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Money, banks and the money market

The interest rate is the price of money. A central bank can't set money demand, but it can move the money supply, and where the two curves cross sets the interest rate.

The market for money

Money demand slopes down: a high interest rate makes holding cash expensive, because you give up the interest you could earn, so people hold less of it. Money supply is a policy choice, so it is drawn as a vertical line. The rate where they cross clears the money market.

Higher nominal GDP means more transactions and more cash needed, which shifts money demand right and pushes the interest rate up, unless the central bank responds.

The direction rule

Central bank tools all point one way or the other:

• Expand the money supply (rates fall): buy bonds in the open market, cut the reserve ratio, cut the discount rate.
• Contract the money supply (rates rise): sell bonds, raise the reserve ratio, raise the discount rate.

Some central banks, including the Bank of Canada, no longer use reserve requirements and steer a short-term interest rate directly, but the textbook tools still show the logic.

Bond prices and interest rates

Bond prices and interest rates move in opposite directions. A bond promises fixed payments, so when market rates rise, existing bonds become less attractive and their prices fall. A bond that pays $50 a year forever is worth $1,000 when the interest rate is 5%, but only $500 if the rate jumps to 10%.

That is why a central bank buying bonds lowers interest rates: its demand pushes bond prices up, and a higher price means a lower yield.

The deposit multiplier

Banks keep only a fraction of deposits as reserves and lend the rest, and those loans end up as new deposits somewhere else. With a required reserve ratio rr, the simple deposit multiplier is 1 / rr. At rr = 10% the multiplier is 10, so $100 of new reserves can support up to $1,000 of deposits.

Real-world expansion is smaller if banks hold excess reserves or the public keeps some of its money as cash. Both are leakages from the lending chain.

Common exam traps

• Getting the direction wrong: an open market purchase expands the money supply; a sale contracts it.
• Forgetting that bond prices and interest rates move in opposite directions.
• Drawing money supply with a slope. It is vertical because the central bank sets it.
• Confusing the deposit multiplier (1 / rr) with the spending multiplier (1 / (1 − MPC)).

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