1. Unit 4: Money and Monetary Policy1

2. The Money Market (Supply and Demand for Money)2

3. 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

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

5. What happens if price level increase? Nominal Interest Rate (ir)
The Demand for Money
What happens if price level increase?
Money Demand Shifters
Changes in price level
Changes in income
Changes in taxation that affects investment
Nominal Interest Rate (ir)
20% 5% 2%
DMoney1
DMoney
Quantity of Money
(billions of dollars) 5

6. 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

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

8. Monetary Policy
When the FED adjusts the money supply to achieve the macroeconomic goals 8

9. Increasing the Money Supply
Interest Rate (ir) SM
SM1
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%
10% 5% 2%
How does this affect AD? DM
200
250
Quantity of Money
(billions of dollars)
Increase money supply
Decreases interest rate
Increases investment
Increases AD

10. Decreasing the Money Supply
Interest Rate (ir)
SM1 SM
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%
10% 5% 2%
How does this affect AD? DM
150
200
Quantity of Money
(billions of dollars)
Decrease money supply
Increase interest rate
Decrease investment
Decrease AD 10

12. Video: The FED Today

13. 2007B Practice FRQ 13

14. 2007B Practice FRQ 14

15. 2007B Practice FRQ 15