Explained: Equilibrium in the Money Market

A money market is said to be in equilibrium if the quantity of money demanded is equal to the quantity of money supplied at a particular rate of interest. A shift in money demand or supply in an economy will lead to a change in the equilibrium interest rate.

The money market involves of money demand and money supply functions, and the equilibrium in the money market happens where the money demand curve intersects the money supply curve. It means, at that point, the quantity of money demand equals the quantity of money supply that determines the equilibrium interest rate and the equilibrium quantity of money. This equilibrium interest rate determined in the money market is the short-term interest rate.

The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope expresses the negative relationship between the amount of money demanded and the interest rate. Its downward slope expresses the negative relationship between the amount of money demanded and the interest rate. The relationship between interest rates and the amount of money demanded is an application of the law of demand.

When the Central Bank of a Country wants to lower the overnight interest rate target, it conducts an open market operation of purchasing securities. The primary aim of open market operations is to regulate the money supply in the economy. When the central bank wants to increase the money supply in the economy, it purchases government securities from the market to infuse liquidity into the system and it sells government securities to suck out liquidity from the system. These operations are often conducted on a day-to-day basis in a manner that balances inflation or recession while helping banks continue to lend. The Central Bank of the country (RBI) uses OMO along with other monetary policy tools such as repo rate, cash reserve ratio, and statutory liquidity ratio to adjust the quantum and price of money in the system. The monetary targets, such as inflation/recession, interest rates, or exchange rates, are used to guide this implementation.

A policy to lower price level and contract economic growth by raising the overnight interest rate target and decreasing money supply through selling securities which the Bank uses when the economy is experiencing inflation.