Eguilibrium in the Money MarketInterestrate,iMS2MSAlternatively, the Fed maydecide to lower the money1.WhentheFedsupply, by selling Treasurydecreasesthe money5%.....the2supplyfromMS,tosecurities.equilibriumMS2-interestraterises.. Now firms andhouseholds (who boughtthe securities with money)MDhold less money than theywant, relative to otherfinancial assets.0900$850Quantityofmoney,MIn order to retain(billions ofdollars)depositors,banks areforced to offer a higherFigure 15.5The effect on the interestratewhentheFedinterestrate oninterest-decreasesthe money supplybearingaccounts.16@2015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 16 Equilibrium in the Money Market Alternatively, the Fed may decide to lower the money supply, by selling Treasury securities. • Now firms and households (who bought the securities with money) hold less money than they want, relative to other financial assets. • In order to retain depositors, banks are forced to offer a higher interest rate on interestbearing accounts. The effect on the interest rate when the Fed decreases the money supply Figure 15.5
A Taleof Two InterestRatesWenowhavetwo modelsoftheinterestrate:Theloanablefundsmodel(chapter21):Concerned withlong-termreal rate of interest.Relevant for long-term investors (firms making capital investmentshouseholds building new homes, etc.)The money market model (this chapter).Concerned with short-term nominal rate of interestMostrelevantfortheFed:changes inmoneysupplydirectlyaffectthisinterestrateUsually, the two interest rates are closely related; an increase in oneresults in the other increasing also2015PearsonEducation,Inc.17
© 2015 Pearson Education, Inc. 17 A Tale of Two Interest Rates We now have two models of the interest rate: The loanable funds model (chapter 21) • Concerned with long-term real rate of interest • Relevant for long-term investors (firms making capital investments, households building new homes, etc.) The money market model (this chapter) • Concerned with short-term nominal rate of interest • Most relevant for the Fed: changes in money supply directly affect this interest rate Usually, the two interest rates are closely related; an increase in one results in the other increasing also
Choosing a MonetaryPolicy TargetThe Fed can choose to target aparticular level of the money supplyor a particular short-term nominal interest rate.: It concentrates on the interest rate, in part because the relationshipbetween the money supply (M1 or M2) and real GDP growth brokedown in the early 1980s (M1) and 1990s (M2)There are many different interest rates in the economy; the Fedtargets the federal funds rate: the interest rate banks charge eachotherforovernightloans.The Fed does not set the federal funds rate but rather affects thesupply of bank reserves through open market operations.182015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 18 Choosing a Monetary Policy Target The Fed can choose to target a particular level of the money supply, or a particular short-term nominal interest rate. • It concentrates on the interest rate, in part because the relationship between the money supply (M1 or M2) and real GDP growth broke down in the early 1980s (M1) and 1990s (M2). There are many different interest rates in the economy; the Fed targets the federal funds rate: the interest rate banks charge each other for overnight loans. • The Fed does not set the federal funds rate but rather affects the supply of bank reserves through open market operations