Supply of and Demand for Money
The supply ol and demand for money jointly determine the market in terest rates. Figure 26-5 shows the total quantity of money (M) on the horizontal axis and the nominal interest rate (i) on the vertical axis. The supply curve is drawn as a vertical line on the
assumption that the Federal Reserve keeps the money supply constant at M in Figure 26-5. In addition, we show the money demand schedule as a downward-sloping curve because the holdings of money decline as interest rates rise. At higher interest rates, people and businesses shift more of their funds to higher-yield assets and away from low-yield zero yield money, as described in the previous chapter. The intersection of the supply and demand schedules ill Figure 26-5 determines the- market’ interest rate. Recall that interest rates are the prices paid for tilt” use of money. Interest rates arc determined
in money markets, which are the markets where short funds are lent and borrowed. interest rates include short-term rates such , the on month Treasury bills and on short paper (notes issued large all 5 noted above, the Federal Reserve operates in the market for federal funds and feral funds rate. Longer-term rates or 20-and corporate bonds and on real estate.(See Figure 25-2 for a graph of recent trends in interest rates.)
In Figure 26-5, the equilibrium interest rate is 4 percent per year. Only at 4 percent is the level of the money supply that the Fed has targeted consistent with the desired money holdings of the public. At a higher interest rate, there would be excessive money balances. People would get rid of their excessive money holdings by buying bonds and other financial instruments, thereby lowering market interest rates toward the equilibrium 4 percent rate. (What would happen at an -interest rate of 2 percent?).
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