Download Interest Rate

The Money Market and
the Interest Rate
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Figure 1 The Money Demand
Curve
Interest
Rate
6%
The money demand curve is
drawn for a given real GDP
and a given price level.
E
At an interest rate of 6
percent, $500 billion of
money is demanded.
F
3%
If the interest rate drops to
3 percent, the quantity of
money demanded increases
to $800 billion.
Md
500
800
Money ($ Billions)
Figure 2 A Shift in the Money
Demand Curve
Interest
Rate
An increase in real GDP or in the price level
will shift the money demand curve rightward.
At any interest rate, more
money will be demanded
after the shift.
6%
E
G
F
3%
H
M1d
500
700 800
1,000
M2d
Money
($ Billions)
Figure 3 Shifts and Movements Along the
Money Demand Curve: A Summary
Interest
Rate
9%
6%
Interest
Interest rate ↑ moves
Rate
us leftward along the
money demand curve
C
A
Entire money demand
curve shifts rightward
if the price level or
income increases
Interest rate ↓
moves us rightward
along the money
demand curve
B
3%
M1d
300 500
800 Money ($ Billions)
M1d M2d
Money ($ Billions)
Figure 4 The Supply of Money
Interest Rate
6%
3%
M1S
M 2S
E
J
500
700
Money ($ Billions)
Figure 5 Money Market Equilibrium
Interest Rate
At the equilibrium
interest rate of
6%, the public is
content to hold
the quantity
of money it is
actually holding.
Ms At a higher interest rate, an
excess supply of money
causes the interest rate to fall.
9%
E
6%
At a lower interest rate,
an excess demand for
money causes the
interest rate to rise.
3%
Md
300
500
800 Money ($ Billions)
How the Money Market Reaches
Equilibrium
Interest
rate higher
than
equilibrium
Excess
supply of
money
Excess
demand for
bonds
Price of
bonds
How the Money Market Reaches
Equilibrium
Interest
rate higher
than
equilibrium
Excess
supply of
money and
excess
demand for
bonds
Price of
bonds
Interest
rate
How the Money Market Reaches
Equilibrium
Interest
rate lower
than
equilibrium
Excess
demand for
money and
excess
supply of
bonds
Price of
bonds
Interest
rate
How the Fed Changes the Interest
Rate
Fed
conducts
open
market
purchases
Money
supply
Excess
supply of
money and
excess
demand for
bonds
Price of
bonds
Interest
rate
Figure 6 An Increase in the
Money Supply
At point E, the money market is in
equilibrium at an interest rate of 6 percent.
Interest
Rate
6%
M1S
M 2S
The excess supply of money (and
excess demand for bonds) would
cause bond prices to rise, and the
interest rate to fall until a new
equilibrium is established at point F
with an interest rate of 3 percent.
E
3%
To lower the interest rate, the
Fed could increase the
money supply to $800 billion.
F
Md
500
800
Money ($ Billions)
How the Fed Changes the Interest
Rate
Fed
conducts
open
market
sales
Money
supply
Excess
supply of
money and
excess
demand for
bonds
Price of
bonds
Interest
rate
Figure 7 Monetary Policy and the
Economy
(a)
Interest Rate
6%
4.5%
3%
Real Aggregate
Expenditures ($ Trillions)
M1S M 2S
H
E
M dY $10 trillion
F
M dY $8 trillion
500 800 Money ($ Billions)
AEr = 4.5%
H
AEr = 6%
E
45°
(b)
8 10
Real GDP ($ Trillions)
Monetary Policy and the Economy
Monetary Policy and the Economy
Increase In Government Purchases
Figure 8 Fiscal Policy and the
Money Market
(a)
Ms
Interest Rate
8%
6%
L
E
M dY $13.5 trillion
M dY $10 trillion
Money ($ Billions)
500
Real Aggregate
Expenditures ($ Trillions)
L
F
AEr = 8%
AEr = 6%
E
(b)
45°
10 15
13.5
Real GDP ($ Trillions)
Figure 9 Interest Rate Expectations
Interest Rate
Ms
10%
5%
E
M2d
M1d
500
Money ($ Billions)
Figure 10a The Fed in Action: 2001
(a)
Interest Rate
6.4%
M1S
M 2S
A
During 2001, the Fed
repeatedly increased the
money supply . . .
3.1%
C
MYd $9,243 billion
MYd $9,130 billion
$1,093
1,170
Money ($ Billions)
Figure 10b The Fed in Action: 2001
(b)
Real Aggregate
Expenditure
($ Billions)
A
C
AEr = 6.4%
AEr = 3.1%
AEpossible severe recession
B
The result: the economy moved
from A to C instead of A to B and
the decrease in GDP was smaller.
45°
9,000 9,243
9,130
Real GDP ($ Billions)
Figure 10c The Fed in Action: 2001
(c)
Money (M1)
($ Billions)
1,200
During 2001, the Fed
repeatedly increased the
money supply . . .
1,150
1,100
1,050
1,000
Aug.
2000
Dec.
2000
Apr.
2001
Aug.
2001
Dec.
2001
Figure 10d The Fed in Action: 2001
(d)
Federal
Funds Rate
Percent
which caused the
interest rate to drop.
6.0
5.0
4.0
3.0
2.0
Aug.
2000
Dec.
2000
Apr.
2001
Aug.
2001
Dec.
2001