Credit Market Equilibrium

The credit market equilibrium occurs at a quantity of credit extended (loans) and a real interest rate where the quantity supplied is equal to the quantity demanded. Toolkit: Section 16.1 “The Labor Market”, Section 16.4 “The Credit (Loan) Market (Macro)”, and Section 16.5 “Correcting for Inflation” You can review the labor market and the credit market, together with the underlying demand and supply curves, in the toolkit. You can also review how to correct for inflation. The classical dichotomy has a key implication that we can study through acomparative statics exercise. Recall that in a comparative statics exercise we examine how the equilibrium prices and output change when something else, outside of the market, changes. Here we ask: what happens to real GDP and the long-run price level when the money supply changes? To find the answer, we begin with the quantity equation: money supply × velocity of money = price level × real GDP. Previously we discussed this equation as an identity—something that must be true by the definition of the variables. Now we turn it into a theory. To do so, we make theassumption that the velocity of money is fixed. This means that any increase in the money supply must increase the left-hand side of the quantity equation. When the left-hand side of the quantity equation increases, then, for any given level of output, the price level is higher (equivalently, for any given value of the price level, the level of real GDP is higher). What then changes when we change the money supply: output, prices, or both? Based on the classical dichotomy, we know the answer. Real variables, such as real GDP and the velocity of money, stay constant. A change in a nominal variable—the money supply—leads to changes in other nominal variables, but real variables do not change. The fact that changes in the money supply have no long-run effect on real variables is called the long- run neutrality of money. Toolkit: Section 16.8 “Comparative Statics” You can find more details on how to conduct comparative static exercises in the toolkit. How does this view of the effects of monetary policy fit with the monetary transmission mechanism? [5] The monetary transmission mechanism explains that the monetary authority affects aggregate spending by changing its target interest rate.