Page 316 - Krugmans Economics for AP Text Book_Neat

figure 28.3

Equilibrium in the Money Market Interest
rate, r
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 Money supply
rate r E : the quantity of money demanded by the curve, MS
––
public is equal to M , the quantity of money sup-
plied. At a point such as L, the interest rate, r L , is
below r E and the corresponding quantity of money
––
demanded, M L , exceeds the money supply, M . In
an attempt to shift their wealth out of nonmoney in- r H Equilibrium
terest -bearing financial assets and raise their H
money holdings, investors drive the interest rate up
to r E . At a point such as H, the interest rate r H is Equilibrium r E E
above r E and the corresponding quantity of money interest L
–– rate r
demanded, M H , is less than the money supply, M. L MD
In an attempt to shift out of money holdings into
nonmoney interest -bearing financial assets, in- M M M
vestors drive the interest rate down to r E . H L
Quantity of
Money supply money
chosen by the Fed

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, MS in Figure 28.3, with a horizontal intercept corresponding to the money

supply chosen by the Fed, M. The money market equilibrium is at E, where MS and MD

cross. At this point the quantity of money demanded equals the money supply, M, lead-
ing to an equilibrium interest rate of r E .
To understand why r E is the equilibrium interest rate, consider what happens if the
money market is at a point like L, where the interest rate, r L , is below r E . At r L the public
wants to hold the quantity of money M L , 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 more than the
quantity of money supplied. The other is that the quantity of interest -bearing nonmoney
assets demanded is less than 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 r L until 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 r E .
Now consider what happens if the money market is at a point such as H in Figure
28.3, where the interest rate r H is above r E . In that case the quantity of money de-

manded, M H , 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 r H . 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 r E .

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