MacroeconomicsI_working_version (1)

Monetary Policy in Details 121
i
MS
i 0
M*
MD
M
Figure 13.2 The market interest rate is determined by demand and supply of money at the money
market. The vertical supply-of-money schedule is exogenously determined by the central bank. The
downward-sloping money demand schedule refers to negative relationship between money demand and
interest rates. Equilibrium interest rate i 0 clears the market.
Let’s examine the impacts of changes in the demand and supply of money in the money
market 2 . Assume the central bank has decided to tighten monetary policy because of the
threat of rising inflation. The central bank will reduce supply of money in the economy by
selling government bonds.
This case of a restrictive monetary policy (tight money) is described in Figure 13.3(a).
Money balances will not meet people’s transaction and assets need at initial interest rate i 0
as the money supply schedule moved leftward. People start to sell off some of their assets
and increase their money holdings to reduce the gap associated with the extent of excess
demand for money at the old interest rate. As the public tries to reach the desired moneystock,
interest rates rise until the new equilibrium at level i 1 referring to E’.
In the other case let’s assume the money supply is held constant by the central bank. The
economy is affected by a shock in a form of rising prices due to increase in oil prices.
Accordingly, the general price level rises and money desired to finance transactions
increase with no change in real GDP. This situation is described in Figure 13.3 (b), where
the demand for money would rise moving the money demand curve rightwards from MD to
MD’, which force the equilibrium interest rates to increase.
2 For broader descriptions of changes in money markets see Samuelson – Nordhaus [11]