14.1 Graphing Exercise: Equilibrium Interest Rate

The total demand for money consists of the amount people desire to hold so they may carry out transactions plus the amount they want to hold in their portfolios of financial assets. While the transactions demand for money is related directly to nominal GDP, the asset demand for money is inversely related to the interest rate. The reasons are straightforward. The higher the prices of goods and services, or the more goods and services people intend to buy, the more money they desire to hold for purchases: higher nominal GDP implies greater quantity of money demanded. On the asset side, bonds pay interest while money does not. The higher the interest rate, the greater the opportunity cost of holding money and the less will be desired.

The Federal Reserve Bank and financial institutions provide the economy with a particular stock of money independent of the interest rate. The interest rate then adjusts until the quantity of money demanded equals this particular stock of money.

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Exploration: How does the interest rate adjust to changes in the supply of and demand for money?

The graph shows the money demand curve and the money supply curve in a hypothetical economy. Initially, the money market is in equilibrium at an interest rate of 6%; the quantity of money demanded at this interest rate is equal to the money stock of $150 billion. To use the graph, click and drag on either the S_m or D_m labels to shift supply or demand, respectively. Click New Equilibrium to observe the interest rate adjust to restore equilibrium. If you then click on Update, the current equilibrium will become the starting point for further investigation.

1. Suppose the Federal Reserve increases the money supply by $50 billion to $200 billion What impact will this have on the interest rate?
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2. Suppose an increase in desired spending has resulted in an increase in nominal GDP. What impact will this have on the interest rate?
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3. Starting from the original equilibrium, suppose the Fed reduces the money stock by $25 billion. What is the new equilibrium interest rate?
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4. If the economy expands, what must the Fed do to prevent a change in the interest rate?
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5. Experiment on your own. What generalization can you make regarding the relationship between the interest rate and changes in the supply and demand for money?
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14.2 Graphing Exercise: Monetary Policy

The Federal Reserve Bank can control the money supply by controlling the amount of bank reserves. It has three tools at its disposal: the conduct of open market operations and changes in the reserve ratio and the discount rate. Monetary policy consists of deliberate changes in the money supply to influence interest rates and thereby the level of aggregate spending and employment in the economy.

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Exploration: How do changes in the money supply affect real GDP and the price level?

The three graphs in the window illustrate the cause-effect chain that links changes in the money supply, the interest rate, investment spending, and aggregate demand. The Fed can, through its control of the money supply, influence aggregate demand, thereby influencing equilibrium real GDP and the price level. To use the graphs, increase or decrease the money supply by dragging the blue triangle at the base of the S_m curve. The other two graphs track the interest-rate induced changes in investment spending and aggregate demand. Click on the Price Adjustment button to see the impact of changes in the money supply on equilibrium GDP and the price level.

1. Suppose the Fed buys bonds on the open market in sufficient quantities to increase the money supply by $600 billion. What impact will this have on the interest rate, investment spending, real GDP, and the price level?
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2. Suppose the Fed increases the discount rate and sells a sufficient number of bonds to reduce the money supply by $300 billion. What impact will this have on the interest rate, investment spending, real GDP, and the price level?
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3. Experiment on your own. How might the Fed respond to a problem of substantial unemployment? How might the Fed respond to a problem of high inflation? Can the Fed fight both inflation and unemployment at the same time?
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