Economics Micro & Macro (CliffsAP)

choosing to give up more value added to your money. Typically, people react to higher interest rates by holding money
(sometimes in mattresses!). Instead of physically holding money, individuals may decide to take advantage of the
higher interest rates and put their money in various interest-earning accounts. To sum it all up, the higher the interest
rate, the less money held. The lower the interest rate, the more money held.

Figure 6-1 illustrates the relationship between the demand for dollars and interest rates. Notice the downward slope of
the demand curve? This slope is attributed to the inverse relationship between quantity demanded and interest rates.

Figure 6-1

Nominal Income

The demand for money also depends on nominal income. Money demand varies directly with nominal income because
as income increases, more transactions are carried out and more money is required for those transactions.

The greater the nominal income, the greater the demand for money. Whether it is an increase in the price level or an in-
crease in real income, nominal income increases the demand for money. A rise in the price level or an increase in real
income can generate a greater volume of dollars for transactions. People are using more money due to an increase in either
the price level or real income. As real income increases, purchasing power increases as well. Individuals are buying and
selling more goods and services. Aggregate supply and aggregate demand both increase because of a rise in real income.

The Money Supply Function

The Fed is responsible for promoting macroeconomic stability, which it accomplishes by controlling the money supply.
It is important to realize that by controlling the money supply, the Fed changes interest rates. When the money supply is
changed, interest rates follow. However, the Fed’s decision to change the money supply is not the final determining fac-
tor of interest rates. The combinationof the Fed’s control of money and how consumers react to this change makes up
equilibrium in the money market. To find the equilibrium interest rate, you must combine both the demand for money
and the supply of money. Once you combine these two factors, you can determine at what interest rate borrowers are
willing to borrow and at what point the Fed is controlling the supply of money.

At times, the interest rate can change without a change in money supply. If people attempt to increase their money hold-
ings by converting assets into money, interest rates will rise. Conversely, if people decide to increase their assets by
converting money into bonds or other non-monetary holdings, the interest rates will decrease.

Note that the Fed can only assumehow the public will react to a change in the money supply. If consumers for some
reason decide to react differently to a policy change, the Fed must then reexamine the situation and try to introduce a
policy that will best remedy the problem. Ultimately, it is the consumers and borrowers who change interest rates. The
Fed can provide incentives to motivate the public; they cannot ultimately control these variables.

Quantity

Interest

Rates

Part II: Macroeconomics