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Chapter 13
Money, Banks, and the Federal Reserve

Chapter Outline
13-1
Money as a Tool of Stabilization Policy
13-2
Definitions of Money
a. The M1 Definition of Money
b. The M2 Definition of Money
c. Money Supply Definitions and the Instability of Money Demand
13-3
High-Powered Money and Determinants of the Money Supply
a. Money Creation on a Desert Island
b. Required Conditions for Money Creation
c. The Money-Creation Multiplier
d. Gold Discoveries and Bank Panics
13-4
The Fed’s Three Tools for Changing the Money Supply
a. The Fed’s Balance Sheet
b. What Action by the Fed Will Raise the Money Supply?
c. First Tool: Open-Market Operations
d. Second Tool: Discount Rate
e. Third Tool: Reserve Requirements
f. Why the Fed Can’t Control the Money Supply Precisely
13-5
Theories of the Demand for Money
a. Interest Responsiveness of the Transactions Demand for Money
b. The Portfolio Approach
IP Box: Plastic Replaces Cash, and the Cell Phone Replaces Plastic
13-6
Why the Federal Reserve “Sets” Interest Rates
a. The Choice of Targets
Summary
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Chapter 13
Money, Banks, and the Federal Reserve
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Chapter Overview
So far, we have restricted our analysis mainly to in real terms, although we have analyzed different
monetary policies and its implication on the economy. This chapter examines this monetary policy
in more detail. It discusses the demand for and supply of money and the role of private financial
institutions, markets, and instruments in determining the stability of money demand. The text
explains various definitions of money (M1 and M2) in the context of financial markets and
financial deregulation are discussed. The chapter then turns to discussion about money supply. It
describes the money-creation process, including the money creation multiplier and the instruments
of the Federal Reserve to control the money supply. Gordon then presents and compares the main
theories of the demand for money (transaction demand approach and portfolio approach). The
chapter concludes with an analysis of why the Fed tends to focus on interest rates rather than money
supply in its attempt to stabilize the economy.
Section 13-1 explains why monetary, rather than fiscal, policy is the major tool of stabilization
policy. Remind students that the stability of the demand for money is central to the conduct of
monetary policy, because stable money demand implies a stable relationship between the money
supply and nominal GDP through the AD curve. However, situation has changed after 2007 when
federal funds rate had been lowered to zero yet economy was in recession.
The general definition of money is discussed in Section 13-2. Note that anything called “money” is
defined by the functions of money: a medium of exchange, a store of value, and a unit of account.
Then, distinguish this definition from the official U.S. definitions of the money supply. Motivate
the definitions of M1 and M2 by chronologically explaining how the official definitions of money
changed with the development of new financial instruments and changes in financial regulations.
Gordon links the destabilizing effects of financial deregulation to difficulty of following the
monetarist constant growth rate rule. Holding the money supply fixed in the face of a shift in
money demand will destabilize both interest rates and output.
Motivate Sections 13-3 and 13-4 by pointing out that to assess the effectiveness and limitations of
countercyclical monetary policy, we first need to understand the monetary structure of the economy
and how various policy instruments available to the Fed influence the nation’s supply of money.
Section 13-3 begins with the traditional presentation of the money-creation process and the
derivation of the money-creation multiplier. Stress the four conditions required for money creation
and intuitively explain what is meant by the term “money creation.” When distinguishing between
the money supply and high-powered money, stress that the relationship between these two concepts
is entirely analogous to the distinction between equilibrium GDP and the level of planned
autonomous spending. The marginal leakage rate is the fraction of household income that leaks out
of the consumption stream and into saving, taxes, and imports. Similarly, the amount of reserves
banks hold is the fraction of total deposits that leaks out of excess reserves, or the “money-creation
stream,” and into required reserves.
There are also several other sources of confusion for students regarding the simple money-creation
multiplier. First, remind students that the official government definition of M1 is basically currency
plus checking accounts (demand deposits). In the absence of currency, as assumed in the simplest
money-creation multiplier, total bank deposits will be identical to the money supply. Also, students
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Chapter Overview
153
are often confused about the actual process by which money is “created.” In addition to providing
the verbal explanation of the role of the reserve-holding ratio in reducing the amount banks can
lend out each time the money is deposited again into the banking system, you may want to
complement this explanation with the conventional “T-accounts” approach. In this way, students
can see clearly how total deposits grow from an initial increase in deposits and, with a simple
application of the geometric series, why the total expansion of the money supply exactly equals the
multiplier times the initial expansion of deposits. Introduce the currency-holding ratio in the
money-creation multiplier, explaining that the “simple” multiplier is too simplistic, since
individuals usually hold a fraction (c) of deposits in the form of currency. This currency held by the
public is an additional leakage from excess reserves, which makes the value of the multiplier fall.
