Interest Rate Determination

Money supply is much easier to describe because we imagine that the level of money balances available in an economy is simply set by the actions of the central bank. For this reason, it will not depend on other aggregate variables such as the interest rate, and thus we need no function to describe it.

We will use the parameter $M_{\$}^{S}$ to represent the nominal U.S. money supply and assume that the Federal Reserve Bank (or simply "the Fed"), using its three levers, can set this variable wherever it chooses. To represent real money supply, however, we will need to convert by dividing by the price level. Hence let $\frac{M_{\$}^{S}}{P_{\$}}$ represent the real money supply in terms of prices that prevailed in the base year.