## The Equilibrium Interest Rate

Recall that, for simplicity, we’re assuming there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 15-3, which illustrates the **liquidity preference model of the interest rate;** this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 15-3 combines the money demand curve, *MD*, with the **money supply curve**, *MS*, which shows how the quantity of money supplied by the Federal Reserve varies with the interest rate.

**Equilibrium in the Money Market** The money supply curve, *MS*, is vertical at the money supply chosen by the Federal Reserve, . The money market is in equilibrium at the interest rate *r*_{E:} the quantity of money demanded by the public is equal to , the quantity of money supplied.

At a point such as *L*, the interest rate, *r*_{L}, is below *r*_{E} and the corresponding quantity of money demanded, *M*_{L}, exceeds the money supply, . In an attempt to shift their wealth out of nonmoney interest-bearing financial assets and raise their money holdings, investors drive the interest rate up to *r*_{E}. At a point such as *H*, the interest rate *r*_{H} exceeds *r*_{E} and the corresponding quantity of money demanded, *M*_{H}, is less than the money supply, . In an attempt to shift out of money holdings into nonmoney interest-bearing financial assets, investors drive the interest rate down to *r*_{E}.
According to the **liquidity preference model of the interest rate**, the interest rate is determined by the supply and demand for money.

The **money supply curve** shows how the quantity of money supplied varies with the interest rate.

In Chapter 14 we learned how the Federal Reserve can increase or decrease the money supply: it usually does this through *open-market operations*, buying or selling Treasury bills, but it can also lend via the *discount window* or change *reserve requirements*. Let’s assume for simplicity that the Fed, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, *MS* in Figure 15-3, with a horizontal intercept corresponding to the money supply chosen by the Fed, . The money market equilibrium is at *E*, where *MS* and *MD* cross. At this point the quantity of money demanded equals the money supply, , leading to an equilibrium interest rate of *r*_{E}.

To understand why *r*_{E} is the equilibrium interest rate, consider what happens if the money market is at a point like *L*, where the interest rate, *r*_{L}, is below *r*_{E}. At *r*_{L} the public wants to hold the quantity of money *M*_{L}, an amount larger than the actual money supply, . This means that at point *L*, the public wants to shift some of its wealth out of interest-bearing assets such as CDs into money.

This result has two implications. One is that the quantity of money demanded is *more* than the quantity of money supplied. The other is that the quantity of interest-bearing money assets demanded is less than the quantity supplied. So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from *r*_{L} until the public wants to hold the quantity of money that is actually available, . That is, the interest rate will rise until it is equal to *r*_{E}.

Now consider what happens if the money market is at a point such as *H* in Figure 15-3, where the interest rate *r*_{H} is above *r*_{E}. In that case the quantity of money demanded, *M*_{H}, is less than the quantity of money supplied, . Correspondingly, the quantity of interest-bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from *r*_{H}. It falls until the public wants to hold the quantity of money that is actually available, . Again, the interest rate will end up at *r*_{E}.