Supply and Demand in the market for the money

Case changes in the equilibrium interest rate due to

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Unformatted text preview: ibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply To see how the liquidity preference framework can be used to analyze the movement of interest rates, we will again look at several cases that will be useful in evaluating the effect of monetary policy on interest rates. (As a study aid, Table 1 summarizes the shifts in the demand and supply curves for money.) Supply and Demand in the Market for Money: The Liquidity Preference Framework Table 1 Summary Variable Income W-33 Factors That Shift the Demand for and Supply of Money Change in Variable Change in Money Demand [M d] or Supply [M s] Change in Interest Rate ↑ Md↑ ↑ Ms i i2 i1 ← Md 1 Md 2 M Price level ↑ Md↑ ↑ Ms i i2 i1 ← Md 1 Md 2 M ↑ Ms↑ ↓ i Ms Ms 1 2 i1 ← Money supply i2 Md M Note: Only increases (↑) in the variables are shown. The effect of decreases in the variables on the change in demand or supply would be the opposite of those indicated in the remaining columns. Changes in Income When income is rising during a business cycle expansion, we have seen that the demand for money will rise. It is shown in Figure 2 by the shift rightward in the demand curve from M d to M d The new equilibrium is reached at point 2 at the intersec1 2 tion of the M d curve with the money supply curve Ms. As you can see, the equilibrium 2 interest rate rises from i1 to i2. The liquidity preference framework thus generates the conclusion that when income is rising during a business cycle expansion (holding other economic variables constant), interest rates will rise. This conclusion is unambiguous when contrasted to the conclusion reached about the effects of a change in income on interest rates using the loanable funds framework. Changes in the Price Level When the price level rises, the value of money in terms of what it can purchase is lower. To restore their purchasing power in real terms to its former level, people will want to hold a greater nominal quantity of money. A higher price level shifts W-34 Appendix 4 to Chapter 4 Interest Rate, i Ms 2 i2 1 i1 Md 1 M Figure 2 Md 2 Quantity of Money, M Response to a Change in Income In a business cycle expansion, when income is rising, the demand curve shifts from M d 1 to M d . The supply curve is fixed at M s M . The equilibrium interest rate rise 2 from i1 to i2. Interest Rate, i Ms i2 2 i1 1 Md 1 M Figure 3 Md 2 Quantity of Money, M Response to a Change in the Price Level An increase in price level shifts the money demand curve from M d to M d , and the equi1 2 librium interest rate rises from i1 to i2. the demand curve for money to the right from M d to M d (see Figure 3). The equi1 2 librium moves from point 1 to point 2, where the equilibrium interest rate has risen from i1 to i2, illustrating that when the price level increases, with the supply of money and other economic variables held constant, interest rates will rise. Supply and Demand in the Market for Money: The Liquidity Preference Framework Interest Rate, i i1 i2 s M1 W-35 s M2 1 2 Md Quantity of Money, M Figure 4 Response to a Change in the Money Supply When the money supply increases, the supply curve shifts from M s to M s , and the equi1 2 librium interest rate falls from i1 to i2. go online Money supply data, which the Federal Reserve reports...
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This note was uploaded on 01/02/2013 for the course ECON 102 taught by Professor Lisa during the Spring '09 term at RMIT Vietnam.

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