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Chapter 14: Money, Interest Rate, and Exchange Rate
Money Defined: A Brief Review
How the Money Supply Is Determined
Money supply: Currency circulation + Demand deposit.
A country’s money supply is determined by its central bank, i.e., we take money supply as
given. Graphically,
R
M/P
MS/P
Aggregate Money Demand
Aggregate money demand: the total demand for money by all households and firms in the
economy.
Three factors affect/determine aggregate money demand:
1) The (nominal) interest rate, R:
2) The price level, P:
3) Real national income, Y:
ECMC61 – Chapter 14 1
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In notation form, aggregate money demand can be expressed as:
( )
( )
)(),(
d
YR,LPM
+
+
×=
Usually, we express money demand in real terms:
( )
Y R,L
P
M
d
=
Diagram.
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Equilibrium in the Money Market
Money market is in equilibrium when (real) money demand = (real) money supply:
( )
Y R,L
P
MS
=
Given the price level (P) and real output (Y), the nominal interest rate (R) adjusts to equate
real money demand to real money supply.
R
R0 A
L(R, Y)
ECMC61 – Chapter 14 2
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M/P
MS/P
Note: Money market is always in equilibrium. Therefore, when there is excess supply of
money in the market, the interest rate falls for a given level of output and price, and vice
versa.
ECMC61 – Chapter 14 3
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Document Summary

Chapter 14: money, interest rate, and exchange rate. How the money supply is determined: money supply: currency circulation + demand deposit, a country"s money supply is determined by its central bank, i. e. , we take money supply as given. Aggregate money demand: aggregate money demand: the total demand for money by all households and firms in the economy, three factors affect/determine aggregate money demand, the (nominal) interest rate, r, the price level, p, real national income, y: In notation form, aggregate money demand can be expressed as: d. Yr,lpm: usually, we express money demand in real terms: The equilibrium interest rate: the interaction of money supply and demand. Equilibrium in the money market: money market is in equilibrium when (real) money demand = (real) money supply: P: given the price level (p) and real output (y), the nominal interest rate (r) adjusts to equate real money demand to real money supply.

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