Why Monetary Policy Matters Anyway (part 2): Liquidity Preference and the Real Money Supply

So we have established that Saving and Investment are determined by the real interest rate (r) which adjusts to equilibrate the two. However, in an economy in which money is used as a store of value, a complication arises. The rate of interest on a bond is the inverse of the price of that bond: bond prices and interest rates move in opposite directions. In an economy is which the only store of value was bonds, any increase in saving would automatically translate into an increased demand for bonds and hence lower interest rates, like the loanable funds model from before indicates.

But once we introduce money into the picture, things become complicated. Savings can be held in the form of either bonds OR money; bonds earn interest, but money has two advantages. The first is that by holding money balances, savers can speculate that the price of bonds is about to fall, i.e. that interest rates are about to rise (no one would buy an asset that's about to decline in value). The other and more important motive for holding money is the transactions motive: households and firms hold money balances to make short-term purchases and meet short-term expenses. You can't pay the contractor in Treasury bills. 

So money-demand is a function of both the interest rate and income, so that we write Md=f(r, Y). Money-supply is not a function of the interest rate, its a perfectly inelastic line indicating the fact that the supply of money is fixed by the central bank at any given moment. Given that, as in all markets, quantity supplied must equal quantity demanded, we can write MS=md (r, Y). Income and the interest rate adjust to equate the money supply with money demand. This market is described in the below chart. 

As you can see, the central bank moves the interest rate up or down by increasing or decreasing the money supply along the money demand curve. 

So we have two markets, the market for loanable funds and the market for money balances, that are both cleared by the same variable: the interest rate. Whats left to be done is to combine them.