Page 350 - Krugmans Economics for AP Text Book_Neat

figure 31.1

The Effect of an Increase Interest
in the Money Supply on rate, r An increase
the Interest Rate in the money
supply . . .
The Federal Reserve can lower the inter-
MS 1 MS 2
est rate by increasing the money supply.
Here, the equilibrium interest rate falls
from r 1 to r 2 in response to an increase in

the money supply from M 1 to M 2 . In
order to induce people to hold the larger
quantity of money, the interest rate must
fall from r 1 to r 2 . . . . leads to r 1 E 1
a fall in the
interest rate. E 2
r 2
MD
M 1 M 2 Quantity
of money

Figure 31.2 shows how interest rate targeting works. In both panels, r T is the target
federal funds rate. In panel (a), the initial money supply curve is MS 1 with money sup-

ply M 1 , and the equilibrium interest rate, r 1 , is above the target rate. To lower the in-
terest rate to r T , the Fed makes an open - market purchase of Treasury bills, which leads
to an increase in the money supply via the money multiplier. This is illustrated in

figure 31.2 Setting the Federal Funds Rate

(a) Pushing the Interest Rate (b) Pushing the Interest Rate
Down to the Target Rate Up to the Target Rate
Interest Interest
rate, r rate, r
An open-market An open-market
purchase . . . sale . . .
MS 1 MS 2 MS 2 MS 1

. . . drives r E 1 . . . drives r T E 2
the 1 the
interest r E 2 interest r E 1
rate down. T MD rate up. 1 MD

M 1 M 2 Quantity M 2 M 1 Quantity
of money of money

The Federal Reserve sets a target for the federal funds rate from MS 1 to MS 2 , and driving the interest rate down to r T . In
and uses open -market operations to achieve that target. In panel (b) the initial equilibrium interest rate, r 1 , is below the
both panels the target rate is r T . In panel (a) the initial equilib- target rate. The Fed reduces the money supply by making an
rium interest rate, r 1 , is above the target rate. The Fed in- open - market sale of Treasury bills, pushing the money supply
creases the money supply by making an open - market purchase curve leftward, from MS 1 to MS 2 , and driving the interest rate
of Treasury bills, pushing the money supply curve rightward, up to r T .

308 section 6 Inflation, Unemployment, and Stabilization Policies