So an increase in the money supply drives the

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Unformatted text preview: e to r2. Why? Because r2 is the only interest rate at which the public is willing to hold the quantity of money actually supplied, M 2. So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate. M O N E TA R Y P O L I C Y 351 PITFALLS the target versus the market Over the years, the Federal Reserve has changed the details of how it makes monetary policy. At one point, in the late 1970s and early 1980s, it set a target level for the money supply and altered the monetary base to achieve that target. Under this policy, the federal funds rate fluctuated freely. Today the Fed does the reverse, setting a target for the federal funds rate and allowing the money supply to fluctuate as it pursues that target. A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works. That is, you’ll sometimes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate. In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money. The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate. It’s important not to confuse a change in the Fed’s operating procedure with a change in the way the economy works. 352 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S PA R T 5 Figure 14-5 UNCORRECTED Preliminary Edition Interest rate, r An increase in the money supply . . . The Effect of an Increase in the Money Supply on the Interest Rate MS2 MS1 The Federal Reserve can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r1 to r2 in response to an increase in the money supply from M1 to M2. In order to induce people to hold a larger quantity of money, the interest rate must fall from r1 to r2. . . . leads to a fall in the interest rate. E1 r1 E2 r2 MD M1 14-6 Setting the Federal Funds Rate (a) Pushing the Interest Rate Down to the Target Rate Interest rate, r r1 (b) Pushing the Interest Rate Up to the Target Rate Interest rate, r An open-market purchase . . . MS1 . . . drives the interest rate down. of money, M In practice, at each meeting the FOMC decides on the interest rate to prevail for the next six weeks, until its next meeting. Recall from Chapter 13 that the federal funds rate is the interest rate at which banks lend reserves to each other. The Fed sets a target federal funds rate, a desired level for the federal funds rate. The Open Market Desk of the Federal Reserve Bank of New York adjusts the money supply through the purchase and sale of Treasury bills until the actual federal funds rate equals the target rate. Figure 14-6 shows how this works. In both panels, rT is the target federal funds rate. In panel (a), the initial money supply curve is MS...
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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.

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