Money Market Shifts
To understand the monetary transmission mechanism we need to see how changes in the money market affect interest rates, Suppose that the Federal Reserve becomes worried about inflation and tightens monetary policy by sealing securities and reducing’ the money supply The impact of a monetary tightening is shown in Figure. The leftward shift of the money supply schedule means that market interest rates must rise to induce people to swap their money for bonds and other non monetary assets. The gap between E and N shows the extent of excess demand for money at the old interest rate. Interest rates rise until the new equilibrium is attained, shown in Figure 2() (a) at point E’, with a new and interest rate of 6 percent per year.
There are also frequent shocks to. money demand. For example, suppose that an increase in oil or commodity prices raised the overall price level. With higher prices, the demand for would increase, shifting the money demand curve to the right from DD to as shown in Figure 26-6(b), and leading to an increase in- equilibrium interest rates. (To check your understanding, make sure you -can answer question 1 at the end of the chapter.)
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