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CHAPTER
The Money Market
and Monetary Policy
PowerPoint Slides
Slides prepared
prepared by:
by:
PowerPoint
Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
The Demand for Money
• Demand for money
– How much money people would like to
hold, given the constraints that they face
– NOT: how much money people would like
to have in the best of all possible worlds
• An individual’s wealth constraint
– At any point in time, total wealth is fixed
– You must give up one kind of wealth in
order to acquire more of another
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2
A Household’s Demand for Money
• An household’s quantity of money
demanded
– Amount of wealth that the household
chooses to hold as money, rather than as
other assets
• Opportunity cost of holding money
– The interest or other financial return you
could have earned by holding other assets
instead
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3
A Household’s Demand for Money
• Households choose how to divide wealth
between two assets
– Money
• Can be used as a means of payment
• Earns no interest
– Bonds
• Earn interest
• Cannot be used as a means of payment
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4
A Household’s Demand for Money
• Tradeoff: The more wealth we hold as
money
– The less often we will have to go through
the inconvenience of changing our bonds
into money
– And the less interest we will earn on our
wealth
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5
A Household’s Demand for Money
• Choosing the amount of money to hold
(quantity demanded of money)
– A rise in price level
• Hold more money
– A rise in real income
• Hold more money
– A higher nominal interest rate
• Hold less money
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6
Economy-Wide Demand for Money
• The quantity of money demanded by
businesses is greater:
– The higher price level
– The higher real income
– The lower interest rate
• Constraint: given wealth
– How much wealth to hold as money rather
than other assets (“bonds”)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
Economy-Wide Demand for Money
• Economy-wide quantity of money
demanded
– The amount of total wealth in the economy
– That all households and businesses,
together
– Want to hold as money rather than as
bonds
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
Economy-Wide Demand for Money
• The demand for money
– A rise in the price level will increase the
demand for money
– A rise in real income (real GDP) will
increase the demand for money
– A rise in nominal interest rates will
decrease the quantity of money demanded
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Economy-Wide Demand for Money
• Money demand curve
– Total quantity of money demanded
– At each (nominal) interest rate
• Change in interest rate
– Move along the money demand curve
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10
Figure 1
The Money Demand Curve
Nominal
Interest
Rate
The money demand curve is drawn for a given real GDP
and a given price level.
At an interest rate of 6 percent, 1,000
billion of money is demanded.
6%
E
If the interest rate drops to 3 percent,
the quantity of money demanded
increases to $1,600 billion.
F
3%
Md
1,000
1,600
Money
($ billions)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Economy-Wide Demand for Money
• Shifts in the money demand curve
– Change in money demand caused by
something other than the interest rate
– Change in real income
– Change in price level
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12
Figure 2
A Shift in the Money Demand Curve
Nominal
Interest
Rate
An increase in real GDP or in the
price level will shift the money
demand curve rightward.
At any interest rate, more
money will be demanded
after the shift.
6%
E
G
H
F
3%
M2 d
M1d
1,000
1,400 1,600
2,000
Money
($ billions)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Figure 3
Shifts &movements along the money demand curve: a summary
Nominal Interest
Rate
9%
Nominal Interest
Rate
Interest rate ↑ moves us
leftward along the money
demand curve.
Entire money demand
curve shifts rightward if
the price level or
income increases.
C
A
6%
Interest rate ↓ moves
us rightward along the
money demand curve.
B
M2d
3%
M1d
600
1,000
1,600
Money
($ billions)
M1d
Money
($ billions)
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14
The Supply of Money
• Money supply curve
– Total quantity of money in the economy at
each interest rate
– Straight vertical line
– Determined by the Fed
• Shift in money supply
– The Fed changes the money supply
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15
Figure 4
The Supply of Money
Nominal Interest
Rate
M1 S
6%
E
3%
J
1,000
Once the Fed sets the
money supply, it remains
constant until the Fed
changes it. The vertical
supply curve labeled M1 S
shows a money supply of
$1,000 billion, regardless of
the interest rate. An
increase in the money
supply to $1,400 billion is
depicted as a rightward
shift of the money supply
curve to M2S.
M2 S
1,400
Money
($ billions)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
Equilibrium in the Money Market
• Equilibrium interest rate
– The interest rate at which the quantity of
money demanded and the quantity of
money supplied are equal
• Equilibrium in the money market
– When the quantity of money people are
actually holding (quantity supplied)
– Is equal to the quantity of money they want
to hold (quantity demanded)
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17
Figure 5
Money Market Equilibrium
Nominal Interest
Rate
MS
At a higher interest rate, an
excess supply of money
causes the interest rate to fall.
9%
At the equilibrium interest rate of 6%,
the public is content to hold the
quantity of money it is actually holding.
E
6%
At a lower interest rate, an
excess demand for money
causes the interest rate to rise.
