Like any good, money has a supply and a demand. The "price" of holding money is the interest you give up by not holding a bond instead. Use what you know about shifts and equilibrium, the money supply and nominal interest rates.
Key idea
In the money market, the nominal interest rate is on the vertical axis. The money supply is vertical, set by the central bank. Money demand slopes down: at a higher interest rate people hold less money. Where they cross sets the nominal interest rate. More money supply lowers the rate; more money demand (from a higher price level or more real GDP) raises it.
Why it works
People hold money because it is handy for buying things, but cash and checking balances earn little or no interest. The higher the interest rate on bonds, the more it costs to keep wealth in money, so people hold less: money demand slopes down. A change in the interest rate moves people along money demand. Money demand shifts when people need more money at every rate: a higher price level means each purchase takes more dollars, and more real GDP means more purchases. The central bank fixes the quantity of money whatever the rate, so supply is vertical.
Worked examples
Worked example: Which curve shifts?
What happens to the nominal interest rate? (a) The central bank buys bonds. (b) The price level rises.
- (a) Buying bonds adds money: supply shifts right, and the interest rate falls.
- (b) Each purchase takes more money: demand shifts right, and with supply fixed, the interest rate rises.
Answer: (a) falls; (b) rises
Worked example: With numbers
Money demand is $i = 10 - \dfrac{M}{100}$ ($i$ in percent, $M$ in billions). The money supply rises from 400 to 500.
- Before: $i = 10 - 4 = 6\%$.
- After: $i = 10 - 5 = 5\%$: a movement along money demand.
Answer: From 6% to 5%
Common mistake
Drawing the money supply sloping up instead of vertical, or shifting money demand when the interest rate changes, which is a movement along it. Check: the interest rate is on the axis, so its changes are movements; only the price level, real GDP and similar factors shift money demand.