7  The money market

7.1 Three motives for money demand

motive what drives it which curve effect
Transactions Need money to buy goods. Rises with Y and P. Shifts M^D when Y or P changes.
Precautionary Buffer against unexpected spending. Shifts M^D under uncertainty.
Speculative Hold money rather than bonds when bonds look unattractive. Falls with r. Movement along M^D.

Sum: M^D = f(Y, P, r). Vertical axis r, horizontal M. Downward sloping in r.

7.2 Equilibrium r^*

The Fed sets M^S (vertical line). M^D is the downward-sloping demand curve. r^* is where they cross — but the actual mechanism of adjustment runs through the bond market.

Money market equilibrium. M^S vertical, M^D downward, r* at the intersection.

When r > r^*: excess supply of money. People try to reduce money holdings by buying bonds. Bond prices rise. Bond yields fall. r falls toward r^*.

When r < r^*: excess demand for money. People sell bonds for cash. Bond prices fall. Yields rise. r rises toward r^*.

7.3 What moves M^S

Anything the Fed does. OMO purchase shifts M^S right, lowering r^*.

Expansionary OMO. M^S shifts right (Fed bought bonds), r^* falls.

7.4 What moves M^D

Income Y (transactions motive). Price level P (transactions motive). Uncertainty (precautionary). All three shift the curve.

A change in r moves you along the curve, not shift it.

Tip

The dual story. “Fed buys bonds, M^S rises, r^* falls” and “Fed bid up bond prices, so the yield-to-maturity fell” describe the same transaction. Money market and bond market are two views of one thing.

7.5 Goods market \leftrightarrow money market

The two markets equilibrate together.

Two-way feedback. Y enters M^D (transactions). r enters I^d (cost of capital). A shock anywhere ripples both ways.

7.5.1 Monetary policy transmission, end to end

  1. Fed conducts an OMO purchase.
  2. \Delta R > 0 \Rightarrow \Delta M^S = K_S \cdot \Delta R > 0.
  3. \uparrow M^S \Rightarrow \downarrow r^*.
  4. \downarrow r \Rightarrow \uparrow I^d (firms find more projects profitable).
  5. \uparrow I^d \Rightarrow \uparrow AE^d \Rightarrow \uparrow Y^* (multiplier K_I).
  6. \uparrow Y \Rightarrow \uparrow M^D (transactions). r^* rises slightly back. Partial offset.

7.5.2 Fiscal policy transmission

  1. Government raises \overline{G}.
  2. \uparrow AE^d \Rightarrow \uparrow Y^* (multiplier K_G).
  3. \uparrow Y \Rightarrow \uparrow M^D \Rightarrow \uparrow r^*.
  4. \uparrow r \Rightarrow \downarrow I^d (private investment crowded out).
  5. The crowding-out partially offsets the original boost. This is why the real-world fiscal multiplier is well below K_G.