3%
Md
600
1,000
1,600
Money
($ billions)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18
Equilibrium in the Money Market
• Excess supply of money
– Amount of money supplied exceeds the
amount demanded at a particular interest
rate
– Interest rate > equilibrium interest rate
– Excess demand for bonds
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19
Equilibrium in the Money Market
• Excess demand for bonds
– Amount of bonds demanded exceeds the
amount supplied at a particular interest
rate
• A bond
– A promise to pay back borrowed funds at a
certain date or dates in the future
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20
Equilibrium in the Money Market
• When the price of bonds rises
– The interest rate falls
• When the price of bonds falls
– The interest rate rises
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21
Equilibrium in the Money Market
• Interest rate, in the long run
– Determined in the market for loanable
funds
• Interest rate, in the short run
– Determined in the money market
• The Fed – can change the money supply
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22
What Happens When Things Change?
• The Fed wants to increase the interest
rate
– Decrease the money supply
– Sell government bonds
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23
What Happens When Things Change?
• The Fed wants to lower the interest rate
– Increase the money supply
– Buy government bonds
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24
Figure 6
An Increase in the Money Supply
Nominal
Interest
Rate
6%
At point E, the money market is in equilibrium at
an interest rate of 6 percent.
M1 S
M2 S
E
F
3%
To lower the interest rate, the Fed
could increase the money supply
to $1,600 billion.
The excess supply of money (and excess
demand for bonds) would cause bond
prices to rise, and the interest rate to fall,
until a new equilibrium is established at
point F with an interest rate of 3 percent.
Md
1,000
1,600
Money
($ billions)
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25
What Happens When Things Change?
• When the Fed increases the money
supply
– The interest rate falls
– And spending on three categories of
goods increases:
• Plant and equipment, new housing, and
consumer durables (especially automobiles)
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26
What Happens When Things Change?
• When the Fed decreases the money
supply
– And spending on three categories of
goods falls:
• Plant and equipment, new housing, and
consumer durables (especially automobiles)
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27
Monetary Policy
• Monetary policy
– Control or manipulation of interest rates by
the Federal Reserve
– Designed to achieve a macroeconomic
goal
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28
Figure 7
Monetary Policy and the Economy
Nominal Interest Rate
M1S
Real Aggregate Expenditure
($ billions)
M2S
F
6%
A
AEr=3%
AEr=6%
E
B
3%
Md
1,000
1,600
Money ($ billions)
45°
8,000
10,000
Real GDP
($ billions)
Initially, the Fed has set the money supply at $1,000 billion, so the interest rate (real and nominal) is 6% (point A).
Given that interest rate, aggregate expenditure is AEr=6% in panel (b), and real GDP is $8,000 billion (point E). If
the Fed increases the money supply to $1,600 billion, money market equilibrium moves to point B in panel (a).
The interest rate falls to 3% (point B), stimulating interest-sensitive spending and driving aggregate expenditures
upward in panel (b). Through the multiplier process, real GDP increases to $10,000 billion (point F).
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29
Monetary Policy
• The Fed: targeting the interest rate
– To prevent fluctuations in money demand
from affecting the economy
– Adjusts the money supply to maintain its
interest rate target
• The Fed: changing the interest rate target
– To prevent or address unwanted changes
in aggregate expenditure
– Change its interest rate target, adjusting
the money supply as needed to reach it
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30
Figure 8
Maintaining an Interest Rate Target
Real Aggregate Expenditure
($ billions)
Nominal Interest Rate
M1S
8%
5%
M2S
B
A
AEr=5%
C
M2d
M1d
1,000
1,400
Money ($ billions)
45°
10,000
YFE
Real GDP
($ billions)
Initially, the money market in panel (a) is at point A, with the interest rate at its target of 5%. In panel (b), this
interest rate positions the AE line to create equilibrium output of $10,000 billion, which results in full
employment. An increase in money demand from M1d to M2d in panel (a), with no action by the Fed, would drive
the interest rate up to 8%, and shift the AE line in panel (b) downward. To prevent this, the Fed increases the
money supply from $1,000 billion (M1S) to $1,400 billion (M2S), moving the money market equilibrium to point C.
This maintains the interest rate at its target of 5%, and prevents any change in equilibrium output in panel (b).
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31
Figure 9
Changing the Interest Rate Target to Prevent a Recession
Real Aggregate Expenditure
($ billions)
Nominal Interest Rate
M1S
M2S
AE1
E
AE2
5%
A
F
C
3%
Md
1,000
1,300
Money ($ billions)
45°
9,000
10,000
Real GDP
($ billions)
Initially, the money market in panel (a) is at point A, with the interest rate at its target of 5%. In panel (b),
equilibrium output is $10,000 billion, which is the full-employment output level. Then, in panel (b), the AE line shifts
downward because of a decrease in some sector’s spending. With no change in Fed policy, output would fall from
$10,000 billion to $9,000 billion (point F). To prevent this recession, the Fed lowers its interest rate target to 3%in
panel (a), and increases the money supply from $1,000 billion (M1S) to $1,300 billion (M2S). This moves the money
market equilibrium to point C. The lower interest rate raises consumption and investment spending, shifting the AE
line in panel (b) back to its original position.
