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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