Page 721 - The Principle of Economics

CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 741
Interest Rate
r1
r2
0
Price Level
P
0
Quantity of Money
(a) The Money Market
Figure 32-3
A MONETARY INJECTION. In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level from Y1 to Y2. Thus,
in panel (b), the aggregate- demand curve shifts to the right from AD1 to AD2.
Money MS2 supply,
MS1
1. When the Fed increases the money supply . . .
Money demand at price level P
2. . . . the equilibrium interest rate falls . . .
(b) The Aggregate-Demand Curve
AD2
Aggregate demand, AD1
Y1 Y2
Quantity of Output
3. . . . which increases the quantity of goods and services demanded at a given price level.
FOMC has chosen to set a target for the federal funds rate (rather than for the money supply, as it has done at times in the past) in part because the money sup- ply is hard to measure with sufficient precision.
The Fed’s decision to target an interest rate does not fundamentally alter our analysis of monetary policy. The theory of liquidity preference illustrates an im- portant principle: Monetary policy can be described either in terms of the money sup- ply or in terms of the interest rate. When the FOMC sets a target for the federal funds rate of, say, 6 percent, the Fed’s bond traders are told: “Conduct whatever open- market operations are necessary to ensure that the equilibrium interest rate equals