Question

“At any point in time, all money is held by someone, but only in equilibrium is the quantity of money held the quantity of money people want to hold.” Discuss why this is true, and why if the quantity of money is different from the quantity of money people want to hold, what adjustments occur (step-by-step) that create equilibrium.

Answer 1

In equilibrium, money supply equals money demand. It means at a given interest rate, the amount of money people want to hold is equal to the quantity of money supplied in the market. If the demand for money falls, people will want to hold more bonds. The increase in demand for bonds increases the price of bonds, which leads to decrease in interest rates. At lower interest rates, the supply of money decreases, hence, equilibrium is restored. And when the demand for money rises, the demand for bonds falls, leading to higher interest rates, thereby causing an increase in interest rates. Thus, supply is increased and equilibrium is restored.