Download Ch 15 Monetary policy

Monetary policy
How does a change in money supply affect the
economy?
Relevant reading: Ch 13
The Federal Reserve System
The central bank of the United States
Functions of the Fed
Clearing checks between private banks
Holding bank reserves
Providing currency
Providing loans
Monetary tools
Reserve requirement
Discount rates
Open market operations
Required reserves
The legal minimum amount of reserves a
bank is required to hold; equal to required
reserve ratio times deposits
Required reserve ratio and money
supply
rd increases  excess reserves decreases and
money multiplier decreases money supply
decreases
rd decreases  excess reserves increases and
money multiplier increases money supply
increases
Discount rate
The rate of interest the Fed charges for lending
reserves to private banks
Discount rate increasesexcess reserves decreases
 money supply increases
Discount rate decreases excess reserves
increasesmoney supply decreases
Open market operations
Open market purchase- the operation in which
the Fed purchases government securities from
the public to increase bank reserves
Open market sale- the operation in which the
Fed sells government securities to the public to
decrease bank reserves
Example: Open market purchase
The Fed buys $1000 worth of government
securities from the public. The Fed writes a check
to pay for the purchase. The seller deposits the
check into the banking system
Example: Open market purchase
Assuming rd= 0.1
Change in money supply
= $1,000 x 1/0.1
= $1,000 x 10
= $10,000
Example: Open market sale
The Fed sells $1000 worth of government securities
from the public. The buyer withdraws money from
the banking system to pay for the securities
Example: Open market sale
Assuming rd= 0.1
Change in money supply
= -$1,000 x 1/0.1
= -$1,000 x 10
= -$10,000
Open market operation and money
supply
Open market purchaseexcess reserves increases , money supply increases
Open market saleexcess reserves decreases , money supply decreases
Money market
 Money demand – The quantity of money people
are willing to hold at alternative interest rates,
holding other things constant.
 Money supply- money stock available in an
economy.
Money demand
 Interest rates as the price of money
Interest rate
MD
Quantity of money, M
Other determinants of money demand 1
 Wealth
 Income
 Liquidity of alternative assets
 Risk of other assets
 Payment technology
Other determinants of money demand 2
 As wealth decreases, money demand decreases
 As income decreases, money demand decreases
 As liquidity of alternative assets increases, money
demand decreases
 As risk of other assets decreases, money demand
decreases
 As payment technology allows transaction to be carried
out without money, money demand decreases. Example:
credit cards
Change in Money Demand 1
 Households’ wealth increases
Interest rate
Quantity of money
Change in Money Demand
 People become less risk averse to alternative assets such
as stocks
Interest rate
Quantity of money
Money Supply
 Assumed as exogenous
Interest rate
Ms
Quantity of money
E.g. an open market purchase (to
increase the money supply)
Interest rate
Ms 1
Ms 2
Quantity of money
Money market equilibrium
Interest rate
MS
ie
Me
Quantity of money, M
Example: An increase in wealth
Interest rate
MS
i1
i0
Md 1
Md 0
Quantity of money, M
Example: The Fed raises the discount
rate
Interest rate
MS1
MS0
i1
i0
MD
M1
M0
Quantity of money, M
Example: The Fed lowers required
reserve ratio
Interest rate
MS0
MS1
i0
I1
MD
M0
M1
Quantity of money, M
Example: The Fed carries out open
market purchase
Interest rate
MS0
MS1
i0
I1
MD
M0
M1
Quantity of money, M
Interest rates and the economy
 Interest rates decreases investment increases  AD
increases
 Interest rates increases investment decreases  AD
decreases
The effect of an expansionary policyincreasing money supply
Interest rate
MS0
MS1
P
AS
i0
I1
MD
AD2
M0
M1
Quantity of money, M
AD1
Real output, Y
The effect of a contractionary policydecreasing money supply
Interest rate
MS1
MS0
P
AS
i1
i0
AD2
MD
AD1
Real output, Y
M1
M0
Quantity of money, M