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Solution
Solution
S-217
1. Using a figure similar to Figure 15A-1, explain how the money market and the loan-
able funds market react to a reduction in the money supply in the short run.
1. In the accompanying diagram, both the money market and the loanable funds market
are initially in equilibrium at the same rate of interest, r1. A decrease in the money
supply shifts the money supply curve leftward, to MS2, and the equilibrium interest
rate rises to r2. The increase in the interest rate leads to a decrease in real GDP,
2. Contrast the short-run effects of an increase in the money supply on the interest
rate to the long-run effects of an increase in the money supply on the interest rate.
2. In the short run, the interest rate is determined in the money market: the short- run
equilibrium interest rate is determined where money demand equals money supply.
An increase in the money supply will lead to a fall in the interest rate in the money
Appendix: Reconciling
the Two Models of the
Interest Rate
15 A
CHAPTER
KrugWellsECPS4e_Macro_CH15A.indd S-217 2/6/15 11:18 AM
In the long run, real GDP cannot differ from potential output. So in the long run,
the interest rate is determined in the loanable funds market: the long - run equilib-
rium interest rate equalizes the supply of loanable funds and the demand for loan-
S-218 CHAPTER 15 APPENDIX RECONCILING THE TWO MODELS OF THE INTEREST RATE
KrugWellsECPS4e_Macro_CH15A.indd S-218KrugWellsECPS4e_Macro_CH15A.indd S-218 2/6/15 11:18 AM2/6/15 11:18 AM
