5 Steps to a 5 AP Macroeconomics 2019

Money, Banking, and Monetary Policy ❮ 147

•       If   you    simply  label   the vertical    axis    in   the    money   market  as   “%”    or   “Interest  rate”   

you may not earn all the graphing points.

Changes in Money Supply

When we talk about monetary policy, we are really talking about money supply policy. The

tools used to expand or contract the money supply are discussed later in this chapter, but it’s

useful to see what is happening in the money market when the money supply increases or

decreases.

An Increase in the Money Supply

Like the market for any commodity, when the supply increases, there exists a temporary

surplus at the original equilibrium price. The money market is no different. At the origi-

nal interest rate of 10 percent, the supply of money is $1,000. Now the Fed increases the

money supply to $1,500. In Figure 11.3, you can see that at 10 percent, there is now a

surplus of money.

With surplus money on their hands, people find other assets, like bonds, as places to

put the extra money. As more people increase the demand for bonds, the bond price rises,

and this lowers the effective interest rate paid on the bonds.

KEY IDEA

MS

MD

Money

Nominal

Interest

Rate, i %

$1,000

10%

$1,500

MS’

Surplus of

Money

Figure 11.3

How does this work?

A bond is selling at a price of $100 and promises to pay $10 in interest. The interest rate

= $10/$100 = 10 percent. But if the price of the bond is driven up to $125, the same $10

of interest actually yields only $10/$125 = 8.0 percent. With lower interest rates available

in the bond market, the opportunity cost of holding cash falls and the quantity of money

demanded increases along the downward-sloping MD curve until MD = $1,500. An

increase in the money supply therefore decreases the interest rate.

A Decrease in the Money Supply

If the Fed decides to decrease the supply of money from $1,000 to $500, there is a short-

age of money at the 10 percent interest rate. A shortage of money sends some bondholders

to sell their bonds so that they have money for transactions. An increase in the supply of

bonds in the bond market decreases the price and increases the rate of interest earned on

those assets.