SUMMARY

1. The money demand curve arises from a trade-off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short-term interest rates, not long-term interest rates. Changes in the aggregate price level, real GDP, technology, and institutions shift the money demand curve.

2. According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shifting the money supply curve. In practice, the Fed uses open-market operations to achieve a target federal funds rate, which other short-term interest rates generally track. Although long-term interest rates don’t necessarily move with short-term interest rates, they reflect expectations about what’s going to happen to short-term rates in the future.

3. Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. Contractionary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run.

4. The Federal Reserve and other central banks try to stabilize the economy, limiting fluctuations of actual output around potential output, while also keeping inflation low but positive. Under a Taylor rule for monetary policy, the target federal funds rate rises when there is high inflation and either a positive output gap or very low unemployment; it falls when there is low or negative inflation and either a negative output gap or high unemployment. Some central banks (including the Fed as of January 2012) engage in inflation targeting, which is a forward-looking policy rule, whereas the Taylor rule method is a backward-looking policy rule. Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the preferred policy tool for stabilizing the economy. Because interest rates cannot fall below zero—the zero lower bound for interest rates—the power of monetary policy is limited.

5. In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run.