Objectives At this point, we know The Fed uses open market operations to purchase/sell U.S. Treasury securities in the open market. These open market operations increase or decrease the money supply, depending upon whether the Fed is purchasing or selling securities. The amount the money supply changes for a given open market purchase or sale will depend upon the money multiplier which, in turn depends upon the reserve ratio, the currency ratio, … These open market operations also will influence the Federal Funds interest rate by affecting the supply of funds in the Federal Funds market.

Objectives The Fed’s monetary policy (i.e., it planned open market operations) targets the Federal Funds rate (or the money supply) in order to influence the economy’s price, output, and employment levels. The primary objectives of Chapter 11 are to: Explain how the Fed’s actions influence spending plans, real GDP, and the price level in the short run Explain how the Fed’s actions influence real GDP and the price level in the long run

Objectives Meeting the first objective (i.e., explaining the short-run consequences of monetary policy) will involve introducing the “money demand” model into our story. Meeting the second object (i.e., explaining the long-run consequences of monetary policy) will involve introducing the “quantity theory of money” into our story.

The Demand for Money The Influences on Money Holding The quantity of money that people plan to hold depends on four main factors The price level The interest rate Real GDP Financial innovation

The Demand for Money The price level We assume that a rise in the price level increases the nominal quantity of money people want to hold (M) but doesn’t change the real quantity of money that people plan to hold (M/P). Nominal money is the amount of money measured in dollars. We assume that the quantity of nominal money demanded is proportional to the price level — a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.

The Demand for Money The interest rate The interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. real return to holding a bond = i – inf, where i = nominal interest rate, inf = inflation rate real return to holding money = -inf So, the real opportunity cost of holding money = (i-inf)-(-inf)=i. A rise in the interest rate decreases the quantity of money that people plan to hold.

The Demand for Money Real GDP Given that there is opportunity cost to holding wealth in the form of money rather than secure bonds, why do people hold any money? To fund current expenditure on goods and services. An increase in real GDP increases the volume of expenditure, and we assume that this increases the quantity of real money that people plan to hold.

The Demand for Money Financial innovation Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of money that people plan to hold to finance a given level of expenditure on goods and services.

The Demand for Money The Demand for Money Curve The demand for money curve is the relationship between the quantity of real money demanded (M/P) and the interest rate when all other influences on the amount of money that people wish to hold remain the same.

The Demand for Money Figure 11.1 illustrates the demand for money curve. The demand for money curve slopes downward A fall in the interest rate lowers the opportunity cost of holding money and brings an increase in the quantity of money demanded--a movement downward along the demand for money curve.

The Demand for Money A rise in the interest rate increases the opportunity cost of holding money and brings an decrease in the quantity of money demanded--a movement upward along the demand for money curve.

The Demand for Money Shifts in the Demand for Money Curve The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.

The Demand for Money Figure 11.2 illustrates an increase and a decrease in the demand for money. A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward. An increase in real GDP increases the demand for money and shifts the demand curve rightward.

Interest Rate Determination Money Market Equilibrium The Fed determines the quantity of money supplied and on any given day, that quantity is fixed. The supply of money curve is vertical at the given quantity of money supplied. Money market equilibrium determines the interest rate.

Interest Rate Determination Figure 11.4 illustrates the equilibrium interest rate.

Interest Rate Determination If the interest rate is above the equilibrium interest rate, the quantity of money that people are willing to hold is less than the quantity supplied. They try to get rid of their “excess” money by buying financial assets. This action raises the price of these assets and lowers the interest rate.

Interest Rate Determination If the interest rate is below the equilibrium interest rate, the quantity of money that people want to hold exceeds the quantity supplied. They try to get more money by selling financial assets. This action lowers the price of these assets and raises the interest rate.

Interest Rate Determination Changing the Interest Rate Figure 11.5 shows how the Fed changes the interest rate. If the Fed conducts an open market sale, the money supply decreases, the money supply curve shifts leftward, and the interest rate rises.

Interest Rate Determination If the Fed conducts an open market purchase, the money supply increases, the money supply curve shifts rightward, and the interest rate falls.