The Market for Money

In micro, money barely showed up at all. In Keynes's macro, the money market sets the interest rate.

People like holding money because it is handy. The more nervous they feel, the more they hold. The central bank fixes how much money exists. The rate settles where the two meet, as the formulas below show. Print more money, and the rate falls.

For example, the whole class together carries a fixed pile of 💰 cash. On field-trip day everyone wants to carry more, so cash gets scarce. Scarce cash means borrowing it costs more — a higher interest rate.

L(r)=L0+kY−hrL(r) = L_0 + k Y - h r
r∗=L0+kY−M/Phr^* = \frac{L_0 + k Y - M/P}{h}

Part of these learning paths

Examples & Exercises

Compute

The central bank raises the real money supply from M/P=90M/P = 90 to 110110 (income stays at Y=200Y = 200).

How far does the interest rate move?

Money 110110, income 200200 — rate 3%3\%.
Show proof

  1. Before, r∗=(L0+kY−M/P)/h=(40+0.5⋅200−90)/10=5r^* = (L_0 + k Y - M/P) / h = (40 + 0.5 \cdot 200 - 90) / 10 = 5. With money at 110110, r∗=(140−110)/10=3r^* = (140 - 110) / 10 = 3.

  2. The move is Δr=−Δ(M/P)/h=−20/10=−2\Delta r = -\Delta (M/P) / h = -20 / 10 = -2 points.

    When money is plentiful, the price of borrowing it falls too — the liquidity effect.

    And at this rate the loanable-funds investment curve I=100−6rI = 100 - 6r points to 8282, so monetary policy reaches aggregate demand through investment.

Answer

r∗=3%r^* = 3\%

Concept check

A boom lifts income from Y=200Y = 200 to 240240 (money stays at M/P=90M/P = 90).

The central bank did nothing — why does the interest rate move anyway?

Money 9090, income 240240 — rate 7%7\%.
  1. The central bank quietly cut the money supply
  2. Higher income raises saving, which shrinks the supply of loanable funds
  3. Higher income raises the transactions demand for money, and with supply fixed the interest rate rises to restore equilibrium
  4. Higher income lowers money demand, which pushes the interest rate up
Show explanation

Answer: Higher income raises the transactions demand for money, and with supply fixed the interest rate rises to restore equilibrium

The money-demand intercept rises to 40+0.5⋅240=16040 + 0.5 \cdot 240 = 160 while supply stays at M/P=90M/P = 90, so equilibrium is r∗=(160−90)/10=7%r^* = (160 - 90) / 10 = 7\%. The central bank did nothing and the money supply never fell. This scene is the money market, not loanable funds, so a saving-curve shift cannot explain the move — and money demand rises, not falls, with income, because more spending needs more money held for transactions.

5. Where the Interest Rate Is Decided