As referred to before, monetary policies are demand-side policies, which means they affect the aggregate demand and they do so by changing the interest rate.
Determining Interest Rate
The interest rate is determined in the money market through the equilibrium of the demand and supply of money.
- As observed in the diagram above, the:
- X-axis measures the quantity of money
- Y-axis measures the interest rate
- At the equilibrium, the interest rate is at $i_1$ and the quantity of money demanded is at $Q_1$.
- The money supply is vertical (and is always vertical), as it is fixed at a level determined by the central bank.
- Now we can view the inverse relationship between the rate of interest and the quantity of money where: as the rate of interest falls, the quantity of money demanded increases.
Think of interest rates as the price for borrowing money.
Demand for Money
The demand for money refers to the desire to hold money rather than investing it.
- As observed in the diagram presented above, the demand curve for money ($D_{money}$) is downwards sloping.
- This is because:
- If the interest rates are higher (there is high return on savings):
- Individuals have less incentive to hold on to cash.
- If the interest rates are higher (there is high return on savings):
