Equilibrium in Money Markets
Having dealt with the forces that determine the supply of money and demand for money, let us combine supply of and demand for money to determine equilibrium in money markets.
The money markets will be in equilibrium when the quantity of real balances demanded equals the quantity supplied.
The real money supply is the nominal money supply divided by the price level. The central bank controls the nominal money supply. The central bank could be assumed to control the real money supply if, for theoretical purposes, we assume the prices of goods to be fixed. The nominal money supply i.e. currency with public and deposit money with public equals the monetary base or high powered money (i.e. currency plus commercial banks' deposits at the bank) multiplied by the money multiplier.
Demand for money is the demand for real money balances. The quantity of real money demanded increases with the level of real income but decreases with the level of nominal interest rates.
Figure 7.1 shows the demand curve LL for real money balances for a given level of real income.
The higher the interest rate and the opportunity cost of holding money, the lower the quantity of real money balances demanded. With a given price level, the central bank controls the quantity of nominal money and real money. The supply curve is vertical at this quantity of real money L0. Equilibrium is at the point E. At the interest rate r0 the quantity of real money that people wish to hold just equals the outstanding stock L0.
Suppose the interest rate is r1, lower than the equilibrium level r0. There is an excess demand for money given by the distance AB in Figure 7.1. How does this excess demand for money bid the interest rate up from r1 to r0 to restore equilibrium? The answer to this question is rather subtle.
A market for money would involve buying and selling rupees with other rupees, which makes no sense.
The other market of relevance to Figure 7.1 is the market for bonds. In saying that the interest rate is the opportunity cost of holding money, we are saying that people who do not hold money will hold bonds instead.
Thus, the stock of real wealth W is equal to the total outstanding stock or supply of real money L0 and real bonds B0. People have to decide how they wish to divide up their total wealth W between desired real bond holdings BD and desired real money holdings LD. Whatever factors determine this division, it must be true that
L0 + B0 = W = LD + BD ...(7.14)
The total supply of real assets determines the wealth to be divided between real money and real bonds. And people cannot plan to divide up wealth they do not have. Since the left-hand side of equation (7.14) must equal the right-hand side, it follows that
B0 - BD = LD - L0 ...(7.15)
An excess demand for money must be exactly matched by an excess supply of bonds. Otherwise people would be planning to hold more wealth than they actually possess.
This insight allows us to explain how an excess demand for money at the interest rate r1 in Figure 7.1 sets in motion forces that will bid up the interest rate to its equilibrium level r0. With excess demand for money, there is an excess supply of bonds. To induce people to hold more bonds, suppliers of bonds must offer a higher interest rate. As the interest rate rises, people switch out of money and into bonds. The higher interest rate reduces both the excess supply of bonds and the excess demand for money. At the interest rate r0 the supply and demand for money are equal. Since the excess demand for money is zero, the excess supply of bonds is also zero. The money market is in equilibrium only when the bond market is also in equilibrium. People wish to divide their wealth in precisely the ratio of the relative supplies of money and bonds.