The Money Supply on the Graph: Study with Video Lessons, Practice Problems & Examples

The money supply in the economy is controlled by the Federal Reserve (Fed) through open market operations, which involve buying and selling treasury securities. The money supply curve is vertical, indicating a fixed quantity of money regardless of interest rates. When the Fed purchases T-bills, the money supply increases, shifting the curve to the right, lowering interest rates. Conversely, selling T-bills decreases the money supply, shifting the curve left and raising interest rates. This dynamic helps the Fed achieve its economic goals, such as stimulating investment during a recession.

Money Supply and Equilibrium in Money Market

Alright. So now let's see the money supply curve on the graph and let's find our equilibrium in the money market. So we're still dealing here with the theory of liquidity preference. That's the technical name for it. But really, it just means the supply and demand. If we're applying the supply and demand principles to the money market. Okay? So now, money is the product. The product, the good that we're talking about in this case. And we saw that the price of money is going to be the interest rate that you have to pay. Well, that's going to be the price of money and the quantity of money. Well, that's just the number of dollars. We'll think of it like that. Just the amount of money available, and when we think about the supply of money, we've defined this before, right? As M₁ and M₂, we went through defining the money supply and we said we were just going to stick with M₁ in this class which is basically currency. So the actual cash that's out there, currency in circulation, and checking account deposits. Checking deposits. Okay. So that's generally what makes up M₁. And that's what we're going to be focusing on in this class. It's just good to know the definition. It doesn't really matter so much at this point to think about, oh, how much checking deposits, how much currency is there. We're just going to be thinking of it in total. So when we think about the supply of money, well, what have we learned so far about the supply of money? Who controls the supply of money? The Fed, right? The Fed controls the supply. So the supply of money is not going to be affected by the interest rate. There's going to be a fixed supply of money in the economy based on where the Fed sets this level, right? The amount of money supply that the Fed wants to set in our economy, well, that's going to be a fixed amount regardless of the interest rate. So if the interest rate doesn't matter, remember, the interest rate is going to be our y-axis and the quantity, the number of dollars is going to be our x-axis. So if the interest rate doesn't matter, there's going to be the same money supply regardless of the interest rate. How do you think this this graph is going to look? It's not going to have an upward slope like we saw in the market, just regular supply and demand graphs we studied at the beginning of the course. It's going to have a straight up, vertical line for our money supply. Why is that the case? So this is the money supply right here. The money supply curve and this has to do with the fact that the Fed controls the supply. Right? So the Fed, regardless of what the interest rate is, is going to have a fixed amount of money supply. And then depending on what they do usually with open market operations of buying and selling treasury securities, we can shift the money supply to the left or to the right based on their actions. But without that, at any given interest rate, at this high-interest rate over here, we're going to have the same amount of money as at this low interest rate. There's going to be the same amount of money in the economy, right? There's always going to be quantity right here and I want to reiterate. I'm going to point to this quantity and I'm going to say fixed by the Fed. Right? The Federal Reserve is fixing that quantity based on where they want the money supply to be. Okay. So what did we see here is that the supply curve for money is vertical, right? It's completely straight up and down because the supply of money is controlled by the Fed. So regardless of the interest rate, we're going to have this amount of money supply. So the money supply, remember, when we define money supply, it's the amount available for use by the public. Okay. So we're separating the money that the Fed has themselves. When the Fed has the money, that's not going to be in the money supply because that's not in circulation. That's not in any checking deposit account. That's out of the money supply. So when it's in the money supply, it's in the hands of the public which would be banks or you and me. Right? Any of that money that we have available, that's included in the money supply. So when we shift the money supply, like I said, it's because the Fed has decided that they want a higher amount of money or a lower amount of money in the money supply. So generally, how it's going to shift is through the Fed's open market operations. Okay. They love to use this term open market operations but all that really means is just buying and selling treasury securities. Generally, what we call T-bills. T-bills are short-term treasury securities that you buy that earn a little bit of interest in the short term. Okay? So when we think about what the Fed is doing, we have to think about who's getting money and who's giving money in these situations. Okay? So when the Fed purchases T-bills, these are the two open market operations. They can either purchase T-bills or they can sell T-bills. Okay? So when they purchase T-bills so let's think about the Fed and the public. And when I say public, generally, the Fed is dealing with banks in this case where they're buying and selling treasury bills from banks but banks are considered part of the public. Right? That's currency that's in circulation when it's in the hands of the banks. So let's think about who's getting what here, the Fed and the banks. So when there's a purchase so let's do first a purchase here. Fed purchase. So a Fed purchase, who if a Fed if the Fed is purchasing, are they giving up money or are they getting money? They're giving up money. Right? The Fed is purchasing something. So there's money going from the hands of the Fed to the public. Right? And the public, which is the banks, are giving securities T-bills are going to the Fed. So what's happening in this case? There's money going into the hands of the public. Right? So money available for the public increases when the Fed purchases T-bills. So if the Fed purchases T-bills, there's money going to the public and the money supply increases. And the opposite is if the Fed sells T-bills. So now let's think about the same little diagram, the Fed and the public. So in this case, the Fed is receiving if they're selling the treasury bills in this case so let me get out of the way. If the Fed is the one selling the treasury bills in this case, well, the Fed is the one receiving money. Right? The Fed is going to be getting cash from the public and the public is getting securities from the Fed. So now money is leaving from the public. The public no longer has this money. The money goes to the Fed. So the money available for the public decreases and the money supply decreases. Okay? So remember, we can shift the money supply curve that we drew up here. It can shift left or right based on these open market operations. So, if the Fed decides that they want to purchase treasury securities, Right? So what happens when they purchase treasury securities? Remember, money goes to the public. Right? Money goes to the public which increases the money supply. Well, we would see something like this happening on the graph. We would shift to the right and we would draw a new curve, a new curve out here and this would be money supply 2. Right? The money supply, the new money supply out to the right and notice that the quantity has increased. Right? The quantity would be bigger here because of the more money available in the public. Okay? So it can shift to the left or shift to the right just like any other curve that we've dealt with. So let's end here by finding the equilibrium in the money market. So we've talked about money demand and money supply at this point. Let's put it all together on one graph. We've got our interest rate and we've got the quantity of money that's demanded and the quantity of money supplied. So let's go ahead and let's draw our graph here. So we're going to have our downward demand just like we saw in our other video. I'll draw it a little cleaner. So our downward demand, this is our money demand curve. Right? Money demand curve and our money supply, we just saw is straight up and down. So when we draw our money supply, we're going to get an intersection here. Right? What does that intersection look like to you? This intersection right here is going to be our equilibrium in the market. So what we're gonna have is our equilibrium interest rate, our star, and then our equilibrium quantity of money which again is going to be fixed. Fixed by the Fed. Right? So since the quantity isn't changing, what happens if the Fed goes ahead and does an open market operation? So again, let's say the Fed purchases treasury bills and more money goes into the public. Right? We see that the money going to the public increases through the purchase. The money available increases, increasing the money supply. Well, look what happens to the interest rate. If the money supply is going to shift to the right, well now we've got a new equilibrium interest rate. A new equilibrium down here. Right? So this is why the Fed would go through open market operations. They want to affect the interest rate. They want to have a certain interest rate. They have targets for the interest rate based on current economic conditions. If let's say we're going through a recession and they want to increase the investment and the opportunities to invest, well, they might go through an operation similar to this to try and reach a lower target interest rate so that there's more incentive to invest, right? There's going to be lower interest rates on the market so loans are cheaper to get and there's more of an incentive to invest. Right? So depending on what the goal of the Fed is at that particular moment, they could go through an open market operation to increase or decrease the money supply and it will find us a new equilibrium interest rate in the market. Okay. So that's generally how it works. We'll see the Fed going through some, they'll have some economic goal that they're trying to reach and then they'll affect the money supply to reach that goal through their open market operations of purchasing and selling Treasury securities. Alright? So that's a lot to handle in just one video here, but that's pretty much everything that happens with monetary policy. It's nothing too crazy. It just has to do with those purchasing and selling of T-bills and the effect it has on this graph. Alright? Let's go ahead and move on.

