KRUGMAN_WELLS_MACRO_CHAPTER14

Figure m2 nominal quantity ms2 ms2 e1 e2 rt md m1 m2

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Unformatted text preview: 1 with money supply M 1, and The target federal funds rate is the Federal Reserve’s desired federal funds rate. Figure M2 Nominal quantity MS2 MS2 E1 E2 rT MD M1 M2 An open-market sale . . . . . . drives the interest rate up. Nominal quantity of money, M The Federal Reserve sets a target for the federal funds rate and uses open-market operations to achieve that target. In both panels the target rate is rT . In panel (a) the initial equilibrium rate, r1, is above the target rate. The Fed increases the money supply by making an open-market purchase of Treasury bills, pushing the money supply curve rT MS1 E2 E1 r1 MD M2 M1 Nominal quantity of money, M rightward from MS1 to MS2 and driving the interest rate down to rT . In panel (b) the initial equilibrium rate, r1, is below the target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward from MS1 to MS2 and driving the interest rate up to rT . UNCORRECTED Preliminary Edition FOR INQUIRING CHAPTER 14 MINDS L O N G - T E R M I N T E R E S T R AT E S Earlier in this chapter we mentioned that longterm interest rates—rates on bonds or loans that mature in several years—don’t necessarily move with short-term interest rates. How is that possible? Consider the case of Millie, who has already decided to place $1,000 in certificates of deposit (CDs) for the next two years. However, she hasn’t decided whether to put the money in a one-year CD, at a 4% rate of interest, or a two-year CD, at a 5% rate of interest. You might think that the two-year CD is a clearly better deal—but it may not be. Suppose that Millie expects the rate of interest on oneyear CDs to rise sharply next year. If she puts her funds in a one-year CD this year, she will be able to reinvest the money at a much higher rate next year. And this could give her a twoyear rate of return that is higher than if she put her funds into the two-year CD. For exam- ple, if the rate of interest on one-year CDs rises from 4% this year to 8% next year, putting her funds in a one-year CD will give her a rate of return over the next two years of about 6%, better than the rate on two-year CDs. The same considerations apply to an investor deciding between short-term and long-term bonds. If they expect short-term interest rates to rise, investors may buy short-term bonds even if long-term bonds offer a higher interest rate. If they expect short-term interest rates to fall, investors may buy long-term bonds even if short-term bonds offer a higher interest rate. In practice, long-term interest rates reflect the average expectations in the market about what’s going to happen to short-term rates. When long-term rates are much higher than short-term rates, as they were in 2003, the market is signaling that it expects short-term rates to rise in the future. the equilibrium interest rate, r1, is above the target rate. To lower the interest rate to rT, the Fed makes an open-market purchase of Treasury bills. As we lea...
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