2 Chapter Outline Measures of money supply Deposit multiplier Tools of monetary policyEquilibrium in money markets
3 Measures of money supply M1 = Currency + Checking at deposits + traveler’s checksM2 = M1 + Saving acounts + Small time deposits + money market mutual fundsM3 = M2 + Large time deposits + institutional money funds + purchase agreements + euro dollarsTable 13-1 pg. 384 (read the details)
4 Deposit multiplier Deposit Multiplier = 1/rr Where rr = reserve requirementsThe higher the reserve requirements the smaller the deposit multiplier
5 Tools of monetary policy Discount rateHigher discount rate results in lower money supply and contraction in the economyOther important ratesPrime rateFederal funds rate
6 Tools of monetary policy Cont… Open market operations (OMOS)OMOS are carried out by federal open market committee (FOMC) by selling and buying government securitiesSelling of government securities by the FED, will reduce money supply in the economy
7 Tools of monetary policy Cont… Reserve requirementsRaising reserve requirements has a contractionary effect on the economyThis tool is used with a lot of caution because it results in a significant change in money-supply and affects financial markets
8 Tools of monetary policy Cont… Discount rateDiscount rate refers to the rate the federal reserve bank charges banks who borrow reserves at the Fed’s discount windowDiscount rate is set by the FedAn Increase in discount rateMakes borrowing by the banks more expensive and reduces bank reservesResults in a contractionary monetary policy
9 Tools of monetary policy Cont… Other ratesFederal funds rate - interest rate that commercial banks charge each other for loans of reserves to meet their minimum reserve requirementsFederal funds rate is targeted by Fed. Fed’s actions (open market operations) affect the federal funds rate. This rate affects other short-term ratesPrime rate – The interest rate that banks charge on loans to their best customers. It is based on the discount rate set by the Fed.
10 Equilibrium in money markets Supply of moneyReal money supply = Nominal money supply = MsPrice level PRLMS = f(r,MS, P)rMS/PReal money – supply does not change with the changes in real interest rate
11 Demand for Money RLMD = MD/P = f [r,y] Interest rate represents the opportunity cost of holding money. At higher interest rates, people hold less money and vice versarMD/P
12 Equilibrium Price of Bond is inversely related to interest rate MS E r MdO
13 Changes in Equilibrium Real MsReal Ms’Change in Money SupplyE1r1E2r2Real MdIncrease in money supply creates excess money supply i.e. demand for money is less than the amount of money suppliedD - for bonds increasesP - of bonds increaseInterest rate goes down
14 Changes in Equilibrium Real MsE2r2Change in Demand for moneyE1Md2r1Md1Increase in demand for money results from an increase in real income (Y).People want to hold more of their assets as moneyThey sell their bonds. This results in lower bond prices and higher interest rates.