KRUGMAN_WELLS_MACRO_CHAPTER14

Given the real money demand curve rmd this reduces

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: vel rises by the same proportion as the increase in the money supply but that in the short run the price level rises by a smaller amount. So the initial effect of an increase in the nominal money supply is a rise in the real money supply, from M 1/P1 to M 2/P2. Given the real money demand curve, RMD, this reduces the equilibrium interest rate from r1 to r2, and the money market moves to X in panel (a). And as we saw earlier, the supply of loanable funds shifts rightward by just enough that the quantity of loanable funds supplied and the quantity of loanable funds demanded are equalized at r2. Correspondingly, the loanable funds market moves to X in panel (b). X corresponds to an aggregate output greater than potential output because the interest rate at X, r2, is lower than the interest rate that holds at potential output, r1. In the long run, however, the aggregate price level rises further, from P2 to P3. As we’ve already seen, this reduces the real money supply back to its original level: M2/ P3 is equal to M1/P1. As a result, the equilibrium interest rate goes back to r1 and each market moves back to E. Meanwhile, aggregate output also falls back to potential output—which means that savings return to their original level, too. In panel (b), the supply of loanable funds, which initially shifted from S1 to S2, shifts back to S1. UNCORRECTED Preliminary Edition Figure 14-14 Interest rate, r Potential output equilibrium 2. . . . but in the long run, the increase in all prices reduces the real money supply back to its original level . . . (b) The Loanable Funds Model Interest rate, r E Potential output equilibrium S1 r1 S2 3. . . . and reduces the supply of loanable funds to its original level and aggregate output back to potential output. E X X r2 r2 RMD 1. In the short run, an increase in the real money supply reduces the interest rate . . . M1/P1 = M2/P3 363 The Long-Run Determination of the Interest Rate (a) The Real Liquidity Preference Model r1 M O N E TA R Y P O L I C Y CHAPTER 14 M2/P2 Real quantity of money, M/P Panel (a) shows the money market expressed in real terms and panel (b) shows the loanable funds market. Each market starts at point E, where the economy is at potential output. In the short run, an increase in the money supply increases the real money supply from M1 /P1 to M2 /P2 and reduces the equilibrium interest rate from r1 to r2 as the money market moves from point E to point X. The fall in the interest rate leads to higher real GDP and higher savings through the multiplier effect. This shifts the supply curve of loanable D Q1 Q2 Quantity of loanable funds funds rightward, from S1 to S2, also moving the market for loanable funds from point E to point X. In the long run, however, the increase in the money supply raises prices: the real money supply returns to its original level, M2 /P3 = M1 /P1, and the supply curve of loanable funds shifts back to its initial position, S1. So in the long run the equilibrium interest rate is determined by the supply and de...
View Full Document

This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

Ask a homework question - tutors are online