Download money - West Ada

Unit 4:
Money, Banking, and
Monetary Policy
1
4.2: The Money Market
(Supply and Demand for Money)
2
The Demand for Money
At any given time, people demand a certain
amount of liquid assets (money) for two
different reasons:
1. Transaction Demand for Money- People
hold money for everyday transactions.
2. Asset Demand for Money - People hold
money since it is less risky than other
assets
3
The Demand for Money
What is the opportunity cost of keeping
money in your pocket or checking account?
The interest you could be earning from
other financial assets like stocks, bonds, and
real estate
4
The Demand for Money
1. What happens to the quantity demanded of
money when interest rates increase? (Hint: what would
you do if tomorrow banks started to pay 20% on interest in savings
accounts?)
Quantity demanded falls because individuals
would prefer to have interest earning assets instead
(the opportunity costs of holding money increased)
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—real
estate or stocks may yield a higher return
5
The Demand for Money
Inverse (negative) relationship between interest
rates and the quantity of money demanded
Nominal
Interest Rate
(ir)
20%
5%
Why the nominal interest rate
and not the real?
The opportunity cost of holding
money includes both:
• the real return that could be
earned on a bank deposit
• the erosion in purchasing
power caused by inflation
2%
0
MD
Quantity of Money
(billions of dollars)
6
The Demand for Money
What happens if price level increase?
Nominal
Interest Rate
(ir)
20%
Money Demand Shifters
1. Changes in price level
2. Changes in income
3. Changes in technology
5%
2%
0
MD1
MD
Quantity of Money
(billions of dollars)
7
3 Shifters of Money Demand
1. Change in Aggregate Price Level
If prices go up, you need more money in your wallet
or checking account for everyday transactions
If prices go down, you need less so demand for
money shifts left
2. Change in Income (real GDP)
As incomes increase, so does the demand for money
shifts right
3. Change in Technology or Regulations
For example the wide spread use of credit cards has
decreased the demand for money
Or in 1980 when Regulation Q was removed so
banks could start paying interest on checking
accounts, the demand for money shifted right
8
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)
20%
The FED is a nonpartisan
government office that sets and
adjusts the money supply to
adjust the economy
5%
This is called Monetary
Policy.
MS
2%
MD
200
Quantity of Money
(billions of dollars)
9
Money Market Graph
Combines the supply of money and the
demand for money
(It is one of the 5 key graphs you must know)
Interest
Rate (ir)
MS
20%
5%
2%
MD
200
Quantity of Money
(billions of dollars)
10
The Federal Reserve
Created in 1913, the FED’s job is to regulate
banks and make sure people have faith in
our financial system
11
What are the 3 shifters of the
Demand for Money?
Nominal
Interest Rate
(ir)
20%
Money Demand Shifters
1. Changes in price level
2. Changes in income
3. Changes in technology
5%
2%
0
MD
Quantity of Money
(billions of dollars)
12
Are we in an
inflationary or
recessionary gap?
What would we need
to know when
drawing our AS/AD
or Phillips Curve?
13
Now that we know
that the natural rate
of unemployment is
4.5 or 5%, draw an
AS/AD and Phillips
Curve showing our
new 4.6%
unemployment.
Can a money market
graph show
inflationary gaps?
14
No.
15
Video: The FED Today
16
Increasing the Money Supply
Interest
Rate (ir)
MS MS1
10%
5%
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%
2%
MD
200
Increase
money supply
250
How does this
affect AD?
Quantity of Money
(billions of dollars)
Decreases
interest rate
Increases
investment
Increases
AD
17
Decreasing the Money Supply
Interest
Rate (ir)
MS1 MS
10%
5%
2%
150
Decrease
money supply
200
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%
How does this
affect
AD?
MD
Quantity of Money
(billions of dollars)
Increase
interest rate
Decrease
investment
Decrease
AD
18
Fractional Reserve Banking
When banks hold only a small portion of deposits
to cover potential withdrawals and then loans the
rest of the money out.
If we all went to the bank to withdrawal money at
the same time what would happen?
BANK RUN!
19
Bank Balance Sheets
Demand Deposits- Money deposited in a
commercial bank in a checking account
Required Reserves- The percent that banks must
hold by law
Excess Reserves- The amount that the bank can
loan out
Balance Sheet- A record of a bank’s assets,
liabilities, and net worth.
Are demand deposits in a bank an asset or
a liability?
Liability for the bank, asset to the depositor
20
The Simple Case of 100-percent reserve
banking
Bank Balance Sheet: T-Account
Assets
Liabilities
Reserves
$100 Deposits
$100
Total Assets
$100 Total Liabilities
$100
No money is being created!!!
21
Fractional Reserve Banking:
T-Account
Assets
Loans
Reserves
Treasury Bonds
Total Assets
Liabilities
$8,000 Demand Deposits
$500 Owner’s Equity
$1,500
$10,000 Total Liabilities
$5,000
$5,000
$10,000
It is “balanced” because the totals must equal
If the bank is holding no excess reserves, how
much is the required reserve ratio?
.1 or 10%
22
Money creation in the banking system
A fractional reserve banking system creates
money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.
23