Unit 4: Money and Monetary Policy 1

The Money Market (Supply and Demand for Money) 2

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Interest Rates are important Way to protect our money from the effects of inflation Opportunity cost for holding money (keeping money in our wallets) is the interest your money would have earned if you put it in the bank. Interest rates that banks pay you for your deposits are related to the interest rates that banks charge when they loan money out. When we look at the relationship between the demand for money and interest rate we are looking at short- term rates 4

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 5

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 6 The Demand for Money

Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money What happens if price level increase? 7 The Demand for Money D Money1 Money Demand Shifters 1.Changes in price level 2.Changes in income/ Changes in Real GDP 3.Changes in taxation that affects investment 4.Changes in banking technology (ATMs) 5.Changes in banking institutions (interest on checking) Nominal Interest Rate (ir)

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) 8 The Supply for Money 20% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir)

Supply and Demand is important The equilibrium interest rate is determined by the supply and demand for money This is called the liquidity preference model of the interest rate 9

Monetary Policy 10 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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2007B Practice FRQ (Do a. and b. only) 14

2007B Practice FRQ 15

2007B Practice FRQ 16