If the real money demand is greater than the real money supply, interest rates must rise to reach equilibrium in the money market as institutions sell bonds to obtain more money.
Yes.
To understand why interest rates rise in response to a real money demand greater than the real money supply, let's break it down step by step.
1. Real Money Demand: The real money demand represents the desire of individuals and institutions to hold money for transactions and speculative purposes. It depends on various factors such as income levels, prices, and interest rates.
2. Real Money Supply: The real money supply refers to the actual amount of money available in the economy. It is determined by the central bank's monetary policy, which includes factors like open market operations, reserve requirements, and interest rates.
3. Equilibrium in the Money Market: The money market is where the demand for money and the supply of money intersect. When the real money demand matches the real money supply, the money market is said to be in equilibrium.
4. Impact of Real Money Demand exceeding Real Money Supply: If the real money demand surpasses the real money supply, it means that individuals and institutions want to hold more money than what is currently available in the economy. This creates excess demand in the money market.
5. Response: To fulfill their increased demand for money, individuals and institutions will need to obtain additional funds. One way they can do this is by selling bonds in the bond market. When bonds are sold, the money received from the bond sales increases the money supply.
6. Increase in Interest Rates: As more bonds are being sold, the demand for bonds in the bond market increases. Higher demand for bonds leads to an increase in bond prices. However, bond prices and interest rates move inversely. Therefore, when bond prices rise, interest rates fall.
7. Restoring Equilibrium: The rise in interest rates acts as a deterrent for borrowing and encourages lending. It reduces the demand for money by encouraging people to hold less money since the opportunity cost of doing so (higher interest rates) has increased. Additionally, the increased interest rates incentivize individuals and institutions to invest in bonds to earn higher returns.
8. Equilibrium Achieved: As interest rates increase, there is a balancing effect on the money market. The rise in interest rates reduces the excess demand for money, gradually bringing it closer to the real money supply. This process continues until equilibrium is reached when the real money demand equals the real money supply.
In summary, when the real money demand exceeds the real money supply, institutions sell bonds to obtain more money. This increased supply of bonds in the bond market raises bond prices and, in turn, lowers interest rates to restore equilibrium in the money market.