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Monetary Policy Chapter 13 Federal Funds Rate Ms i Supply Money Reserves ffro i0 Md Demand $ Reserves Supply P0 Price Level AS Goods and Services Bonds P0 Demand AD GDP GDP National Income Demand for Money (Md): The amount public wants to hold in liquid form Households Does not earn Interest Stocks, Funds Bonds, CD’s, Life Insurance Md Depends Buy on dollar Need in Deposits goods value of liquid form and Cash and transactions d services M Earns Interest Money Supply Ms: Amount the public actually holds (Deposits & Cash) Ms 500b Ms 0 Public wants less cash: looking for borrowers who would pay interest At 3%: : the Public holds the amount it to hold Federal Funds Rate Supply ffro Reserves Demand Federal Funds Rate Reserves MARKET FOR RESERVES Banks’ Demand for depends on Banks’ Demand for depends on size of : = r* Banks’ Demand for depends on Federal Funds Rate Supply When GDP or Prices increase, Bank’s Demand for Reserves shifts right and ffr increases ffr1 Reserves ffro Demand Reserves Federal Funds Rate MARKET FOR RESERVES Inverse Relationship Between Price of Bonds and Interest Rate Amount you get at maturity 25% 11% Interest = rate - Price you paid for Bond $90 $80 $100 Price you paid for Bond $90 $80 The lower the price on the bond, the higher the interest rate. Market for Reserves: Fed Buys Bonds Federal funds Rate Supply= excess reserves + Fed changes ffro ffr1 Demand: Banks + Public Money Supply: Government and Fed Bonds P0 Demand: Public Price of Bonds MARKET FOR BONDS Bond Market: Fed Buys Bonds When the fed buys bonds it decreases the supply of bonds available to the public…. Bond Market: Fed Buys Bonds Supply of bonds i1=4% P1 P0 Bond Price rises: Interest Rates Decrease i0 =8% Demand for bonds Interest Rate and Velocity of Money As interest rate rise, public holds less Velocity of money: Number cash for transactions: each dollar is of times a dollar bill is used used more times. Dollar value of what we buy Ms = Deposits + currency Velocity = Nominal GDP/Ms Contractionary Policy: interest rate rise, public holds less cash and deposits (Ms):Velocity increases I increase AE line Shifts up AD shifts Right Aggregate Expenditures 45 Price level P0 The size of the change in equilibrium Y Y0 Y1 Equilibrium Income increase Prices are the same AD1 Is the size of the shift in AD AD0 Y0 Y1 Price Level AS Goods and Services P0 AD AD = C + I + G + NX GDP0 GDP Price Level GOODS AND SERVICES Fed Buys Bonds: Interest rate drops, Investment Increase Price Level AS AD shifts Right Prices Rise AD1 = C0 + I1=G0+NX0 AD0 = C0 + I =G +NX 0 0 GDP GDP Increase 0 When the Fed Wants to Reduce Unemployment Use Expansionary Monetary Policy Buy Bonds Increase Reserves and Money Supply Decrease d Decrease r Decrease the interest rate. Increase Investment Increase Aggregate Demand for goods and services s Banks may Fed Controls Reserves but not the M may OMO: What can goPublic wrong? not want to Loans are lend not deposited Fed buys in the bonds banking from the public or system banks not want to borrow Fed increases banking system reserves Money Supply Increases Deposits Increase Loans Increase Banks increase loans Interest Rates decrease Credit easier to get 27 Open Market Operations: Fed Buys Bonds Fed buys bonds from the public or banks Fed increases banking system reserves Money Supply Increases Deposits Increase Loans Increase Banks increase loans Interest Rates decrease Credit easier to get 28 Open Market Operations: Fed Buys Bonds Fed buys bonds to the public or banks Fed increases banking system reserves Banks increase loans Aggregate demand Increase Investment increases Interest Rates decrease Credit easier to get 29 Market for Reserves: Fed Sells Bonds Federal funds Rate Supply= excess reserves + Fed changes ffr1 ffro Demand: Banks + Public Money Open Market Operations: Fed Sells Bonds Fed sells bonds to the public or banks Fed reduces banking system reserves Money Supply Decreases Deposits Decrease Banks decrease loans Interest Rates increase Loans Decrease Credit harder to get 31 The Money Market: Fed Sells Bonds Money scarce: Everyone needs to borrow cash: willing lenders can be found only at higher interest s M0 Ms1 rate. Reserves, Loans, Deposits and the Ms decrease i i =5% Amount of Money the Amount of checking Money the the Money into Amount of Money Public holds in deposit Public in accounts: look for willing Public holds holds in deposit deposit accounts = Amount accounts < the lenders accounts = Amount Amount the the public wants to public wants to public wants to hold hold hold when i0 =3% when i00 =3% when =5% 0 i =3% 0 $ Ms1 M d0 Open Market Operations: Fed Sells Bonds Fed sells bonds to the public or banks Fed reduces banking system reserves Banks decrease loans Aggregate demand Drops Investment Decrease Interest Rates increase Credit harder to get 33 Price Level Fed Sells Bonds AS Prices Drop AD0 = C0 + I =G +NX 0 0 AD1 = C0 + I1=G0+NX0 GDP Decrease Real GDP 0 Bond Market: Fed Sells Bonds i =25% i =11% Supply of bonds: Fed, government Bond Price falls: Interest Rates Increase P0=90 P1=80 Demand for bonds When the Fed Wants to Reduce Inflation Use Contractionary Monetary Policy Decrease the Money Supply Increase the interest rate. Sell Bonds Increase d Increase r Decrease Investment and Consumption? Decrease Aggregate Demand for goods and services Price = $100 i=10% Get at maturity = $110 Interest 10% rate Price you Amount you paid for get at maturity Bond 100 110 = Price you paid for 100 Bond Price = $100 i=10% Get at maturity = $110 Interest rates drop to 8% Amount at maturity - Bond Price 110 100 P? 10% 8% = Bond Price P? 100 10% 8% = Interest rates drop to 8% 0.08 = 110 - 100 P? P? 110 P + 0.08P = 110 1.08P = 110 P = 110/1.08 P? P P? Bond Price rises = $101.85