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From my notes:

We analyze the determination of the interest rate using a supply/demand model relating the interest rate (price of money) to the quantity of money. Since we assume:

1) no excess reserve

2) no excess currency in circulation

Real money supply (Ms/P) does not change with with a change in the interest rate, thus perfectly inelastic Ms

This is the part I don't really get. If money supply is determined by the central bank/government, does my notes have any connection to understanding why money supply is inelastic?

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The Fed controls the nominal money supply as they are the only ones who can add or remove money from the economy by printing it. Real money supply is only affected by increases or decreases in inflation and is fixed assuming inflation is 0. In the IS-LM model which is what I assume you are referring to it is assumed that inflation is fixed or that the fed will maintain the real money supply at a given point by changing the nominal money supply for given price levels.

Graphically money supply can be shown like so: enter image description here

The equilibrium between money supply (which is set by the fed) and money demand (which is set by economic factors) generates the interest rate for the economy at a given time. The fed thus has power to affect the interest rate by increase or decrease the real money supply in order to maintain an interest rate. Given that the fed has complete control over the interest rate under this model it is often assumed that LM is horizontal due to the fact that the fed can set whatever rate they choose regardless of economic factors.

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It seems to context of your question is the IS-LM model, where your question is specifically about the LM. In the Hicks (IS-LM) view of the money market, the nominal money supply is fixed, as it depends directly on the amount of money printed by the government (although now we tend to think in terms of the central bank) and not on the actions of the other agents of the economy. As such, it is a defining assumption and exogenous to the dynamic of the model.

Now, notice that the real money supply could change when prices move. In the IS-LM context, this could be due to an increase in government spending financed via taxation, where a multiplier higher than one leads to an expansion of aggregate demand and, in the short-run at least, a boom and an increase in the price (assuming a positive sloped aggregate supply).

Now, moving away from such a simplistic assumption, the concept of the money supply is more complex than that. The money supply is usually defined as:

$$M_{s}=\phi B$$

where $\phi$ is the money multiplier and $B$ is the monetary base. A government/central bank can directly alter the the latter by printing money or buying/selling short term debt. It can also affect the multiplier by altering banking regulation like maximum reserve ratios. But, importantly it is the action of bankers and the agents in the economy that determine the value of the multiplier (e.g. via lower lending or more demand for currency, respectively). So, in the end, the money supply does not depend only of the government or central bank agency but of the rest of the agents too.

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  • $\begingroup$ Any feedback on why the downvote is greatly appreciated :) $\endgroup$ – luchonacho Apr 12 '17 at 8:08

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