🔎 Supply and Demand

This page is for people who are interested in learning more about supply and demand, the model that we use both for the money market diagram and for the reserves diagram.

Demand Curve: How much do buyers want to buy?

The demand curve shows how much of a product buyers want to purchase at different prices.

Imagine we’re looking at a graph where:

• The x-axis (horizontal) shows the quantity of the product.
• The y-axis (vertical) shows the price.

The curve tells us how many units of the product people are willing to buy at any given price. For example:

• At higher prices, buyers usually want to buy less of the product.
• At lower prices, buyers tend to buy more.

The demand curve usually slopes down because of this behavior: when things are cheaper, people want more.

Supply Curve: How much will sellers provide?

The supply curve shows how much of a product sellers are willing to provide at different prices.

• The x-axis still shows the quantity of the product.
• The y-axis still shows the price.

This curve works differently from the demand curve. Sellers are more likely to provide more of a product when the price is higher because they can make more profit. So:

• At higher prices, sellers are willing to produce and sell more.
• At lower prices, sellers are likely to provide less.

The supply curve usually slopes up because higher prices encourage sellers to offer more of the product.

Equilibrium: Where Supply and Demand Meet

The intersection of the supply and demand curves is where they balance each other out. This is called the equilibrium price.

At this point:

• The amount buyers want to buy (demand) is equal to the amount sellers want to sell (supply).
• There’s no shortage or surplus, and the price doesn’t need to change unless something external happens.

This balance determines the market price for the product. If the price is higher or lower than this equilibrium, the market adjusts: sellers reduce prices if there’s too much supply, or increase prices if there’s too much demand.

Why Demand Slopes Down and Supply Slopes Up

• Demand slopes down because people generally want to buy more when prices are lower. For example, if apples are cheap, you might buy more; if they’re expensive, you’ll buy fewer.
• Supply slopes up because businesses generally want to sell more if prices are higher. If apples are selling for a lot of money, apple farmers will produce more to take advantage of that.

However, the slopes of these curves can vary:

• A flat (horizontal) curve means that quantity demanded or supplied doesn’t change much with price.
• A steep (vertical) curve means that quantity changes a lot when prices move, which suggests people (or suppliers) are very price-sensitive. This steepness depends on how people or businesses react to price changes.

Shifting Curves: External Factors Can Change Everything

External factors like changes in technology, consumer preferences, or production costs can shift these curves. For example:

• If a new technology makes producing apples cheaper, the supply curve shifts right, meaning more apples can be supplied at every price.
• If people suddenly love apples, the demand curve shifts right, meaning more people want to buy apples at every price.

When these curves shift, prices change. How much the price changes depends on the steepness of the curves. If one of the curves is very steep, prices might change a lot when demand or supply shifts.

Supply and Demand for Money

You can apply the same idea of supply and demand to money. In this case:

• Supply of money comes from central banks or other institutions that control the amount of money available.
• Demand for money comes from people or businesses deciding how much money they want to hold versus investing in other assets (like stocks or bonds).

Here, the price of money is the interest rate, which represents the cost of holding money. Since money doesn’t earn interest, the opportunity cost is what you could have earned by investing it elsewhere.

• When interest rates are high, people may want to hold less money because they can earn more by investing.
• When interest rates are low, people may hold more money since the opportunity cost of not investing it is smaller.

The intersection of the supply and demand for money determines the equilibrium interest rate.

This basic idea of supply and demand applies to many areas in economics, not just goods or services. It’s a core concept for understanding how markets function.