# ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing The Money Market and the Interest Rate.

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ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing The Money Market and the Interest Rate

Figure 1 The Money Demand Curve Money (\$ Billions) Interest Rate 6% E F 800500 3% MdMd The money demand curve is drawn for a given real GDP and a given price level. At an interest rate of 6 percent, \$500 billion of money is demanded. If the interest rate drops to 3 percent, the quantity of money demanded increases to \$800 billion.

Figure 2 A Shift in the Money Demand Curve Money (\$ Billions) Interest Rate 6% E F G H 1,000800700500 3% 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.

Figure 3 Shifts and Movements Along the Money Demand Curve: A Summary A B C 800500300 Money (\$ Billions) Interest Rate 6% 9% 3% Interest rate ↑ moves us leftward along the money demand curve Entire money demand curve shifts rightward if the price level or income increases Interest rate ↓ moves us rightward along the money demand curve Interest Rate Money (\$ Billions)

Figure 4 The Supply of Money 6% E J 700500 3% Money (\$ Billions) Interest Rate

Figure 5 Money Market Equilibrium E 500300 Money (\$ Billions) Interest Rate 6% 9% 3% MsMs 800 MdMd At the equilibrium interest rate of 6%, the public is content to hold the quantity of money it is actually holding. At a higher interest rate, an excess supply of money causes the interest rate to fall. At a lower interest rate, an excess demand for money causes the interest rate to rise.

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 E F 500 Money (\$ Billions) Interest Rate 6% 3% 800 MdMd At point E, the money market is in equilibrium at an interest rate of 6 percent. To lower the interest rate, the Fed could increase the money supply to \$800 billion. 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.

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 6% E F H 500 3% 4.5% Money (\$ Billions) Interest Rate 800 8 45° 10 Real GDP (\$ Trillions) Real Aggregate Expenditures (\$ Trillions) E H AE r = 4.5% AE r = 6% (a) (b)

Monetary Policy and the Economy

Increase In Government Purchases

Figure 8 Fiscal Policy and the Money Market 6% E L 500 8% MsMs 10 13.5 15 E F L AE r = 8% AE r = 6% Money (\$ Billions) Interest Rate Real GDP (\$ Trillions) Real Aggregate Expenditures (\$ Trillions) 45° (a) (b)

Figure 9 Interest Rate Expectations E 500 Money (\$ Billions) Interest Rate 5% 10% MsMs

Figure 10a The Fed in Action: 2001 3.1% C A \$1,093 6.4% 1,170 During 2001, the Fed repeatedly increased the money supply... Money (\$ Billions) Interest Rate (a)

Figure 10b The Fed in Action: 2001 (b) 9,000 9,130 9,243 B A C AE r = 6.4% AE r = 3.1% 45° AE possible severe recession The result: the economy moved from A to C instead of A to B and the decrease in GDP was smaller. Real GDP (\$ Billions) Real Aggregate Expenditure (\$ Billions)

Figure 10c The Fed in Action: 2001 (c) Money (M1) (\$ Billions) 1,000 1,050 1,100 1,150 1,200 Aug. 2000 Dec. 2000 Apr. 2001 Aug. 2001 Dec. 2001 During 2001, the Fed repeatedly increased the money supply...

Figure 10d The Fed in Action: 2001 which caused the interest rate to drop. 5.0 4.0 6.0 Federal Funds Rate Percent 2.0 3.0 Aug. 2000 Dec. 2000 Apr. 2001 Aug. 2001 Dec. 2001 (d)

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