Q. Explain the Money market diagram?

Let's begin by studying the money market when GDP is given. When Y is given, MD will only rely (negatively) on R and we can draw a figure with supply and demand for money as functions of R.

Figure

In the figure above, R* is the interest rate in that demand for money is exactly equal to the supply of money (again for a given Y). IS-LM model, R will all the time tend to R* till they are equal and we have an equilibrium in money market. 

Justification for why R will tend to R* is not completely straightforward:  

• Say that R < R*.
• In this case, M_D> M_S, which is, people want to hold more money than what is available.
• People increase amount of money they hold by selling bonds so there is an excess supply of bonds.
• This excess supply of bonds will drive down the price of bonds.
• When price of bonds falls, interest rates increase.
• The interest rate will increase until R = R*. Only then will the demand for money have decreased enough such there is no longer an excess demand for money. Then there is no excess supply of bonds either. Money market is in equilibrium.
• Case of R > R* can be analysed similarly.

Money market diagram can be used to conclude the equilibrium rate of interest if we know GDP