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AP Macroeconomics

AP Macroeconomics. The Money Market. The Money Market. The market where the Fed and the users of money interact thus determining the nominal interest rate ( i %). Money Demand (MD) comes from households, firms, government (Congress and fiscal policy) and the foreign sector.

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AP Macroeconomics

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  1. AP Macroeconomics The Money Market

  2. The Money Market • The market where the Fed and the users of money interact thus determining the nominal interest rate (i%). • Money Demand (MD) comes from households, firms, government (Congress and fiscal policy) and the foreign sector. • The Money Supply (MS) is determined only by the Federal Reserve.

  3. Transaction Demand • Transaction Demand – demand for money as a medium of exchange (independent of the interest rate) • Changes in technology • Example: ATMs allow us to keep less money on hand • Changes in real GDP • More purchases require more cash • Changes in aggregate price level • P up, demand for money shifts right

  4. Money Demand • Asset Demand – demand for money as a store of value (dependent on the interest rate). • At higher rates of interest you give up more by holding money instead of putting it into a Certificate of Deposit • At lower interest rates people sacrifice less when they hold money so they’ll hold more

  5. Total Money Demand – (MD) is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold bonds or certificates of deposit.

  6. Money Supply • The money supply is determined by the Federal Reserve because the Fed has monopoly control over the supply of money.

  7. Why Nominal Interest Rate on Money Market Graph? • Opportunity cost of holding cash includes both the return on interest forgone and the eroding effects of inflation. • Nominal interest rate includes both factors whereas real interest rate is adjusted for inflation.

  8. When we hold money as cash, we are NOT putting that money into a CD. • We are NOT earning interest on that money. • Ceteris paribus, inflation is present. • Our money is worth less every year because inflation erodes its purchasing power. • Real interest rates strip out effects of inflation • We want to include the effects of inflation

  9. The Money Market i% MS i MD Q QM The equilibrium of MS & MD determines the nominal interest rate (i%). MD is downward sloping because the nominal interest rate is the opportunity cost of holding money. MS is vertical because it is independent of the interest rate.

  10. Changes in Money Demand • Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP • Nominal GDP↑ .: MD .: i%↑ • Nominal GDP↓ .: MD .: i%↓

  11. Increase in Money Demand i% MS  i1  MD1  i MD Q QM MD .: i%↑

  12. Decrease in Money Demand i% MS  i  MD  i1 MD1 Q QM MD .: i%↓

  13. Changes in the Money Supply • Only the Fed determines the money supply • Expansionary Monetary Policy • Required Reserve Rate ↓ • Discount Rate ↓ • Federal Funds Rate ↓ • Caused by open market operation of Fed buying Treasury bonds (or securities) • MS .: i%↓

  14. Changes in the Money Supply • Contractionary Monetary Policy • Required Reserve Rate ↑ • Discount Rate ↑ • Federal Funds Rate ↑ • Caused by open market operation of Fed selling Treasury bonds (or securities) • MS .: i%↑

  15. Increase in Money Supply i% MS MS1  i   i1 MD Q Q1 QM MS .: i%↓

  16. Decrease in Money Supply i% MS1 MS  i1   i MD Q1 Q QM MS .: i%↑

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