Warm Up What is the interest rate on currency?

Current Events Press Release Release Date: January 29, 2014 For immediate release Information received since the Federal Open Market Committee met in December indicates that growth in economic activity picked up in recent quarters. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate declined but remains elevated. Household spending and business fixed investment advanced more quickly in recent months, while the recovery in the housing sector slowed somewhat. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

Poster Creation Requirement Problem: The Fed wants to increase the money supply. Decision: How should you accomplish this? What tools did you choose? Why?  Create a poster to advertise for the Fed’s choice (your choice) on how to increase the monetary policy and include three arguments why people should be accepting of this choice  Include a nonlinguistic representation and an overview of who “the Fed” is

Warm Up Imagine life without ATM’s and Cashback. Do you think people would hold more or less cash? Why

Warm Up: “ IF THE FED WANTS TO”

Today, we will visit the money market!

Module 28:The Money Market (Supply and Demand for Money) 7

Review: M1: money in circulation; checking M2: M1 plus deposits easily transferred into checkable deposits

DRAW A MONEY MARKET MODEL

Why hold cash? -“cash only” -Forgot lunch -Borrow money -Bake sale -Emergencies -Lost job -Health problems

What is the Opportunity cost of holding money?

The higher the short- term interest rate, the higher the opportunity cost of holding money and vice versa

The Money Demand curve slopes down and to the right because, all else being equal, higher interest rates increase the opportunity cost of holding money, thus leading public to reduce quantity of money it demands

Why interest rates instead of other investments such as stocks or real estate? Looking for liquid investments (things we can easily change into cash if needed. (Certificate of deposit)

Money Demand Curve Shifters 1.Changes in Aggregate Price Level 2.Changes in Real GDP 3.Changes in Technology 4.Changes in Institutions

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 16 The Demand for Money

Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money What happens if price level increase? 17 The Demand for Money D Money1 Money Demand Shifters 1.Changes in aggregate price level 2.Changes in real GDP (income) 3.Changes in technology (ATM’s) 4.Changes in institutions Nominal Interest Rate (ir)

Federal funds rate moves with CD’s (because both reflect short term interest rates) The Fed: carrying out the open market operations 1.Achieve a target federal funds rate 2.Affect interest rates

The Equilibrium Interest Rate Liquidity Preference Model of the interest Rate

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

The Money Demand curve slopes down and to the right because, all else being equal, higher interest rates increase the opportunity cost of holding money, thus leading public to reduce quantity of money it demands

Factors that can cause the MD Curve to shift Changes in Aggregate Prices Changes in Real GDP Changes in banking technology (ex: ATM’s) Changes in Banking Institution Regulations

AS the Credit Crisis got worse between 2007 and 2008 the Fed lowered interest rates hoping to increase liquidity in the market place and help pull the nation out of a recession. This is reflected in the lower interest rates banks were willing to pay on deposits.

The Equilibrium Interest Rate The Equilibrium Interest Rate Liquidity Preference Model of the Interest Rate (rates are determined by supply and demand of money) Equilibrium interest rate is rate where quantity demanded equals quantity supplied

2007B Practice FRQ: Just Do the Graph for (b) 27

2007B Practice FRQ 28

Demand for money has 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 of borrowed liabilities 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 29

30 The role of the Fed is to “take away the punch bowl just as the party gets going”