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Unformatted text preview: According to the liquidity preference
model of the interest rate, the interest
rate is determined by the supply and demand for money.
The money supply curve shows how the
nominal quantity of money supplied
varies with the interest rate. Figure We’ll start by assuming for simplicity that there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand
how the interest rate is determined, consider Figure 14-4, which illustrates the liquidity
preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 14-4 combines the (nominal) money demand curve, MD, with the money supply curve, which
shows how the nominal quantity of money supplied by the Federal Reserve varies with
the interest rate. So what we are considering is the nominal version of the liquidity preference model, in which the nominal interest rate is determined by the nominal demand
and supply of money. Equivalently, we could use the real version of the liquidity preference model, in which the real interest rate is determined by the real demand and supply 14-4 Equilibrium in the Money Market
The money supply curve, MS, is vertical at the
money supply chosen by the Federal Reserve, M.
The money market is in equilibrium when the
quantity of money demanded by the public is
equal to M, the quantity of money supplied—that
is, when the interest rate is equal to rE. At a
point such as L, the interest rate, rL, is below rE
and the quantity of money demanded, ML, exceeds the money supply, M. In an attempt to
shift their wealth out of nonmonetary interestbearing financial assets and raise their money
holdings, investors drive the interest rate up to
rE. At a point such as H, the interest rate rH is
above rE and the quantity of money demanded,
MH, exceeds the money supply M. In an attempt
to shift out of money holdings into nonmonetary
interest-bearing financial assets, investors drive
the interest rate up to rE. Interest
curve, MS rH
rate H Equilibrium E rE L rL
chosen by the Fed MD ML
money, M UNCORRECTED Preliminary Edition CHAPTER 14 of money. From now on we will drop the word nominal with the understanding that it
still applies. In Chapter 13 we learned how the Federal Reserve can increase or decrease
the money supply by buying or selling Treasury bills. Let’s assume for simplicity that the
Fed simply chooses the level of the money supply. Then the money supply curve is a vertical line, MS in Figure 14-4, with a horizontal intercept corresponding to the money
supply chosen by the Fed, M. The equilibrium is at E, where MS and MD cross. At this
point the quantity of money demanded equals the money supply, M, leading to an equilibrium interest rate of rE.
To understand why rE is the equilibrium interest rate, consider what happens if the
money market is at a point like L, where the interest rate,...
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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