sg27 - Chapter 11 MONEY, INTEREST, REAL GDP, AND THE PRICE...

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163 11 MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL* Key Concepts ± The Demand for Money Four factors influence the demand for money: The price level — An increase in the price level in- creases the nominal demand for money. The interest rate — An increase in the interest rate raises the opportunity cost of holding money and decreases the quantity of real money demanded. Real GDP — An increase in real GDP increases the demand for money. Financial innovation — Innovations that lower the cost of switching between money and other assets decrease the demand for money. Figure 11.1 shows the demand for money curve ( MD ). The real quantity of money equals the nominal quan- tity divided by the price level. Changes in the interest rate create movements along the demand curve; changes in the other relevant factors change the de- mand and shift the demand curve. ± Interest Rate Determination An interest rate is the percentage yield on a financial security; other variables being the same, the higher the price of the security, the lower is the interest rate. The interest rate is determined by the equilibrium in the market for money, as illustrated in Figure 11.2. The real supply of money is $3.0 trillion, so the supply curve of money is MS . The demand curve for money is MD , and the equilibrium interest rate is 5 percent. If the Fed increases the quantity of money, the supply of money curve shifts rightward and the equilibrium interest rate falls. If the Fed decreases the quantity of money, the supply of money curve shifts leftward and the equilibrium interest rate rises. * This is Chapter 27 in Economics . Chapter
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164 CHAPTER 11 (27) ± Short-Run Effects of Money on Real GDP and the Price Level The Fed’s actions ripple through the economy. Higher interest rates: Decrease investment and consumption expenditure Increase the foreign exchange price of the dollar, which then decreases net exports A multiplier process then occurs Real GDP growth and the inflation rate both slow when the Fed raises the interest rate. The opposite ef- fects occur when the Fed lowers the interest rate. These effects are how the Fed influences the economy. The macroeconomic short run is a period during which some money prices are sticky and real GDP might be below, above, or at potential GDP. If real GDP exceeds potential GDP so there is an infla- tionary gap, the Fed tightens to avoid inflation. The Fed decreases the quantity of money, which raises the interest rate. The higher interest rate decreases interest- sensitive components of aggregate expenditure, such as investment. The decrease in investment leads to a mul- tiplier effect that decreases aggregate demand, thereby lowering the price level and decreasing real GDP so it equals potential GDP. If the Fed eases to avoid a reces- sion, the reverse results occur. ± Long-Run Effects of Money on Real GDP
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sg27 - Chapter 11 MONEY, INTEREST, REAL GDP, AND THE PRICE...

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