Equilibrium nominal interest rates in the money market | AP Macroeconomics | Khan Academy

So we've spent a lot of time justifying why we have this downward sloping demand curve for money, but you're probably asking, "Well, this is a market. What we need to think about an equilibrium point?" And to do that, we need to think about the supply of money.

In previous videos, we've started thinking about the supply of money and we'll think more in future videos about different monetary policies. But in a classical model, we assume a perfectly inelastic supply of money, so we draw it as a vertical line, which is another way of saying that the supply of money is not impacted by the nominal interest rate.

So this is the supply of money. I'll call that money supply one, where it intersects the quantity of money. I'll just call that m sub 1 right over here. The point where it intersects is the equilibrium point in our money market. The equilibrium nominal interest rate right over here we could call r1. This would be the opportunity cost for holding money.

Now, I have to give a little bit of a disclaimer. This is a classical model here, and we'll talk more about it in future videos. Most introductory economics classes talk about this classical model where the central bank might set the supply of money, and that doesn't change according to the nominal interest rate. Then the nominal interest rate gets set, essentially, by this equilibrium point.

Now, in the world that we live in, it actually goes the other way around. Central banks actually target a nominal interest rate. If the central bank is able to achieve that target interest rate, well, that's going to impact the actual quantity of money. So keep that little disclaimer in the back of your mind, but in an introductory economics class, we assume this world.

So now that we have this neat little model for our money market, let's think about what would happen in different situations. Let's think about a situation where, for whatever reason, people lose confidence in the electrical grid. What would happen to the demand curve for money? Let's call this the md sub 1.

Pause this video and think about it. Well, if people lose trust in the electrical grid, then this precautionary motive for holding money becomes stronger. Regardless of what the opportunity cost is of holding money, people would want to hold more of it because, like, "Hey, you know, I don't know if I'll be able to access money if the lights go out again. I'm not going to be able to go to the ATM or the banks are going to close."

So at any nominal interest rate, I would, or an aggregate, people are going to want to hold more money. That would shift the demand curve for money to the right. I could have drawn it a little less hairy, but there you go; that would be md sub 2. We have this shift to the right.

Then, if that happened, if you had this demand for money increase, well, then what happens to the actual equilibrium nominal interest rate? If you look at this point right over here, assuming that the quantity of money has not changed, you have a new equilibrium interest rate—nominal interest rate—it has gone up.

That makes sense. If more people want to hold money, in order to get people to part with that money, you have to offer them more. The opportunity cost of holding that money has to go up. You can imagine the reverse scenario. If, for some reason, people thought it's a lot less likely that the lights are going to go out, or they said, "You know, I don't need as much cash around for transactions, or I'm not really into speculation," well, then the demand curve for money would shift to the left.

In that situation, you would have a decrease in the equilibrium nominal interest rate. I will leave you there. Always keep these models with a grain of salt. There are simplifications of the real world, especially here, where we're assuming a perfectly inelastic supply of money, which actually isn't the case in the real world. But we can go with this just for the purposes of starting to study the money market.