Money Supply

The first piece of the theory of liquidity preference is the supply of money. As we first discussed in Chapter 29, the money supply in the U.S. economy is controlled by the Federal Reserve. The Fed alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open-market operations. When the Fed buys government bonds, the dollars it pays for the bonds are typically deposited in banks, and these dollars are added to bank reserves. When the Fed sells government bonds, the dollars it receives for the bonds are with drawn from the banking system, and bank reserves fall. These changes in bank reserves, in turn, lead to changes in banks’ ability to make loans and create money. In addition to these open-market operations, the Fed can alter the money supply by changing reserve requirements (the amount of reserves banks must hold against deposits) or the discount rate (the interest rate at which banks can borrow reserves from the Fed). These details of monetary control are important for the implementation of Fed policy, but they. are not crucial in this chapter. Our goal here is to examine how changes in the money supply affect the aggregate demand for goods and services. For this purpose, we can ignore the details of how Fed policy is implemented and simply assume that the Fed controls the money supply directly. In other words, the quantity of money supplied in the economy is fixed at whatever level the Fed decides to set it. Because the quantity of money supplied is fixed by Fed policy, it does not depend on other economic variables. In particular, it does not depend on the interest rate. Once the Fed has made its policy decision, the quantity of money supplied is the same, regardless of the prevailing interest rate. We represent a fixed money supply with a vertical supply curve, as in Figure 1

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