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1 Macro McEachern ECON 2010-2011 16 CHAPTER Monetary Theory and Policy Designed by Amy McGuire, B-books, Ltd. 2 The Demand for Money Demand for money Interest rate How much money people to hold People demand money LO1 want Pay for purchases Money Carry out economic transactions Easily Efficiently 3 The Demand for Money More active economy More goods and services exchanged More money demanded The higher the price level LO1 Greater the demand for money Money Medium of exchange Store of value Liquidity 4 The Demand for Money Opportunity cost of holding money Quantity of money demanded Interest forgone Inversely: market interest rate Money demand curve Downward slope The lower interest rate LO1 The lower opportunity of holding money cost 5 LO1 Exhibit 1 Demand for Money Interest rate The money demand, Dm, slopes downward. As the interest rate falls, other things constant, so does the opportunity cost of holding money; the quantity of money demanded increases. Dm 0 Quantity of money 6 The Supply of Money Supply of money Stock of money In economy A particular time Determine by the Fed Vertical line LO1 Independent of interest rate 7 The Supply of Money Equilibrium interest rate Demand for money Supply of money Interest rates Above equilibrium Below equilibrium LO1 Higher opportunity cost of holding money Lower opportunity cost of holding money 8 The Supply of Money Given money demand curve Increase money supply Decrease money supply LO1 Lower interest rate Higher interest rate 9 LO1 Exhibit 2 Interest rate Effect of an Increase in the Money Supply Sm Because the money supply is determined by the Federal Reserve, it can be represented by a vertical line. S’m At point a, the intersection of the money supply, Sm, and the money demand, Dm, determines the market interest rate, i. a i b i’ Dm 0 M M’ Quantity of money Following an increase in the money supply to S’m, the quantity of money supplied exceeds the quantity demanded at the original interest rate, i. People attempt to exchange money for bonds or other financial assets. In doing so, they push down the interest rate to i’, where quantity demanded equals quantity supplied. This new equilibrium occurs at point b. 10 Money and Aggregate Demand in the Short Run Short run: Money affects the economy Through changes in interest rate The Fed: stimulate output; employment Open-market purchases Money supply – increase Interest rate – reduce Investment – stimulate Aggregate demand – increase Real GDP – increase LO2 Exhibit 3 LO2 a i i b i’ (b) Demand for investment (c) Aggregate demand Price level (a) Supply and demand for money Sm S’m Interest rate Interest rate Effects of an Increase in the Money Supply on Interest Rates, Investment, and Aggregate Demand a P b i’ b a AD’ Dm AD DI 0 11 M M’ Money An increase in the money supply drives the interest rate down to i'. 0 I I’ Investment With the cost of borrowing lower, the amount invested increases from I to I‘. 0 Y Y’ Real GDP This sets off the spending multiplier process, so the aggregate output demanded at price level P increases from Y to Y‘ 12 Money and Aggregate Demand in the Short Run The Fed: cool down the economy Open-market sale Money supply – decrease Interest rate – increase Investment – reduce Aggregate demand – decrease Real GDP - decrease LO2 13 Adding the Short-Run Aggregate Supply Curve Contractionary gap Output < potential Price level < expected Wages > negotiated The Fed: expansionary monetary policy Stimulate AD Increase money supply Equilibrium LO2 LO2 14 Exhibit 4 Expansionary Monetary Policy to Correct a Contractionary Gap Price level Potential output LRAS At a, the economy is producing less than its potential in the short run, resulting in a contractionary gap of $0.2 trillion. SRAS130 b 130 a 125 AD’ AD 0 13.8 14.0 Real GDP (trillions of dollars) Contractionary gap If the Federal Reserve increases the money supply by just the right amount, the aggregate demand curve shifts rightward from AD to AD’. A short-run and long-run equilibrium is established at b, with the pride level at 130 and output at the potential level of $14.0 trillion 15 Money and Aggregate Demand in the Long Run Equation of exchange Buyer: exchanges money for goods Seller: exchanges goods for money M – quantity of money in economy V – velocity of money P – average price level Y – real GDP LO3 16 Targets for Monetary Policy Short-run Long-run Price level Money market: equilibrium Increase money demand curve The Fed – target money supply LO4 Interest rate Does nothing Increase interest rate Increase money supply The Fed – target interest rate LO4 17 Exhibit 7 Targeting Interest Rates Versus Targeting the Money Supply Interest rate Sm S’m If the Federal Reserve holds the money supply at Sm, the interest rate rises from i (at point e) to i ' (at point e'). e’ i’ i An increase in the price level or in real GDP, with velocity stable, shifts rightward the money demand curve from Dm to D'm. e’’ e D’m Dm 0 M M’ Alternatively, the Fed could hold the interest rate constant by increasing the supply of money to S'm. The Fed may choose any point along the money demand curve D'm. Quantity of money 18 Targets for Monetary Policy LO4 Targets before 1982 Stabilize interest rates October 1979: target money aggregates Volatile interest rates Sharp reduction in money growth, 1981 Recession, 1982 Declining inflation Rising unemployment