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32
Monetary Policy: Many Interest Rates
• Federal funds market
– Banks with excess reserves lend them out
to other banks
– For very short periods, usually a day
– Interest rate: federal funds rate
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33
Monetary Policy: Many Interest Rates
• Federal funds rate
– The interest rate charged for loans of
reserves among banks
– Targeted by the Fed
• New tool: interest on reserves (IOR)
– Interest rate for reserves sets a floor for
the federal funds rate
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34
Unconventional Monetary Policy
• Fed’s conventional monetary policy less
effective if:
– Changing interest rate spreads
– The zero lower bound
– Financial crises
• Interest rate spread
– The difference between any particular
interest rate and a benchmark interest rate
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35
Unconventional Monetary Policy
• Changing interest rate spreads
– The Fed cannot use federal funds rate
– The Fed can change spreads by arranging
the buying or selling of assets other than
government bonds
– Economic and political cost
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36
Unconventional Monetary Policy
• Zero lower bound
– Even when the federal funds rate hits the
zero lower bound
– The Fed still has unconventional tools to
increase aggregate expenditure
• Purchasing assets other than short-term
government bonds to reduce spreads
• Increasing expected inflation to reduce real
interest rates
– These policies have potential downsides
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37
Unconventional Monetary Policy
• Financial crises
– Conventional features – for banks
• Deposit insurance
• The discount window
– Expand and extend these features to nonbanks
– When a financial crisis looms, the Fed’s
most important job is to help stabilize the
financial system itself and prevent a
financial collapse
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38
The Recession, the Financial
Crisis, and the Fed
• Conventional tools in 2007 and early 2008
– Lower federal funds target, September
2007
• Before the AE line began shifting downward
• Continued to lower it for the next 15 months
– Not enough to prevent a recession
– Other interest rates in the economy
remained stubbornly high
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39
Figure 10
Conventional Monetary Policy to Fight the Recession (a)
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40
Figure 10
Conventional Monetary Policy to Fight the Recession (b)
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41
Figure 10
Conventional Monetary Policy to Fight the Recession (c)
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42
The Recession, the Financial
Crisis, and the Fed
• The need for unconventional tools
– Rising spreads
– Federal funds rate was fast approaching
the zero lower bound
– Financial crisis was worsening
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43
The Recession, the Financial
Crisis, and the Fed
• How the Fed (and Treasury) responded
– Lender of last resort: easier for banks to
borrow anonymously for short periods
– Created incentives for other financial
players to purchase mortgage-backed
securities
– Purchase $1 trillion worth of mortgage
backed securities
• Selling government bonds
• Newly created reserves
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44
The Recession, the Financial
Crisis, and the Fed
• How the Fed (and Treasury) responded
– Assisted the Treasury as it lent out
hundreds of billions of dollars to troubled
financial institutions
• Taking newly issued shares of stock as
collateral
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45
The Recession, the Financial
Crisis, and the Fed
• Fed’s further moves during the Slump
– Designed to reduce the stubbornly
elevated spreads between the federal
funds rate and other interest rates
– In late 2010: purchase $600 billion in longterm government bonds
• Within the next year, paying with new
reserves
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46
The Recession, the Financial
Crisis, and the Fed
• Fed’s further moves during the Slump
– In mid-2011: announced that it expected to
keep the federal funds rate at
“exceptionally low levels” for at least
another two years
– September 2011: acquire another $400
billion in long-term government bonds
• By selling an equivalent amount of short-term
government bonds
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47
The Recession, the Financial
Crisis, and the Fed
• Attacks on the Fed for doing too much
– The Fed’s policies would create
hyperinflation (explosive growth in
reserves at banks)
• Rise in reserve: mostly excess reserves
• Short-run relationship between money supply
and inflation
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48
Figure 11
Total Reserves of U.S. Banks
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49
The Recession, the Financial
Crisis, and the Fed
• Attacks on the Fed for doing too much
– The Fed might not be able to prevent high
inflation later, as the economy recovered
• New tool: IOR (interest on reserves) rate—
would enable it to slow lending to any desired
level
– The Fed’s emergency loans and other
assistance to financial institutions had put
taxpayer dollars at risk
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50
The Recession, the Financial
Crisis, and the Fed
• Attacks on the Fed for doing too little
– The Fed had done much too little during
the long slump: aggressive Fed policy to
raise expected inflation
• To boost aggregate expenditure
– By reducing the real value of household debt
– By lowering real interest rates
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51