<p>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 <span class="math-container">$5\%$</span>, 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).</p>
<p>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, <em>ceteris paribus</em> when central bank targets interest rate demand for money is fixed.</p>
<p>Now have a look at the visualization below:</p>
<p><a href="https://i.sstatic.net/tvCHmm.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/tvCHmm.png" alt="enter image description here" /></a></p>
<p>Let us suppose that we originally had equilibrium interest rate <span class="math-container">$r$</span> at a point where original money supply <span class="math-container">$M$</span> intersected money demand <span class="math-container">$L$</span>. Next let us suppose that central bank decides to target higher interest <span class="math-container">$r''$</span> as it want to pursue contractionary monetary policy.</p>
<p>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 <span class="math-container">$r''$</span> but <span class="math-container">$M$</span> 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 <span class="math-container">$M$</span> shifts to <span class="math-container">$M''$</span> 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.</p>
<p>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).</p>
<p><a href="https://i.sstatic.net/GhByUm.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/GhByUm.png" alt="enter image description here" /></a></p>
<p>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.</p>

CC BY-SA 4.0
2021-04-06T10:47:07.130Z
2021-04-06T10:47:07.130Z
1muflon1
<p>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 <em>in</em> 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.</p>
<p>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.</p>
<p>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.</p>

CC BY-SA 4.0
2020-07-09T03:09:51.083Z
2020-07-09T03:09:51.083Z
manifold
<p>This is quote from Gregory Mankiw's macroeconomics text about mechanism of formation of the interest rate in the money market model:</p>
<blockquote>
<p>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.</p>
</blockquote>
<p>I also noticed that the money supply curve is strictly vertical.</p>
<p>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?</p>

CC BY-SA 4.0
2020-07-02T17:52:28.560Z
I don’t own it, but it is a safe bet that this textbook is totally out of date with regards to how interest rates are determined in the real world. Central banks announce a target rate of interest, and largely ensure that it is hit by setting a corridor on borrowing/lending rates with counterparty banks. The Fed has changed its operating procedures, and it was the only central bank that slightly resembled that model.  However, if you are studying economics from Mankiw’s text, you probably will need someone to explain the logic. Since it”s not applicable to the real world, I can’t help you.
Brian Romanchuk
CC BY-SA 4.0
2020-07-02T18:15:59.953Z
@BrianRomanchuk Are you saying that the money market model is irrelevant because central planning of the interest rate by the central bank?
KarmaPeasant
CC BY-SA 4.0
2020-07-02T18:27:40.080Z
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.
Brian Romanchuk
CC BY-SA 4.0
2020-07-06T08:54:02.190Z
The money supply curve being strictly vertical suggests that the supply of money is unaffected by interest rates and is instead exogenous.  This has probably never been true.
Henry
CC BY-SA 4.0
2020-07-06T17:03:20.587Z
@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."
KarmaPeasant
CC BY-SA 4.0
2020-07-06T17:23:03.893Z
@user161005 - (1) When dud Krugman write this? (2) Krugman is wrong. Take a look at Canada - until they launcher a QE programme, the monetary base equalled the amount of currency in circulation - which is not under the BoC’s control.
Brian Romanchuk
CC BY-SA 4.0
2020-07-06T17:33:35.557Z
@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
KarmaPeasant
CC BY-SA 4.0
2020-07-07T12:37:21.657Z
The money supply under the control of the central bank was always equal to zero, yet they moved interest rates. Mainstream undergraduate textbooks are not reliable sources  in this area.
Brian Romanchuk
CC BY-SA 4.0
2020-07-07T12:51:05.947Z
@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.
KarmaPeasant
CC BY-SA 4.0
2020-07-07T13:34:17.463Z
As I wrote, the monetary base consisted of cash in circulation. The BoC does not have the right to hand out $100 bills. Bank settlement balances were zero, and were *expected to be zero* - regulators forced banks to keep to that target. As such, the BoC had no control over the size of the monetary base in practice. They steered rates with a corridor system - like other central banks. (They decided in 2020 to create excess settlement balances.) All of this is explained in research available at central banks. Look up “money creation” at the BoE.
Brian Romanchuk
<macroeconomics><interest-rate><bonds>
Is the money market model based on assumption of no interest rate targeting on the part of the central bank?
KarmaPeasant
# Is the money market model based on assumption of no interest rate targeting on the part of the central bank?

(Asked by: username_0 on 2020-07-02)

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?

**Tags:** macroeconomics, interest-rate, bonds

> **Comments:**
> **username_1**: I don’t own it, but it is a safe bet that this textbook is totally out of date with regards to how interest rates are determined in the real world. Central banks announce a target rate of interest, and largely ensure that it is hit by setting a corridor on borrowing/lending rates with counterparty banks. The Fed has changed its operating procedures, and it was the only central bank that slightly resembled that model.  However, if you are studying economics from Mankiw’s text, you probably will need someone to explain the logic. Since it”s not applicable to the real world, I can’t help you.  
> **username_0**: @BrianRomanchuk Are you saying that the money market model is irrelevant because central planning of the interest rate by the central bank?  
> **username_1**: 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.  
> **username_2**: The money supply curve being strictly vertical suggests that the supply of money is unaffected by interest rates and is instead exogenous.  This has probably never been true.  
> **username_0**: @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."  
> **username_1**: @user161005 - (1) When dud Krugman write this? (2) Krugman is wrong. Take a look at Canada - until they launcher a QE programme, the monetary base equalled the amount of currency in circulation - which is not under the BoC’s control.  
> **username_0**: @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  
> **username_1**: The money supply under the control of the central bank was always equal to zero, yet they moved interest rates. Mainstream undergraduate textbooks are not reliable sources  in this area.  
> **username_0**: @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.  
> **username_1**: As I wrote, the monetary base consisted of cash in circulation. The BoC does not have the right to hand out $100 bills. Bank settlement balances were zero, and were *expected to be zero* - regulators forced banks to keep to that target. As such, the BoC had no control over the size of the monetary base in practice. They steered rates with a corridor system - like other central banks. (They decided in 2020 to create excess settlement balances.) All of this is explained in research available at central banks. Look up “money creation” at the BoE.  

---

## 2 answers

### Answer by username_3 on 2021-04-06. Score: 0

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](https://i.sstatic.net/tvCHmm.png)](https://i.sstatic.net/tvCHmm.png)

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](https://i.sstatic.net/GhByUm.png)](https://i.sstatic.net/GhByUm.png)

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.


---

### Answer by username_4 on 2020-07-09. Score: 0

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.


---

