1. CHAPTER 13
Role of money

2. Chapter Outline Measures of money supply Deposit multiplier
Tools of monetary policy
Equilibrium in money markets

3. Measures of money supply
M1 = Currency + Checking at deposits + traveler’s checks
M2 = M1 + Saving acounts + Small time deposits + money market mutual funds
M3 = M2 + Large time deposits + institutional money funds + purchase agreements + euro dollars
Table 13-1 pg. 384 (read the details)

4. Deposit multiplier Deposit Multiplier = 1/rr
Where rr = reserve requirements
The higher the reserve requirements the smaller the deposit multiplier

5. Tools of monetary policy
Discount rate
Higher discount rate results in lower money supply and contraction in the economy
Other important rates
Prime rate
Federal funds rate

6. Tools of monetary policy Cont…
Open market operations (OMOS)
OMOS are carried out by federal open market committee (FOMC) by selling and buying government securities
Selling of government securities by the FED, will reduce money supply in the economy

7. Tools of monetary policy Cont…
Reserve requirements
Raising reserve requirements has a contractionary effect on the economy
This tool is used with a lot of caution because it results in a significant change in money-supply and affects financial markets

8. Tools of monetary policy Cont…
Discount rate
Discount rate refers to the rate the federal reserve bank charges banks who borrow reserves at the Fed’s discount window
Discount rate is set by the Fed
An Increase in discount rate
Makes borrowing by the banks more expensive and reduces bank reserves
Results in a contractionary monetary policy

9. Tools of monetary policy Cont…
Other rates
Federal funds rate - interest rate that commercial banks charge each other for loans of reserves to meet their minimum reserve requirements
Federal funds rate is targeted by Fed. Fed’s actions (open market operations) affect the federal funds rate. This rate affects other short-term rates
Prime rate – The interest rate that banks charge on loans to their best customers. It is based on the discount rate set by the Fed.

10. Equilibrium in money markets
Supply of money
Real money supply = Nominal money supply = Ms
Price level P
RLMS = f(r,MS, P) r
MS/P
Real money – supply does not change with the changes in real interest rate

11. Demand for Money RLMD = MD/P = f [r,y]
Interest rate represents the opportunity cost of holding money. At higher interest rates, people hold less money and vice versa r
MD/P

12. Equilibrium Price of Bond is inversely related to interest rate MS E rMd O

13. Changes in Equilibrium
Real Ms
Real Ms’
Change in Money Supply E1 r1 E2 r2
Real Md
Increase in money supply creates excess money supply i.e. demand for money is less than the amount of money supplied
D - for bonds increases
P - of bonds increase
Interest rate goes down

14. Changes in Equilibrium
Real Ms E2 r2
Change in Demand for money E1
Md2 r1
Md1
Increase in demand for money results from an increase in real income (Y).
People want to hold more of their assets as money
They sell their bonds. This results in lower bond prices and higher interest rates.