location : United States







Related Discussions:- Changes in money market equilibrium, Assignment Help, Ask Question on Changes in money market equilibrium, Get Answer, Expert's Help, Changes in money market equilibrium Discussions

Write discussion on Changes in money market equilibrium
Your posts are moderated
Related Questions
estimate paper by stock and watson in a bayesian manner

Trade-FDI Nexus: Economic liberalization promotes both trade and FDI. FDI could be export-promoting, import substituting or import enhancing depending upon supply and demand f

what are the factors effecting reciprocal demand?

Factors Responsible for changes in Aggregate Supply We know that changes in input costs such as wages, oil and other input prices will cause changes in aggregate supply. Most


Determine Why banks raise their interest rates A way to explain why banks raise their interest rates is as follows. With higher overnight interest rates, it is more expensive fo

Augmented Saving An alternative way of determining equilibrium  GDP  is to find the level of income where the sum of desired injections equals the sum of desired leakages. Desi

One of our clients is a major homebuilder in the Midwest. This company believes that sales of their new homes are highly correlated with business cycles in the overall US economy.

At first, it may seem obvious that consumption will rely on Y. If GDP is doubled in real terms over a number of years, government consumption, private consumption and investment wi

what reasons limit the bargaining power of trade union in developing countries