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The Money Market

The money market comprises the demand for money and the money supply. The equilibrium in the money market is such a state of balance when the demand for money from household and businesses is satisfied by the quantity of the money supplied. The equilibrium in the money market is reached by changing bond prices.

People can hold their wealth in various forms – money, equities and property. For simplicity we assume that there are only two assets: money, the medium of exchange that pays no interest, and bonds, which we use to stand for all other interest – bearing assets that are not directly a means of payment. As people earn income, they add to their wealth. As they spend, they deplete their wealth. How should people divide their wealth at any instant between money and bonds to gain the best profits possible and not to incur losses?

There is an obvious cost of holding money. The opportunity cost of holding money is the interest one would have gained if he (or she) had held bonds. It naturally follows that people will hold money rather than bonds only if there is a benefit to offset this cost, only if holding money is more profitable than holding bonds. It may happen only when interest rates on bonds are too low to make it profitable to hold bonds.

Suppose the money market is in equilibrium when the interest rate on interest - bearing assets is 6% and the amount of money demanded is € 200 mln. Now suppose the interest rate goes down, say, to 4%. In this case interest – bearing assets are no longer profitable as they can’t earn a sufficient return. Hence the demand for money will rise and lead to a temporary lack of money in the money market. If they lack money, households and businesses are likely to sell bonds they possess for cash. That will cause an increase in the bond supply which lowers bond prices and rises interest rates on interest – bearing assets. With a higher interest rate the amount of money people are willing to have in hand will decrease again. Consequently, the money supply will adjust to a current demand to reflect a new higher interest rate.

Answer the questions:

1. What is the equilibrium in the money market?
2. How is the equilibrium in the money market achieved?
3. What are the various forms people can hold their wealth in?
4. When will the demand for money rise and lead to a temporary lack of money?
5. When are households and businesses likely to sell bonds they possess for cash?

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