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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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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”) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 What Happens When Things Change? • The Fed wants to increase the interest rate – Decrease the money supply – Sell government bonds © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 What Happens When Things Change? • The Fed wants to lower the interest rate – Increase the money supply – Buy government bonds © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Monetary Policy • Monetary policy – Control or manipulation of interest rates by the Federal Reserve – Designed to achieve a macroeconomic goal © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 $10,000 billion (point F). © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 Monetary Policy • The Fed: targeting the interest rate – To prevent fluctuations in money demand from affecting the economy – Adjusts the money supply to maintain its interest rate target • The Fed: changing the interest rate target – To prevent or address unwanted changes in aggregate expenditure – Change its interest rate target, adjusting the money supply as needed to reach it © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Figure 8 Maintaining an Interest Rate Target Real Aggregate Expenditure ($ 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 $1,400 billion (M2S), moving the money market equilibrium to point C. This maintains the interest rate at its target of 5%, and prevents any change in equilibrium output in panel (b). © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 Figure 9 Changing the Interest Rate Target to Prevent a Recession Real Aggregate Expenditure ($ 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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39 Figure 10 Conventional Monetary Policy to Fight the Recession (a) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 40 Figure 10 Conventional Monetary Policy to Fight the Recession (b) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 41 Figure 10 Conventional Monetary Policy to Fight the Recession (c) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 48 Figure 11 Total Reserves of U.S. Banks © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 51