We have so far discussed tow separate demands for money: speculative demand and transactions/precautionary demands. These add up to the total demand for money, which in equilibrium must equal to supply of money.

The rate of interest is the relevant price in the money markets. The monetary authorities set the level of interest rates and the money supply adjusts to become equal to the quantity of money demanded at the policy-determined rate of interest.

The easiest way to understand how this works is to start by showing how interest rates would adjust to equate demand and supply of money, if there were  a given money supply. This principle is also called the liquidly preference theory of interest or the portfolio balance theory.

Liquidity Preference Theory or the portfolio Balance Theory. The theory can be explained with the help theory can be explained with the help of. At point E, corresponding to Or₁ rate of interest quantity demanded of money equals quantity supplied. Or₁, thus, is the equilibrium rate of interest.


At Or₃ rate, there is excess demand for money. Bonds will be offered for sale in an attempt to increase money holdings. This will force the rate of interest to move up toward Or₁. At Or₃ rate. there is excess supply; bonds will be demanded in return for excess money balances. This will force the rate of interest down to the equilibrium.

Changes in money supply. A change in the policy-determined interest rate requires the money supply to change. This is illustrated in.

In the original money supply line is M^S₁. Equilibrium rate of interest is Or₁. The monetary authorities chose to lower the rate of interest to Or₂. In order to make this effective, the money stock would have to increase to M^S₂.


Conversely, if the monetary authorities chose raise the interest rate, money stock in the economy would have to be reduced.

We may now take an example to determine the monetary equilibrium by equating the supply and demand for money (i.e., Ms = M^D_T + M^Da  where M_T = transaction demand for money, and M^Da = asset demand for money.

For more help in Simple Model of Monetary Equilibrium click the button below to submit your homework assignment