Unit 4: Money and Monetary Policy 1

Think about it.... If I move $200 from my checking account to my savings account what happen to M1? What happens to M2? What is the relationship between bond prices and interest rates? What is the opportunity cost of holding money? 2

The Money Market (Supply and Demand for Money) 3

4 MonthInterest Rate on Savings at the Bank IncomeFixed Expenses Variable Expenses (FCE) Savings January10%$2000$1200 February6%$2000$1200 March2%$2000$1200 April20%$2000$1200 May15%$2000$1200 June.5%$2000$1200

Opportunity Cost of Holding Money Two choices: Spend or Save People hold money (M1) to make transactions Alternative is interest bearing assets As nominal interest rises, the opportunity cost of holding money rises, so the quantity of money held falls. 5

The Demand for Money At any given time, people demand a certain amount of liquid assets (money) for everyday purchases The Demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded 1. What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets instead 2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increases. There is no incentive to convert cash into interest earning assets 6

Nominal Interest Rate (ir) Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money Inverse relationship between interest rates and the quantity of money demanded 7 The Demand for Money

Nominal Interest Rate (ir) Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money Money Demand Curve is for a GIVEN Real GDP and a GIVEN Price Level 8 The Demand for Money Interest rate is the opportunity cost of holding money.

Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money 9 The Demand for Money D Money1 Money Demand Shifters 1.Changes in price level 2.Changes in income 3.Changes in technology 4.Changes in Institutions Nominal Interest Rate (ir)

Shifters of Demand for Money 1)Changes in Aggregate Price Level a)PL ↑, M D ↑ 2)Changes in Real GDP a)Real GDP ↑, M D ↑ 3)Changes in Technology a)Technology↑, M D ↓ 4)Changes in Institutions a)Banks viewed as unstable, M D ↑ 10

200 D Money S Money The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy This is called Monetary Policy. The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) 11 The Supply for Money 20% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir)

Monetary Policy 12 When the FED adjusts the money supply to achieve the macroeconomic goals

If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% Increasing the Money Supply Increase money supply Decreases interest rate Increases investment Increases AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 250 S M1

If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% Decreasing the Money Supply Decrease money supply Increase interest rate Decrease investment Decrease AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 150 S M1

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