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Probably this question is a bit(or very) stupid.

I'm self-teaching by reading a book on macro, and the author states that in the Money Market, when the output increases the demand for money also increases, and given a certain money supply, the interest rate must go up to maintain the equilibrium. So, in this case, the Central bank(CB) would just sell bonds => diminish price of bonds=> increase interest rate. My question is, why should this equilibrium be maintained? Isn't there a situation, when people may want more money to acquire/trade, but the CB just won't sell bonds?

Any help would be appreciated

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In your textbook, it says that given a certain money supply, the interest rate must increase if the demand for money increases.

The money supply is determined by the central bank, which can buy bonds (which takes bonds out of circulation and increases the supply of money in circulation), or sell bonds (putting bonds in circulation but decreasing the supply of money in circulation). It can also, as in your example, do nothing.

If the demand for money increases, then market participants are willing to either "buy" more money at a given price (where the "price" of money is the interest rate), or pay a higher price for a given amount of money. This is true of all goods— and so long as demand isn't either perfectly elastic or perfectly inelastic, both are true.

So since in your example the money supply is fixed (i.e., the supply curve is perfectly inelastic), if the demand for money increases, the interest rate will increase. The interest rate increasing as a result of increased demand for money isn't dependent on the central bank doing anything, it's dependent on the central bank doing nothing.

In practice, central banks usually target a particular interest rate. When they do so, they can't directly observe the demand for money, but they can observe the equilibrium price (i.e., the interest rate). So what they do is engage in open-market operations— buying [or selling] bonds to increase [or decrease] the supply of money, in turn decreasing [or increasing] the interest rate until it is close to their target.

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  • $\begingroup$ Hi, thanks for your answer. I still have a doubt. When 'all' the market participants want more cash, who would be able to buy cash for more cash? Are we to assume that different people have different demand for cash, and in this way, some would be indifferent in holding cash, and lending cash for a higher interest rate, while others would still prefer to hold cash at the cost of paying more for it in the future? $\endgroup$ – An old man in the sea. Aug 27 '15 at 18:34
  • $\begingroup$ @Anoldmaninthesea. — Market participants do have different individual demand functions for cash. In the real world, cash lenders tend to be firms that have large cash balances (think companies like Apple) or pension funds, which hold cash to meet liquidity needs. These firms lend out cash, while on the other side, dealers tend to borrow cash, often on behalf of customers who are financing long-term assets by borrowing in short-term cash markets (this is known as "maturity transformation"). $\endgroup$ – dismalscience Aug 27 '15 at 18:38
  • $\begingroup$ I was thinking something similar to people wanting cash(coins and banknotes), but not having it since the CB wouldn't supply it. There would be a shortage of cash. Then people start trading among themselves for cash at a higher interest. If this shortage were to be maintained for long, wouldn't the interest rate be ever increasing? $\endgroup$ – An old man in the sea. Aug 27 '15 at 19:12
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    $\begingroup$ @Anoldmaninthesea. First— "cash" isn't usually coins or banknotes, it's just ledger entries. Second— the interest rate wouldn't be constantly increasing, as the demand curve is negatively-sloped... some would just not borrow (and would thus engage in less investment in future output). That doesn't mean that rates wouldn't end up being high, they just would not increase indefinitely. $\endgroup$ – dismalscience Aug 28 '15 at 13:30
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I assume you are currently reading about the IS LM model, which covers a goods (IS: interest and savings) and a capital market (LM: liquidity and money). In this model type, the central bank controls the money (cash) supply; and people “decide” whether to hold cash or bonds.

So from the model perspective your question would assume that the central bank keeps the money supply fixed and people have a higher demand for cash. Thus, if e.g. production increases, people need more money to conduct the transactions (everything else being equal). Hence, bonds would be sold to acquire cash. With bonds being held by the population the central bank has no direct influence. The increased supply of bonds then reduces their price and increases the implied interest rate. This has an effect on the goods market, where higher interest rates reduce investments (overall demand) so that production/output decreases.

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  • $\begingroup$ Hi @philip thanks for the answer. I didn't understand part of your answer. So, people want more cash. They buy bonds. How can the increased supply of bonds, which will decrease certainly the price of the bonds, increase the interest rate of the bonds? $\endgroup$ – An old man in the sea. Aug 27 '15 at 18:27
  • $\begingroup$ @Anoldmaninthesea.— Given that bonds pay some combination of a particular coupon or a particular payment at maturity, and that this does not vary, a decrease in the price of the bond is equivalent to an increase in the interest rate that is paid by the bond. This is mechanical. Imagine a bond that pays \$100 in one year. If you buy it for \$99, it's paying you about 1% annual interest. If you buy it for \$95, it's paying you about 5.3% interest. $\endgroup$ – dismalscience Aug 27 '15 at 18:41
  • $\begingroup$ I've just reread and understood the stupidity of my comment. lol thanks for the help @dismalscience $\endgroup$ – An old man in the sea. Aug 27 '15 at 18:57
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Another reasoning could be that people would be willing to take larger loans from commercial banks to cover their increased spending needs. This increased demand for loans drives up interest rates as well.

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