IBonomicsInterest Rate Determination – Money Market EquilibriumHL
MacroeconomicsThis diagram shows how the equilibrium interest rate is determined in the money market by the interaction of money demand and money supply.
Curves and elements
- Dm
- The demand for money, downward-sloping: it decreases with higher interest rates.
- Sm
- The supply of money: vertical, fixed by the central bank.
- ie
- The equilibrium interest rate, where Dm intersects Sm.
- Qe
- The quantity of money at the equilibrium interest rate.
Key explanations
- 1
The vertical yellow line (Sm) represents the money supply, which is perfectly inelastic and determined by the central bank.
- 2
The downward-sloping blue line (Dm) represents the demand for money, which decreases as the interest rate rises.
- 3
The equilibrium interest rate (ie) is where money demand equals money supply, at quantity of money Qe.
- 4
Changes in the money supply (shifts in Sm) can be used as a tool of monetary policy to influence interest rates and thus aggregate demand.
- 5
An increase in the money supply shifts Sm to the right, lowering the interest rate and stimulating investment and consumption.
Example exam question
Using a money market diagram, explain how central banks use monetary policy to influence interest rates.
Show example answer
In the money market diagram, the vertical Sm line represents the fixed money supply. If the central bank increases the money supply, Sm shifts right. This leads to a lower equilibrium interest rate (ie), encouraging borrowing and spending. This is an example of expansionary monetary policy.
