International Finance Theory and Policy
by Steven M. Suranovic
Finance 40-8
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Money Market Equilibrium StoriesAny equilibrium in economics has an associated behavioral story to explain the forces that will move the endogenous variable to the equilibrium value. In the money market model the endogenous variable is the interest rate. This is the variable that will change to achieve the equilibrium. Variables that do not change in the adjustment to the equilibrium are the exogenous variables. In this model, the exogenous variables are P$, Y$, and MS$ . Changes in the exogenous variables are necessary to cause an adjustment to a new equilibrium. However, in telling an equilibrium story it is typical to simply assume that the endogenous variable is not at the equilibrium (for some unstated reason), and then to explain how and why the variable will adjust to the equilibrium value. Suppose that for some reason the actual interest rate, i'$
lies below the equilibrium interest rate, i$
, as shown on the adjoining diagram. At i'$,
real money demand is given by the value A along the horizontal axis, while
real money supply is given by the value B. Since A is to the right of
B, real demand for money exceeds the real money supply. This means that
people and businesses wish to be holding more If the actual interest rate is higher than the equilibrium rate, for some unspecified reason, then the opposite adjustment will occur. In this case, real money supply will exceed real money demand meaning that the amount of assets or wealth people and businesses are holding in a liquid, spendable form is greater than the amount they would like to be holding. The behavioral response would be to convert assets from money into interest bearing non-money deposits. A typical transaction would be if a person deposits some of the cash in their wallet into their savings account. This transaction would reduce money holdings since currency in circulation is reduced, but will increase the amount of funds available to loan out by the banks. The increase in loanable funds, in the face of constant demand for loans, will inspire banks to lower interest rates to stimulate the demand for loans. However, as interest rates fall, the demand for money will rise until it equalizes again with money supply. Through this mechanism average interest rates will fall, whenever money supply exceeds money demand. International Finance Theory and Policy - Chapter 40-8: Last Updated on 1/11/05 |