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
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
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.