Money, Banking, and Monetary Policy ❮ 145MSMDMoneyNominal
interest
rate, i %^M*i *MDtMD = MDt + MDa
MDa
MoneyNominal
interest
rate, i %MDtMDtFigure 11.1Figure 11.2The Money Market
The central bank, having established a given level of money supply circulating in the
economy, allows us to incorporate a vertical money supply (MS) curve with a downward-
sloping money demand curve to complete the money market. John Maynard Keynes
developed the theory of liquidity preference, which postulates that the equilibrium “price”
of money is the interest rate where money supply intersects money demand. Just like any
market, if the price is below equilibrium (a shortage), the price must rise, and if the price
is above equilibrium (a surplus), the price must fall. Money demand can increase if more
transactions are being made, but the real focus of the rest of this chapter is on changes in
money supply. Equilibrium is shown in Figure 11.2.Asset Demand. Money can be held as an asset at very little risk. If you put money under your
mattress, there is the advantage of knowing that a crashing stock market or real estate market
does not diminish the value of this asset. The main disadvantage of putting this asset under your
mattress is that it cannot earn any interest as it would were you to invest that money in bonds,
for example. As the interest rate on bonds rises, the opportunity cost of holding money under
your mattress begins to rise, and so you are more likely to lessen your asset demand for money.
At a lower interest rate on bonds, you are more likely to increase your asset demand for money.
Total Demand. Plotted against the nominal interest rate, the transaction demand for
money is a constant MDt. Adding this constant amount of money needed to make trans-
actions to a downward-sloping asset demand for money (MDa) provides us with the total
money demand curve. This is seen in Figure 11.1.TIP