This means that the total money supply (currency plus demand deposits) will fall relative to the
supply of high-powered money (H). Point out that the important concept essential to the
understanding of the money-creation multiplier is the distinction among “actual” reserves,
“required” reserves, and “excess” reserves. Notice also that instead of directly defining the variable
e as the reserve-holding ratio required by the Fed, the text develops this concept by first defining it
as the amount of reserves that banks “decide to hold.” Then, the concept of the required reserveholding ratio is introduced when the chapter analyzes the Federal Reserve’s monetary policy tools.
Furthermore, when explaining the reserve-holding ratio in relation to the Fed, stress that e may be
larger than that required by the Fed since banks may desire to keep greater reserves for
precautionary purposes (as occurred in the late 1930s). Third, stress that the formulas presented in
the text are approximations and that in practice, neither the reserve-to-deposit nor currency-todeposit ratios is constant.
Section 13-4 turns to the operation of the Federal Reserve System. It describes the Fed’s balance
sheet (Table 13-2) and the instruments the Fed may use to influence the money supply. The primary
instrument the Fed uses is open-market operations. Point out that because purchases of government
bonds or Treasury bills add to the amount of excess reserves available for bank loans, the total
money supply will rise by exactly the multiplier times the amount of the initial bond purchase.
Explain that, of the other two Fed instruments of monetary control, the discount rate influences the
quantity of high-powered money by affecting the interest rate the Fed charges on loans to member
banks, while the reserve requirement directly influences the reserve-to-deposit ratio e and, thus, the
money-creation multiplier. Stress also that the Fed cannot exercise precise control over the money
supply because of money-multiplier shocks that can result from changes in the ratio of currency to
deposits (c) and from shifts of funds among assets with different reserve requirements, behaviors
that are beyond the Fed’s control. Remind students that there are multiple money supply definitions
and that, in general, the public’s ability to shift its funds across asset categories also makes it
difficult for the Fed to hit M1 and M2 growth targets simultaneously.
The treatment of the modern theories of money demand given in Section 13-5 is straightforward.
You may, however, point out that the quantity theory as discussed in Chapter 8 is the classical
explanation for the demand for money. The critical difference between the quantity theory and
modern theories is whether velocity is constant or stable. If you choose to review the quantity
theory, stress the difference between the definitional relationship of the quantity equation and the
classical assumption of velocity stability that converts the equation into a theory. Also, stress the
institutional factors that quantity theorists believed would affect velocity. Although Keynes’ theory
of the demand for money is not discussed in this chapter, you might want to include a review in
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your lecture. In Keynes’ theory, money demand is motivated by both the interest rate (speculative
motive) and the need to finance transactions (transactions motive and precautionary motive). If you
choose not to review the quantity theory and Keynes’ theory of the demand for money, you can start
directly with the modern theories of Section 13-5. The essential contribution of the Baumol–Tobin
transactions theory of the demand for money is that it eliminated the need for Keynes’ unrealistic
fixed “normal” interest rate and the need for any speculative motive at all to explain why money
demand depends on the interest rate. The main message to convey about the Baumol–Tobin
approach is that a higher rate of interest at every given “brokerage fee” per dollar charged will
induce individuals to keep more money tied up in interest-bearing accounts and incur the higher
total brokerage cost of withdrawals to finance transactions. Because the Baumol–Tobin
transactions money demand function depends directly on income and inversely on the interest rate,
it is consistent with an upward sloping LM curve without resorting to Keynes’ speculative motive.
Also, stress that the brokerage fee is not necessarily an explicit charge. It may simply be
represented by the “shoe-leather” costs of making withdrawals.