Here’s what students ask on this topic:

What is the money supply curve and why is it vertical?

The money supply curve represents the total amount of money available in the economy, controlled by the Federal Reserve (Fed). It is vertical because the Fed sets a fixed quantity of money regardless of the interest rate. This means that changes in interest rates do not affect the total money supply. The Fed uses tools like open market operations to adjust this supply, but at any given moment, the quantity of money is fixed, leading to a vertical supply curve on the graph.

How does the Federal Reserve use open market operations to influence the money supply?

The Federal Reserve uses open market operations to control the money supply by buying and selling treasury securities (T-bills). When the Fed purchases T-bills, it injects money into the economy, increasing the money supply and shifting the money supply curve to the right. Conversely, when the Fed sells T-bills, it withdraws money from the economy, decreasing the money supply and shifting the curve to the left. These actions help the Fed achieve its economic goals, such as managing interest rates and stimulating investment during a recession.

What happens to the interest rate when the Fed increases the money supply?

When the Fed increases the money supply by purchasing treasury securities, the money supply curve shifts to the right. This increase in the money supply leads to a lower equilibrium interest rate. Lower interest rates make borrowing cheaper, encouraging investment and spending in the economy. This is often done to stimulate economic activity, especially during periods of recession or slow economic growth.

What is the relationship between the money supply and the interest rate?

The relationship between the money supply and the interest rate is inverse. When the money supply increases, the interest rate tends to decrease, and when the money supply decreases, the interest rate tends to increase. This is because an increased money supply means more money is available for lending, which lowers the cost of borrowing (interest rates). Conversely, a decreased money supply means less money is available, raising the cost of borrowing.

How does the Fed achieve its economic goals through monetary policy?

The Fed achieves its economic goals through monetary policy by adjusting the money supply and influencing interest rates. By using open market operations to buy or sell treasury securities, the Fed can increase or decrease the money supply. For example, during a recession, the Fed might increase the money supply to lower interest rates, making loans cheaper and encouraging investment and spending. Conversely, to combat inflation, the Fed might decrease the money supply to raise interest rates, reducing spending and borrowing.