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This diagram shows how the equilibrium interest rate is determined in the money market by the interaction of money demand and money supply.
Dm: Downward-sloping demand for money, decreasing with higher interest rates.
Sm: Vertical supply of money, fixed by the central bank.
ie: Equilibrium interest rate where Dm intersects Sm.
Qe: Quantity of money at equilibrium interest rate.
The vertical yellow line (Sm) represents the money supply, which is perfectly inelastic and determined by the central bank.
The downward-sloping blue line (Dm) represents the demand for money, which decreases as the interest rate rises.
The equilibrium interest rate (ie) is where money demand equals money supply, at quantity of money Qe.
Changes in the money supply (shifts in Sm) can be used as a tool of monetary policy to influence interest rates and thus aggregate demand.
An increase in the money supply shifts Sm to the right, lowering the interest rate and stimulating investment and consumption.
Explore other diagrams from the same unit to deepen your understanding
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