Money supply meets money demand, how the nominal interest rate is set.
Warming up the engine…
The demand for holding money (for transactions, falling as interest rates rise) meets the money supply set by the central bank, determining the nominal interest rate.
Md(i, Y) = Ms ; Md rises with income Y, falls with interest rate i
Holding cash means giving up interest, so when rates are high people hold less money. If the central bank expands the money supply, people find themselves holding more cash than they want and buy bonds, pushing bond prices up and interest rates down: that is the liquidity effect behind every rate cut.
The money supply curve is vertical (the central bank fixes the quantity, not the price). Higher income shifts money DEMAND right and raises rates, a favourite twist question.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Equilibrium at M 50, i 4.5.
Equilibrium: M* = 50.0, i* = 4.5
Current equations
The market for liquidity itself. The central bank fixes the money supply (the vertical line); households and firms demand money for transactions, more when incomes or prices are high, less when interest rates make parking cash costly. The nominalnominalMeasured in current dollars, unadjusted for inflation. interest rate balances the two.
Source: Mishkin, Money, Banking and Financial Markets, ch. 5