The Money Market and Monetary Policy

1. The Money Market and Monetary Policy Unit 4 Lesson 5 Activity 39-40 Goodman, Jean B. U.S. Naval Academy Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y

2. Objectives • Define transactions demand for money, precautionary (liquidity) demand for money and the speculative demand for money and explain how each affects the total demand for money. • Discuss the motives for holding assets as money. • Identify the factors that cause the demand for money to shift and explain why the shift occurs. • Explain how interest rates are determined in the money market. • Describe Federal Reserve policy and the interest rate. • Explain how interest rates affect monetary policy.

3. Introduction and Description • In this lesson, the demand for and supply of money are brought together in the money market. • The effects of the federal Reserve System’s monetary policy are integrated into the money market and then linked to aggregate demand. • In Activity 39, you will practice manipulating the money market and understand the impact of the Fed’s actions in this market. • Activity 40. provides practice in relating monetary policy to changes in the monetary variables such as the federal funds rate, the money supply and velocity.

4. Individuals are faced with a simple decision; how much of their wealth do they want to hold as money and how much do they want to hold as interest-bearing assets? • If you hold money, you are forgoing the interest you could earn on the money in an interest –bearing asset.

5. Money Demand There is an opportunity cost of holding money: The forgone interest The visual shows that as the interest rate decreases from r to r1, the amount of money held by people increases from MD to MD1.

6. The demand for money also depends on the price level and on the level of real GDP or real income. • If prices double, a person will need twice as much money to buy groceries or other goods and services. • People are most concerned with the real value of income: what the income can buy or its purchasing power. As income rises. The demand for money increases.

7. To complete the money market, we now add the supply of money, which is determined by the Federal Reserve through its tools. • The diagram shows the money market. • What happens to the interest rate as prices rise? • (MD increases and the interest rate rises) • Income increases (MD increases and the interest rate rises) • Or, the money supply increases (interest rate decreases)

8. The Money Market • The money market consists of the demand for money and the supply of money. • We generally assume that the Federal Reserve determines the supply of money. Thus, the supply of money is a vertical line. • The demand for money is based on a decision of whether to hold your wealth in the form of interest bearing assets (savings accounts, stocks, etc.) or as money (noninterest bearing).

9. The demand for money is a function of interest rates and income, and is determined by three motives: • Transaction demand – the demand for money to make purchase of goods and services • Precautionary demand – the demand for money to serve as protection against an unexpected need. • Speculative demand – the demand for money because it serves as a store of wealth.

10. The interest rate represents the opportunity cost of holding money; that is, the interest rate represents the forgone income you might have made had you held an interest-bearing asset. • Thus, the demand for money has an inverse relationship with the interest rate. • The demand curve represents the demand for money at various levels of the interest rate for the given income level (GDP).

11. The graph of the money market looks like this:

12. Activity 39: Money Market • Suppose the Federal Reserve increases the money supply by buying Treasury securities. • What happens to the interest rate? • What happens to the quantity of money demanded? • Explain what happens to loans and interest rates as the fed increases the money supply. The interest rate decreases The quantity of money demanded increases As the Federal Reserve buys treasury securities from the public, demand deposits in financial institutions increase. Thus, financial institutions have more money to make loans. To encourage people to take out the loans, the financial institutions lower the interest rate.

13. If the Federal Reserve increases the money supply by buying Treasury securities Interest Rate MS MS1 r MD r1 M M1 Money

14. Suppose the demand for money increases. • What happens to the interest rate? • What happens to the quantity of money supplied? The interest rate increases The quantity of money supplied remains the same as shown by the vertical money supply curve.

15. If the fed wants to maintain a consent interest rate when the demand for money increases, explain what policy the Fed needs to follow and why. • Why might the Fed want to maintain a constant interest rate? It must increase the money supply to meet the increase in the demand for money. To stabilize the amount of investment in the economy.

