Information About The Money Demand Curve

The easiest job facing the Fed is responding to shifts in the money demand curve. As you saw in Figure 2, the Fed can stop money demand shocks from affecting output or the price level by adjusting the money stock to keep the interest rate unchanged. If the money demand curve shifts to M2, the interest rate rises, so the Fed knows it must increase the money supply to keep the interest rate at r1. The Fed maintains the interest rate by moving along the new money demand curve.

But Figure 2 also reveals a potential problem: The Fed cannot know how much to increase the money stock unless it knows the slope of the new money demand curve. For example, if the money demand curve has become flatter, the Fed will have to increase the money supply beyond M2 in order to maintain its interest rate target.

How does the Fed deal with this problem? In two ways. First, the Fed's research staff tries to estimate the changes in the position and slope of the money demand curve from available data. While the techniques are not perfect, they enable the Fed to make reasonable guesses about the required change in the money supply on any given day.

Second, the Fed uses the trial-and-error procedure that we discussed earlier. For example, suppose the interest rate rises and Fed officials underestimate the required change in the money supply. Then the interest rate will remain above its target rate, and the Fed can try again the next day, increasing the money supply further. In recent years, using a combination of research on the one hand and trial and error on the other, the Fed has been quite successful in reaching and maintaining its interest rate target.

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