Page 525 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 499

EXHIBIT 14.6
Monetary Policy Choices

(a) Before 1979: Target Range of Interest Rates

D D D’

Interest rate i * Interest rate i * 2 1

S S S’
1 = The demand for money increases
2 = The Fed increases the money supply
to stay in the interest rate target

Quantity of money
M
Quantity of money
Shifts in money demand and then
money supply keep interest rates
in the target range.

(b) After 1979: Target Range of Money Supply
D D D’

i 1 2
Interest rate Interest rate i 0 1

S S
1 = The demand for money increases
2 = Interest rates increase

M * M *
Quantity of money Quantity of money
A shift in money demand and no shift
in money supply causes interest rates
D = Money demand curve M = Quantity of money
to rise and target range of money
S = Money supply curve i = Interest rate level supply to be maintained.
interest to later pay the rising prices of goods and services. Let’s say that the real rate
of interest is 2 percent and is fairly constant over time, which is generally true. Now,
if the inflation rate increases from 3 to 4 percent, the nominal interest rate will
increase from 5 to 6 percent. Importantly, as inflation increases and pushes up
nominal interest rates, business firms are less likely to borrow funds from banks
and others. The higher cost of money has similar negative effects on business firms
as do the higher costs of labor and goods; interest costs are expenses that can lower
profits. Generally speaking, high inflation rates disrupt normal business opera-
tions. Many business firms fail due to difficulties in keeping down their operating
costs of labor, goods, and borrowed funds.
Due to the problem of inflation disrupting businesses, causing failures, and
slowing economic growth, in 1979 central banks changed their monetary policy and
made fighting inflation the primary economic goal. The bottom portion of Exhibit
14.6b illustrates this policy. A target range of money supply M* was set, and if the
demand for money increased, interest rates were allowed to increase as determined
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