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Unformatted text preview: odel, the equilibrium interest rate in the economy is the
rate at which the quantity of money supplied is equal to the quantity of money demanded in the money market. Panel (b) represents the loanable funds model of the
interest rate. S1 is the initial supply curve and D is the demand curve for loanable
funds. According to the loanable funds model, the equilibrium interest rate in the
economy is the rate at which the quantity of loanable funds supplied is equal to the
quantity of loanable funds demanded in the market for loanable funds.
In Figure 14-11 both the money market and the market for loanable funds are initially in equilibrium at the same interest rate, r1. You might think that this would
only happen by accident, but in fact it will always be true. To see why, let’s look at
what happens when the Fed increases the money supply. This action pushes the
money supply curve rightward to MS2, and the equilibrium interest rate in the market
for money falls to r2. What happens in panel (b), in the market for loanable funds?
In the short run, the fall in the interest rate leads to a rise in real GDP, which generates a rise in savings through the multiplier process. This rise in savings shifts the
supply curve for loanable funds rightward from S1 to S2, reducing the equilibrium interest rate in the loanable funds market, too. And we know that savings rise by exactly
enough to match the rise in investment spending. This tells us that the equilibrium
rate in the loanable funds market falls to r2, the same as the new equilibrium interest
rate in the money market.
In the short run, then, the supply and demand for money determine the interest
rate, and the loanable funds market follows the lead of the money market. When a
change in the supply of money leads to a fall in the interest rate, the resulting rise in
real GDP causes the supply of loanable funds to rise. As a result, the equilibrium interest rate in the loanable funds market is the same as the equilibrium interest rate in
the money market. UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y Notice our use of the phrase “in the short run.” Recall from Chapter 10 that
changes in aggregate demand affect only aggregate output in the short run. In the
long run, aggregate output is equal to potential output. So our story about how a fall
in the interest rate leads to a rise in aggregate output, which leads to a rise in savings,
applies only to the short run. In the long run, as we’ll see in the next section, the determination of the interest rate is quite different, because the roles of the two markets
are reversed. In the long run, the loanable funds market determines the equilibrium
interest rate, and the market for money adjusts to that rate. economics in action
The Fed and the Output Gap, 1985–2004
In Figures 14-8 and 14-9 we showed how monetary policy can play a useful role: expansionary monetary policy can close recessionary gaps, and contractionary monetary policy can close inflationary gaps. A look back at U.S. monetary policy between
1985 and 2004...
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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.
- Spring '09
- Monetary Policy