AP_Krugman_Textbook

Fed, using one or more of these methods, simply chooses the level of the money supply

that it believes will achieve its interest rate target. Then the money supply curve is a ver-

tical line, MSin Figure 28.3, with a horizontal intercept corresponding to the money

supply chosen by the Fed, M. The money market equilibrium is at E,whereMSandMD

cross. At this point the quantity of money demanded equals the money supply, M,lead-

ing to an equilibrium interest rate of rE.

To understand why rEis the equilibrium interest rate, consider what happens if the

money market is at a point like L,where the interest rate, rL,is below rE.AtrLthe public

wants to hold the quantity of money ML,an amount larger than the actual money sup-

ply, M. This means that at point L,the public wants to shift some of its wealth out of in-

terest -bearing assets such as high-denomination CDs (which aren’t money) into money.

This has two implications. One is that the quantity of money demanded is morethan the

quantity of money supplied. The other is that the quantity of interest -bearing nonmoney

assets demanded is lessthan the quantity supplied. So those trying to sell nonmoney as-

sets will find that they have to offer a higher interest rate to attract buyers. As a result, the

interest rate will be driven up from rLuntil the public wants to hold the quantity of

money that is actually available, M.That is, the interest rate will rise until it is equal to rE.

Now consider what happens if the money market is at a point such as Hin Figure

28.3, where the interest rate rHis above rE. In that case the quantity of money de-

manded,MH,is less than the quantity of money supplied, M. Correspondingly, the

quantity of interest -bearing nonmoney assets demanded is greater than the quantity

supplied. Those trying to sell interest -bearing nonmoney assets will find that they can

offer a lower interest rate and still find willing buyers. This leads to a fall in the interest

rate from rH.It falls until the public wants to hold the quantity of money that is actu-

ally available, M. Again, the interest rate will end up at rE.

Two Models of the Interest Rate

Here we have developed what is known as the liquidity preference model of the interest

rate. In this model, the equilibrium interest rate is the rate at which the quantity of

money demanded equals the quantity of money supplied. This model is different from,

274 section 5 The Financial Sector

figure 28.3

Equilibrium in the Money Market

The money supply curve, MS,is vertical at the

money supply chosen by the Federal Reserve, M––.

The money market is in equilibrium at the interest

rate rE:the quantity of money demanded by the

public is equal to M––, the quantity of money sup-

plied. At a point such as L,the interest rate, rL,is

below rEand the corresponding quantity of money

demanded, ML,exceeds the money supply, M––. In

an attempt to shift their wealth out of nonmoney in-

terest -bearing financial assets and raise their

money holdings, investors drive the interest rate up

torE.At a point such as H,the interest rate rHis

aboverEand the corresponding quantity of money

demanded, MH,is less than the money supply, M––.

In an attempt to shift out of money holdings into

nonmoney interest -bearing financial assets, in-

vestors drive the interest rate down to rE.

M

Quantityof

money

rH

rE

rL

Interest

rate, r

L

E

MD

MH ML

H

Equilibrium

interest

rate

Money supply

chosen by the Fed

Money supply

curve, MS

Equilibrium