AP Macroeconomics

## Learning Outcomes

- Understand how money market equilibrium is found where the quantity of money demanded equals the quantity of money supplied
- Identify the correct axes and curve shapes on the AP money market graph
- Explain why the money demand curve slopes downward and why the money supply curve is vertical
- Distinguish between movements along money demand and shifts of money demand
- Predict how open market operations, income changes, and price-level changes affect the equilibrium nominal interest rate
- Avoid confusing the money market with the loanable funds market

## AP Macroeconomics Syllabus

For the AP Macroeconomics, you are expected to understand money market equilibrium, with a focus on the following syllabus points:

- Know that money market equilibrium occurs where **Md = Ms**
- Identify the money market graph with the **nominal interest rate** on the vertical axis and the **quantity of money** on the horizontal axis
- Explain why the **money demand** curve slopes downward because holding money has an opportunity cost
- Know that the **money supply** curve is vertical in the basic AP model because the Federal Reserve sets it
- Understand that an increase in **real GDP/income** shifts money demand right, while a decrease shifts it left
- Understand that a change in the **price level** changes money demand and, in real-balance form, affects real money supply **M/P**
- Explain how an **open market purchase** increases money supply and lowers the equilibrium nominal interest rate
- Explain how an **open market sale** decreases money supply and raises the equilibrium nominal interest rate

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What condition defines equilibrium in the money market?
2. Why is the money demand curve downward sloping?
3. Why is the money supply curve vertical in the standard AP Macro model?
4. What happens to the equilibrium nominal interest rate if the Fed increases the money supply?
5. How does an increase in real GDP affect money demand?

## Introduction

The money market is one of the core AP Macroeconomics graphs. It appears in multiple-choice questions, short explanations, and free-response questions where you may need to connect monetary policy to interest rates and then to aggregate demand. If you cannot explain why the curves look the way they do, it becomes very easy to make graph errors later.

At its heart, this topic is about one simple idea: the money market is in equilibrium when the amount of money people want to hold is exactly equal to the amount of money the Federal Reserve has supplied. When those quantities are not equal, the nominal interest rate adjusts until they are.

> **Key Term: money market equilibrium**
> The point at which the quantity of money demanded equals the quantity of money supplied, determining the equilibrium nominal interest rate.

### The basic graph and the equal-quantities condition

In the AP money market graph, the vertical axis is the **nominal interest rate** and the horizontal axis is the **quantity of money**. Some teachers and textbooks discuss the horizontal axis as money holdings or real money balances. On the AP exam, the safest label is usually **quantity of money** unless the prompt clearly asks for real balances.

> **Key Term: nominal interest rate**
> The interest rate not adjusted for inflation; this is the interest rate used on the money market graph.

The equilibrium condition is:

$$
M_d = M_s
$$

That does not just mean “the curves cross.” It means that at one particular nominal interest rate, the public wants to hold exactly the amount of money that the banking system and the Fed have made available.

If the interest rate is above equilibrium, people want to hold less money than exists. There is an **excess supply of money**. If the interest rate is below equilibrium, people want to hold more money than exists. There is an **excess demand for money**.

Why does that matter? Because the interest rate is the adjusting variable.

- If **Md > Ms**, the public is short of money balances. People try to get money by selling bonds or other interest-earning assets. More bond selling pushes bond prices down. Since bond prices and interest rates move inversely, the nominal interest rate rises.
- If **Ms > Md**, the public is holding more money than it wants. People use excess money to buy bonds. More bond buying pushes bond prices up. Higher bond prices mean lower interest rates.

This is the logic students often skip. The graph is not arbitrary. The interest rate changes because people rebalance between money and interest-earning financial assets.

> **Key Term: excess demand for money**
> A situation where the quantity of money demanded is greater than the quantity of money supplied, creating upward pressure on the nominal interest rate.
>
> **Test Tip:** In FRQs, do not stop at “the interest rate rises.” Add the mechanism: people sell bonds to obtain money, bond prices fall, and the nominal interest rate rises. That extra chain often earns the explanation point.

A very common AP detail is this: when **money demand shifts** and the **money supply does not**, the equilibrium quantity of money stays fixed at the amount supplied by the Fed. The graph shows a new equilibrium at a different interest rate, but on the same vertical money supply line.

Students often think both interest rate and quantity must change whenever a curve shifts. In the money market, that is wrong when only money demand changes. The vertical money supply curve means the quantity is pinned down by the Fed at that moment.

### Why the curves have their shapes

The money demand curve slopes downward. The reason is the **opportunity cost of holding money**.

Money is very liquid. You can spend it immediately. But money in a wallet or checking account usually earns little or no interest compared with bonds or similar assets. So when the nominal interest rate is high, holding money becomes more costly. People would rather hold less money and more interest-earning assets. Quantity of money demanded falls.

When the nominal interest rate is low, the cost of holding money is low. People are more willing to keep funds in liquid form. Quantity of money demanded rises.

> **Key Term: money demand**
> The quantity of money households, firms, governments, and foreigners want to hold at different nominal interest rates.

This is why the money demand curve is downward sloping:

- higher nominal interest rate -> lower quantity of money demanded
- lower nominal interest rate -> higher quantity of money demanded

Now compare that with the money supply curve. In the standard AP model, the money supply curve is vertical because the **Federal Reserve determines the money supply**. At a given moment, the supplied quantity does not depend on the nominal interest rate.

> **Key Term: vertical money supply**
> The AP Macro assumption that the quantity of money supplied is fixed by the central bank and does not change when the nominal interest rate changes.

This is one of the easiest graph points to lose. Students sometimes draw the money supply curve upward sloping by habit because many supply curves in economics slope upward. Do not do that here. In the money market, **Ms is vertical**.

