KRUGMAN_WELLS_MACRO_CHAPTER14

This means that at point l the public wants to shift

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Unformatted text preview: rL , is below rE. At rL the public wants to hold the quantity of money ML , an amount larger than the actual money supply, M. This means that at point L, the public wants to shift some of its wealth out of nonmonetary interest-bearing financial assets such as Treasury bills into money. This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of non-monetary interest-bearing financial assets demanded is less than the quantity supplied. So those trying to sell interest-bearing assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from rL until the public wants to hold the quantity of money that is actually available, M. That is, the interest rate will rise until it is equal to rE. Now consider what happens if the money market is at a point such as H in Figure 14-4, where the interest rate rH is above rE. In that case the quantity of money demanded, MH, is less than the quantity of money supplied, M . Correspondingly, the quantity of non-monetary interest-bearing financial assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing financial assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from rH; it falls until the public wants to hold the quantity of money that is actually available, M . Again, the interest rate will end up at rE. Two Models of Interest Rates? At this point you may be a bit puzzled. This is the second time we have discussed the determination of the interest rate. In Chapter 9 we studied the loanable funds model of the interest rate; according to it, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market. Which of these models is correct? The answer is both. But that will take a little time to explain, something we will do later in this chapter. For now, let’s put the loanable funds model to one side and concentrate on the liquidity preference model of the interest rate. The most important insight from this model is that it shows us how monetary policy—actions by the Federal Reserve and other central banks—works. Monetary Policy and the Interest Rate Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 14-5 on page 352 shows what happens when the Fed increases the money supply from M 1 to M 2. The economy is originally in equilibrium at E1, with an equilibrium interest rate of r1 and money supply M 1. An increase in the money supply by the Fed to M 2 shifts the money supply curve to the right, from MS1 to MS2, and leads to a fall in the equilibrium interest rat...
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