The total demand for money consists of the amount people desire to hold so they may carry out transactions plus the amount they want to hold in their portfolios of financial assets. While the transactions demand for money is related directly to real output at the price level, the asset demand for money is inversely related to the nominal interest rate. The reasons are straightforward. The higher the prices of goods and services, or the more goods and services people intend to buy, the more money they desire to hold for purchases: higher nominal GDP implies greater quantity of money demanded. On the asset side, bonds pay interest while money does not. The higher the nominal interest rate, the greater the opportunity cost of holding money and the less will be desired.

The Bank of Canada and financial institutions provide the economy with a particular money supply independent of the nominal interest rate. The nominal interest rate then adjusts until the quantity of money demanded equals this money supply.

Exploration: How does the nominal interest rate adjust to changes in the supply and demand for money?

The graph shows the money demand curve and the money supply curve in a hypothetical economy. Initially, the money market is in equilibrium at a nominal interest rate of 6%; the quantity of money demanded at this interest rate is equal to the money supply of $150 billion. To use the graph, click and drag on either the S_m or D_m labels to shift supply or demand, respectively. Click New Equilibrium to observe the interest rate adjust to restore equilibrium. If you then click on Update, the current equilibrium will become the starting point for further investigation.

1		Suppose the Bank of Canada increases the money supply by $50 billion to $200 billion What impact will this have on the interest rate?
2		Suppose an increase in desired spending has resulted in an increase in nominal GDP. What impact will this have on the interest rate?
3		Starting from the original equilibrium, suppose the Bank of Canada reduces the money supply by $25 billion. What is the new equilibrium nominal interest rate?
4		If the economy expands, what must the Bank of Canada do to prevent a change in the nominal interest rate?
5		Experiment on your own. What generalization can you make regarding the relationship between the nominal interest rate and changes in the supply and demand for money?