A useful formal version of the equilibrium condition is:

$$
M/P = L(i, Y)
$$

This says real money balances equal money demand.

- **M** = nominal money supply
- **P** = price level
- **M/P** = real money balances
- **i** = nominal interest rate
- **Y** = real GDP or real income

You do not always need this formula on the AP exam, but it helps explain some tricky questions. If **P** rises while **M** stays unchanged, then **M/P** falls. That means the real money supply shrinks even if the Fed did nothing to nominal money supply.

> **Test Tip:** If the prompt changes the nominal interest rate itself, that is a **movement along** the money demand curve. If the prompt changes income, real GDP, or price level, that is a **shift of** money demand. This distinction is tested often.

### What shifts equilibrium and what stays unchanged

There are two major categories of changes in this topic:

1. shifts in **money demand**
2. shifts in **money supply**

Start with money demand. In AP Macro, two major shifters matter most:

- **real GDP/income**
- **price level**

If **real GDP rises**, households and firms carry out more transactions. More output and income usually mean more spending, payrolls, purchases, and business activity. At every nominal interest rate, people want to hold more money. So money demand shifts right.

If **real GDP falls**, fewer transactions occur. Money demand shifts left.

If the **price level rises**, ordinary purchases cost more dollars. People and firms need larger money holdings to carry out the same amount of real transactions. Money demand shifts right.

If the **price level falls**, less money is needed for transactions. Money demand shifts left.

Here is the important equilibrium result:

- **Md right, Ms unchanged -> nominal interest rate rises**
- **Md left, Ms unchanged -> nominal interest rate falls**

Why does the quantity of money not change here? Because in the standard graph the Fed has not moved the vertical money supply line.

Now turn to money supply. In AP Macro, the central bank changes money supply through policy. The most direct exam-tested story is **open market operations**.

> **Key Term: open market operations**
> Federal Reserve purchases or sales of government securities used to change bank reserves and the money supply.

If the Fed makes an **open market purchase**, it buys government securities. Payment to sellers enters the banking system, bank reserves rise, and the money supply increases. The vertical money supply curve shifts right.

- **Ms right -> equilibrium nominal interest rate falls**

If the Fed makes an **open market sale**, it sells government securities. Buyers pay from bank accounts, reserves leave the banking system, and the money supply decreases. The money supply curve shifts left.

- **Ms left -> equilibrium nominal interest rate rises**

Work through the logic carefully:

1. Fed buys bonds
2. bank reserves increase
3. money supply increases
4. money supply curve shifts right
5. excess supply of money exists at old interest rate
6. people buy bonds with excess money
7. bond prices rise
8. nominal interest rate falls

That full sequence is excellent FRQ reasoning.

Now add the real-balance angle. Suppose the price level rises but the Fed leaves nominal money supply unchanged. Then **M/P falls**. In real terms, the money supply is smaller. That pushes interest rates upward unless the Fed offsets the change.

This explains why some teachers say “a higher price level raises money demand,” while others say “a higher price level lowers real money supply.” Both ideas fit together. They are two ways of describing why the equilibrium nominal interest rate tends to rise when prices rise and nominal money supply is fixed.

### Reading AP questions and avoiding common mistakes

Many students lose points on this topic not because they do not know the answer, but because they mix up closely related markets.

First, do not confuse the **money market** with the **loanable funds market**.

Money market:

- vertical axis = **nominal interest rate**
- horizontal axis = **quantity of money**
- money supply is **vertical**
- demand for money slopes **downward**

Loanable funds market:

- vertical axis = **real interest rate**
- horizontal axis = **quantity of loanable funds**
- supply slopes **upward**
- demand slopes **downward**

The AP exam likes this distinction.

Second, do not confuse **nominal money supply** with **real money balances**. If the Fed does nothing, nominal money supply may stay the same while real money supply changes because the price level changed.

Third, do not say equilibrium is “where bond demand equals bond supply.” Bonds help explain the adjustment process, but the money market equilibrium condition is **Md = Ms**.

Fourth, label graphs fully. A correct but unlabeled graph may not earn full credit.

A good graph should show:

- vertical axis: nominal interest rate
- horizontal axis: quantity of money
- downward-sloping **Md**
- vertical **Ms**
- equilibrium interest rate clearly marked

Finally, connect the topic to macro policy. Lower nominal interest rates make borrowing cheaper, which tends to increase investment and some interest-sensitive consumption. That is how an increase in the money supply can shift aggregate demand right in the short run.

> **Test Tip:** For FRQs, use a chain like this: open market purchase -> Ms increases -> nominal interest rate falls -> investment rises -> aggregate demand rises. The AP exam rewards this step-by-step logic.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Money market equilibrium occurs where the quantity of money demanded equals the quantity of money supplied
- The money market graph uses the nominal interest rate on the vertical axis and quantity of money on the horizontal axis
- The money demand curve slopes downward because holding money has an opportunity cost
- The money supply curve is vertical in the standard AP Macro model because the Fed sets the money supply
- If money demand exceeds money supply, the nominal interest rate rises
- If money supply exceeds money demand, the nominal interest rate falls
- An increase in real GDP or income shifts money demand to the right
- An increase in the price level shifts money demand to the right
- A money demand shift changes the equilibrium nominal interest rate, while the quantity of money stays fixed if money supply does not change
- An open market purchase shifts money supply right and lowers the nominal interest rate
- An open market sale shifts money supply left and raises the nominal interest rate
- Students must not confuse the money market with the loanable funds market or nominal money supply with real money balances

## Key Terms and Concepts

- money market equilibrium
- nominal interest rate
- excess demand for money
- money demand
- vertical money supply
- open market operations


The Money Market - Money market equilibrium equal quantities