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The Money Market
The money market consists of the demand for money (MD) and the supply of money (MS). The
Fed determines the quantity of money supplied. Since it is determined by the Fed, the money supply is
independent of the interest rate, and the money supply curve is a verticalline.
[] Transactions demand-- to make purchases of goods and services
[] Precautionary demand -- to serve as protection against an unexpected need
[] Speculative demand-- to serve as a store of wealth
The demand for money is a function of interest rates and income, The interest rate is the opportunity
cost of holding money because it represents the forgone interest income that was given up in order to
hold money. The demand for money has an inverse relationship with the interest rate. As the interest rate
increases, the opportunity cost of holding money increases and people hold less money. As the interest
rate falls, the opportunity cost of holding money falls and people hold more money. The negatively sloped
demand curve for money represents the quantity of money demanded at various interest rates.
The demand for money is based on a decision by consumers to hold wealth in the form of interest-
bearing assets (e.g. savings accounts) or as money (noninterest-bearing). There are three types of money
demand, based on the three basic motives people have for holding money (rather than interest-bearing
assets).
The quantity of money (e.g., M1) is determined by the Federal Reserve (the Fed) through its control of
the reserve requirement and money creation by the banldng system. The price of money is the interest
rate. The interest rate is the price of money because it is what borrowers must pay to obtain money
and it is also the opportunity cost of holding rdoney rather than loaning it out.
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The Money Market
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QUANTITY OF MONEY
Advanced Placement Economics Macroeconomics: Student Resource Manual © Council for EconomAc Education, New York, N,Y,
137
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