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This is quote from Gregory Mankiw's macroeconomics text about mechanism of formation of the interest rate in the money market model:

How does the interest rate get to this equilibrium of money supply and money demand? The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their portfolios of assets and, in the process, alter the interest rate. For instance, if the interest rate is above the equi- librium level, the quantity of real money balances supplied exceeds the quantity demanded. Individuals holding the excess supply of money try to convert some of their non-interest-bearing money into interest-bearing bank deposits or bonds. Banks and bond issuers, who prefer to pay lower interest rates, respond to this excess supply of money by lowering the interest rates they offer. Conversely, if the interest rate is below the equilibrium level, so that the quantity of money demanded exceeds the quantity supplied, individuals try to obtain money by sell- ing bonds or making bank withdrawals.To attract now-scarcer funds, banks and bond issuers respond by increasing the interest rates they offer. Eventually, the interest rate reaches the equilibrium level, at which people are content with their portfolios of monetary and nonmonetary assets.

I also noticed that the money supply curve is strictly vertical.

Both of these things make me suspect that this model assumes that the central bank doesn't target the interest rate. Am I right? Or is it somehow possible for the central bank to target the interest rate in this model without breaking the interest-rate forming mechanism outlined above?

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  • $\begingroup$ I find that WIlliam M. Scarth's Macroeconomics: An introduction to Advanced Methods can provide you with the answers you're searching for and more. Look at chapter 2, Demand and Supply (my version is that of 1996). I'm not posting a legitimate answer because at this time I'm preoccupied with studying. $\endgroup$ – S. Iason Koutsoulis Jul 2 '20 at 17:19
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    $\begingroup$ Yes, the model has no resemblance to the real world. Look at policy statements by developed country (floating currency) central banks - they announce interest rate targets. The last time one could pretend that the money supply mattered was around 2008, when the Fed was operating a system with no excess reserves. $\endgroup$ – Brian Romanchuk Jul 2 '20 at 18:27
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    $\begingroup$ @BrianRomanchuk From Krugman: "You’ll sometimes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate. In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money. The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate." $\endgroup$ – user161005 Jul 6 '20 at 17:03
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    $\begingroup$ @BrianRomanchuk In their macroeconomics book in chapter about monetary policy. (The book is fresh, 2015 edition) Please, elaborate how the logic presented by Krugman is wrong. So far I fail to see how what you said about Bank of Canada proves Krugman wrong $\endgroup$ – user161005 Jul 6 '20 at 17:33
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    $\begingroup$ @BrianRomanchuk "The money supply under the control of the central bank was always equal to zero" But it's wrong. The central bank can change money supply by selling or buying bonds. Or by printing more cash. Or by changing fractional reserve requirements. $\endgroup$ – user161005 Jul 7 '20 at 12:51
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I remember making myself the same question when studying those models in Mankiw's book. The answer I arrived is that from the point of view of the model, the Central Bank's policy is reflected in the money supply variable, and the interest rate variable is an abstraction that represents the main interests rates in an economy that are given by the equilibrium.

Think about this, in the model when there's an increase in money supply, what happens with the equilibrium interest rate ceteris paribus? It goes down. And the opposite is also true. But, who controls the money supply variable? The Central Bank.

So if you look at what happens in reality is somehow like that, the Central Bank cuts rates so the money supply decreases. Obviously the mechanism by which this happens in reality is different compared to the model, even they're like the 'opposite', but remember that models simplify reality in order for it to be more understandable, and in this case the CB intervention is modeled this way.

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No, the central bank can target interest rate and the supply of money can still be vertical. This is because, under the exogenous supply of money model, when the central bank targets some interest rate, let us say $5\%$, central bank has to adjust money supply in a way that there is equilibrium in the market (Blanchard et al Macroeconomics has more detailed explanation of this).

First, you have to be careful and realize that interest rate is price for money and change in prices on a market do not shift demand, demand can change as we move along demand curve but for a shift in demand the demand would have to change at all possible prices. So, ceteris paribus when central bank targets interest rate demand for money is fixed.

Now have a look at the visualization below:

enter image description here

Let us suppose that we originally had equilibrium interest rate $r$ at a point where original money supply $M$ intersected money demand $L$. Next let us suppose that central bank decides to target higher interest $r''$ as it want to pursue contractionary monetary policy.

Now higher interest rate does not shift demand curve for money, it does reduce demand for money but that is movement along the demand curve not shift in demand curve. Consequently if central bank sets $r''$ but $M$ does not move there would be disequilibrium at money market and there would be excess supply of money. In order to prevent this from happening money supply has to be contracted to the point where $M$ shifts to $M''$ and equilibrium on the money market is restored. If central bank would not let money supply contract it would purposefully just distort money market which is exactly the opposite of what good central bank should do. Of course, it goes without saying that in the case it pursues expansionary monetary policy exactly the opposite will happen - even if central bank just sets low interest rate it has to follow up with increase in money supply or there would shortage of money in money market.

This works even in endogenous model of money supply where money supply is not vertical but upward sloping (since in the endogenous model even if the narrow money is fully controlled by central bank, broad money can be additionally supplied by private entities). Again, the same thing happens, if central bank increases interest rates supply for money has to shift to the left otherwise there would be surplus of money on the money market. There is simply no other way of restoring equilibrium at money market (under the strict ceteris paribus assumption of course).

enter image description here

Hence to sum it up the model does not assume that central bank do not target interest rate. The model just shows that, under ceteris paribus assumption, if central bank increases interest rate it has to reduce supply of money to avoid disequilibrium and if central bank decreases interest rate it has to increase money supply to avoid disequilibrium as well. Of course, central bank could just move the money supply and let the interest rate be determined by the market as well. Even in real world central banks do not just set interest rates but perform open market operations and other policies that change money supply so they are both moving supply of money and interest rates at the same time.

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