16. Suppose the demand for money increases. Interest Rate MS r1 MD1 r MD M Money

17. Alternative Money Demand Curves • Suppose there are two money demand curves – MD and MD1 – and the Fed increases the money supply from MS to MS1 Interest Rate MS MS1 r r1 MD MD1 M M1 Money

18. The interest rate declines further with the more inelastic money demand curve (MD1) than with the more elastic money demand curve (MD). • Compare what happens to the interest rate with each MD curve. Interest Rate MS MS1 r r1 MD MD1 M M1 Money

19. Explain the effect of the change in the money supply on C, I, real outputand P. Would there be a difference in the effects under the two different money demand curves? If so, explain. With either demand curve, the increase in supply will cause interest rates to decline and investment and consumption – and us real output – to increase. AD increases, so prices are likely to increase (or decrease) with a greater decrease (or increase) in the interest rate. For example: a large decrease in interest rates will usually lead to a greater increase in investment. The increase in investment will increase AD. Then, the increase in the money supply will lead to an increase in AD, which will lead to an increase in real output and in prices. Interest Rate MS MS1 r r1 MD MD1 M M1 Money

20. How would you describe, in economic terms, the difference between the two money demand curves? MD1 is more interest inelastic than MD Interest Rate MS MS1 r r1 MD MD1 M M1

21. The fed would prefer the more inelastic money demand curve because a given increase in the money supply will lead to a grater decrease in interest rates, which should stimulate the economy. D. If the federal Reserve is trying to get the economy out of a recession, which money demanded curve would it want to represent the economy? Explain. Interest Rate MS MS1 r r1 MD MD1 M M1

22. The Money Market, Investmentand Aggregate Demand • Given the demand for money, by controlling the money supply, the Federal Reserve controls the interest rate in the short run. • The interest rate affects the level of investment and a portion of the level of consumption.

23. An increase in the money supply (MS to MS1) causes the interest rate to decrease (r1 to r) and investment (I to I1) and consumption to increase. • In turn, AD increases (AD to AD1)

24. Explain step-by-step what happens in the economy once the federal Reserve decides to increase (decrease) the money supply. (Note: An increase in bond prices leads to a decrease in the interest rate.) Fed purchases Treasury securities→ bond prices increase to entice households and businesses to sell Treasury securities → Money supply increases and interest rate decreases → Investment increases (and interest-sensitive components of consumption increase) → AD increases → Output increases and the price level increases.

25. The Federal Reserve: Monetary Policy and Macroeconomics: Activity 40 • What is monetary policy? • From 1998 to 2002, what was the dominant focus of monetary policy and why? Monetary policy is action by the federal Reserve to increase or decrease the money supply to influence the economy. From 1998 to 2001, the focus of monetary policy was to slow the growth of the economy to prevent an increase in inflation. In 2001 and 2002, the focus was to stimulate the economy w/out stimulating inflation. (Much like 2009!)

26. Explain why the money supply and short-term interest rates are inversely related. When the fed buys Treasury securities from the public, bank reserves increase. To decrease excess reserves and make loans, banks lower the interest rate to entice consumers and businesses to borrow

27. What are some reasons for lags and imperfections in data used by central banks? Financial institutions report at specified periods, and the reporting time is not necessarily when the central bank can use the data. For short periods of time, the central bank collects data from only a sample of banks, and this leads to a certain amount of error in the data.

28. Why do many economists believe that central banks have more control over the price level than over real output? Many economists believe that real output is determined by the level of capital stock and the productivity of workers. Thus, changes in the money supply affect prices more than real output.

29. What might cause velocity to change? Some factors that might cause velocity to change are changes in how money is transferred (institutional changes), changes in interest rates and changes in the price level.

30. If velocity were extremely volatile, why would this complicate the job of making monetary policy? One of the rules of monetary policy is stabilization of the price level. Thus, based on the equation of exchange (MV = PQ), changes in the money supply will yield a given change in PQ if velocity (V) is constant. If velocity is volatile, changes in the money supply may be either too small or too large, leading to inflation.

31. What role does the money multiplier play in enabling the Fed to conduct monetary policy? The money multiplier times the change in excess reserves yields the change in the money supply. Thus, if the Fed wants to change the money supply by a given amount, the money multiplier indicates by how much the excess reserves need to be changed.

32. The interest rate that financial institutions charge other financial institutions for short-term borrowing • What is the fed funds rate? • What happens to the fed funds rate if the fed follows a contractionary (tight money) policy? The federal funds rate increases.

33. What happens to the fed funds rate if the Fed follows an expansionary (easy money) policy? • Why do observers pay close attention to the federal funds rate? The federal funds rate decreases. It is an early indicator of monetary policy and provides a forecast of the direction for other interest rates and the Fed policy.