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Monetary Policy and AD/AS Chapter 20 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... The graphic representation of the effect of changes in monetary policy and money demand on interest rate. Interest Rate Money supply r1 Equilibrium interest rate r2 0 Money demand Md1 Quantity fixed by the Fed Md2 Quantity of Money Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... The interest rate is a nominal rate. Monetary policy targets the Federal Funds rate (the rate banks charge each other for over-night loans). Changes in Interest this rate indicate to the Fed the Rate amount of excess reserves in the Money banking system. supply r1 Equilibrium interest rate r2 0 Money demand d M 1 Quantity fixed by the Fed d M 2 Quantity of Money Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... Interest Rate Money supply r1 Equilibrium interest rate Money demand 0 d M 1 Quantity fixed by the Fed Money is defined as M1- Quantity of spending money Money Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... This is the quantity of money made available in the economy by the Money Federal Reserve Open supply Market Committee (FOMC). Interest rates do not affect the money supply. Interest Rate r1 Equilibrium interest rate r2 0 Money demand d M1 Quantity fixed by the Fed M d2 Quantity of Money Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... Interest Rate Money supply The money demand is the quantity of money the public is willing to hold (not save) as cash or checking deposits. r1 Equilibrium interest rate r2 0 Money demand d M1 Quantity fixed by the Fed M d2 Quantity of Money Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... Interest Rate Money Demand consists of two parts: Asset demand (liquidity theory)- how much money the public wants to hold as a financial asset for spending purposes; this is determined by interest rates and moves demand along the curve. High interest rates discourage asset demand (we prefer to save not spend). Money supply r1 r2 0 Money demand Md1 Quantity fixed by the Fed Md2 Quantity of Money Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Money Market... Interest Rate Transaction demand- how much money the public needs in order to buy available goods and services; this is determined by Nominal GDP and causes the curve to shift. Higher NGDP would shift the demand curve right. Another factor would be alternative means of spending such as credit card use. Higher use of credit cards would shift the curve down. Changes in money demand changes the interest rate. Money supply Interest rate 2 Equilibrium interest rate MD2 Money demand 0 Quantity fixed by the Fed Quantity of Money