The Supply Of Money

Just as we did for money demand, we would like to draw a curve showing the quantity of money supplied at each interest rate. In the previous chapter, you learned how the Fed controls the money supply: It uses open market operations to inject or

FIGURE 3

shifts and movements along the money demand curve: a summary

FIGURE 3

300 500

800 Money ($ Billions)

300 500

800 Money ($ Billions)

Interest Rate

Entire money demand curve shifts rightward if the price level or income increases

Entire money demand curve shifts rightward if the price level or income increases m2

Money ($ Billions)

FIGURE 4

Once the Fed sets the money supply, it remains constant until the Fed changes it. The vertical supply curve labeled M^ shows a money supply of $500 billion, regardless of the interest rate. An increase in the money supply to $700 billion is depicted in a right-ward shift of the money supply curve to M 2.

withdraw reserves from the banking system and then relies on the demand deposit multiplier to do the rest. Since the Fed decides what the money supply will be, we treat it as a fixed amount. That is, the interest rate can rise or fall, but the money supply will remain constant unless and until the Fed decides to change it.

Look at the vertical line labeled Mst in Figure 4. This is the economy's money supply curve, which shows the total amount of money supplied at each interest rate. The line is vertical because once the Fed sets the money supply, it remains constant until the Fed changes it. In the figure, the Fed has chosen to set the money supply at $500 billion. A rise in the interest rate from, say, 3 percent to 6 percent would move us from point J to point E along the solid money supply curve, leaving the money supply unchanged.

Now suppose the Fed, for whatever reason, were to change the money supply. Then there would be a new vertical line, showing a different quantity of money supplied at each interest rate. Recall from the previous chapter that the Fed raises the money supply by purchasing bonds in an open market operation. For example, if the demand deposit multiplier is 10, and the Fed purchases government bonds worth $20 billion, the money supply increases by 10 X $20 billion = $200 billion. In this case, the money supply curve shifts rightward, to the vertical line labeled M2 in the figure.

Money supply curve A line showing the total quantity of money in the economy at each interest rate.

Open market purchases of bonds inject reserves into the banking system, and shift the money supply curve rightward by a multiple of the reserve injection. Open market sales have the opposite effect: They withdraw reserves from the system and shift the money supply curve leftward by a multiple of the reserve withdrawal.

EQUILIBRIUM IN THE MONEY MARKET_ Find the Equilibrium

Now we are ready for Key Step #3: to combine what you've learned about money demand and money supply to find the equilibrium interest rate in the economy. But

FIGURE 5

Money market equilibrium occurs when households and firms are content to hold the amount of money they are actually holding. At point E—at an interest rate of 6 percent—the quantity of money demanded equals the quantity supplied, and the market is in equilibrium. At a higher interest rate, such as 9 percent, there would be an excess supply of money, and the interest rate would fall. At a lower interest rate, such as 3 percent, there would be an excess demand for money, and the interest rate would rise.

money market equilibrium

Interest Rate

300 500

300 500

Money ($ Billions)

before we do, a question may have occurred to you. Haven't we already discussed how the interest rate is determined? Indeed, we have. The classical model tells us that the interest rate is determined by equilibrium in the loanable funds market— where a flow of loanable funds is offered by lenders to borrowers. But remember: The classical model tells us how the economy operates in the long run. We can rely on its mechanisms to work only over long periods of time. Here, we are interested in how the interest rate is determined in the short run, so we must change our perspective. Toward the end of the chapter, we'll come back to the classical model and explain why its theory of the interest rate does not apply in the short run.

In the short run—our focus here—we look for the equilibrium interest rate in the money market: the interest rate at which the quantity of money demanded and the quantity of money supplied are equal. Figure 5 combines the money supply and demand curves. Equilibrium occurs at point E, where the two curves intersect. At this point, the quantity of money demanded and the quantity supplied are both equal to $500 billion, and the equilibrium interest rate is 6 percent.

It is important to understand what equilibrium in the money market actually means. First, remember that the money supply curve tells us the quantity of money, determined by the Fed, that actually exists in the economy. Every dollar of this money—either in cash or in checking account balances—is held by someone. Thus, the money supply curve, in addition to telling us the quantity of money supplied by the Fed, also tells us the quantity of money that people are actually holding at any given moment. The money demand curve, on the other hand, tells us how much money people want to hold at each interest rate. Thus, when the quantity of money supplied and the quantity demanded are equal, all of the money in the economy is being willingly held. That is, people are satisfied holding the money that they are actually holding.

Equilibrium in the money market occurs when the quantity of money people are actually holding (quantity supplied) is equal to the quantity of money they want to hold (quantity demanded).

Can we have faith that the interest rate will reach its equilibrium value in the money market, such as 6 percent in our figure? Indeed we can. In the next section, we explore the forces that drive the money market toward its equilibrium.

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