Motivate Tobin’s portfolio approach by pointing out that in addition to the fixed “normal” interest
rate assumption, Keynes’ original theory was also criticized for assuming that individuals held all
their wealth in the form of a single interest-bearing asset (consol) once the interest rate exceeded
each individual’s subjective expectation of the “normal” interest rate. Tobin’s insight was to model
a world consisting of different assets, so that individuals diversified their portfolios to include an
optimal combination of both low-yielding safe assets and high-yielding risky assets. Although the
portfolio approach cannot explain why individuals will hold non-interest-bearing checking accounts
and cash, stress that its principal contribution is that it explains why most households diversify
between the safe interest-bearing components of M1 and M2 and risky high-yielding stocks and
bonds. Friedman’s portfolio model, or “Friedman’s quantity theory of money,” models a general
demand for assets in which money is just one of several alternative assets that can be held. The
main point of Friedman’s approach is that the demand for money must be influenced by the same
factors that influence the demand for any other asset. Stress the role of wealth and inflation in
Friedman’s approach. Furthermore, stress the existence of substitutability between money and
goods, as well as between money and assets, and relate this to the Pigou or real-balance effect.
To supplement the text, you might want to explicitly list the factors modeled in Friedman’s model.
With rm representing the rate of return on money (such as interest-bearing checking accounts),
Friedman modeled the real demand for money as a positive function of income (technically, this
should be permanent income, which is covered in Chapter 15), Y, and a negative function of the
expected return on bonds and equity relative to the return on money, (rb – rm) and (re – rm),
respectively, and the expected rate of inflation relative to the return on money (pe – rm):
(M/P)d = f(Y, rb – rm, re – rm, pe – rm).
Friedman claimed that as the rate of return on bonds and equity issues increases, it tends to pull up
the rate of return on money as well, so that the relative return on bonds and equity remains stable
with an increase in the interest rate. Therefore, unlike Keynes’ approach, Friedman’s approach
placed very little importance on the interest rate as a determinant of the demand for money. Point
out that for this reason Friedman called it a “restatement” of the quantity theory of money.
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Emphasize that all these money demand theories make the demand for real or nominal balances
depend on the nominal rate of interest, given that the rate of return on money is zero. Thus, other
things being equal, a rise in the expected rate of inflation will raise the nominal rate of interest,
reducing the quantity demanded of money.
The IP Box discusses the fading out of cash as plastic takes over. It presents the share of debit-card
and credit-card transactions in total retail transactions. In the year 2003 use of plastic card
surpassed the use of cash and checks to pay for the goods and services. Situation has changed
further in the year 2008 when cash and checks together comprised about 37percent of the total
transactions, whereas credit cards and debit cards together comprise about 59 percent. But it may
have made life harder for people without bank. The next wave of cashless society is the use of cell
phones to pay for almost everything.
Section 13-6 compares three monetary policy targets—money supply, interest rate, and real GDP—
to discover which target will best maintain stability of real output in the presence of commodity
demand and money demand instability. Explain why a money supply target is superior to an interest
rate target if commodity demand is unstable, while an interest rate target is preferred if money
demand is unstable. A real GDP target performs better than either interest rate or money supply
targets when commodity demand is unstable, and identically with an interest rate target with
unstable money demand. However, real supply shocks make real GDP targeting difficult.

Changes in the Twelfth Edition
This chapter’s structure has changed significantly from the 11th edition. Two sections have been
deleted completely, another subsection has been deleted, and Tables have been updated. The pie
diagram and the content in the IP Box have been updated. In several instances, additional
explanations have been added in the content area.
There are significant changes in Section 13-1. The title has been changed from “Money in a World
of Many Financial Assets and Liabilities” to “Money as a Tool of Stabilization Policy.”
Introductory discussion in this section has been modified significantly and the side bar definition
has been deleted. Section 13-2 (in the 11th edition) with title “Financial Institutions, Markets, and
Instruments” has been deleted. The new Section 13-2, “Definitions of Money,” is the old section
13-3 of 11th edition. This section has remained almost unchanged. Table 13-1 has been updated
with new data for the year 2010. There is no change in Section 13-3. (Section 13-4 in the previous
edition). There are slight changes in Section 13-4. The discussion about the “The Fed’s Balance
Sheet” in Subsection 13-4(a) has been modified. Similarly, discussion about the subsections
“Second Tool: Discount Rate” and “Third Tool: Reserve Requirements” have been supplemented
with information about more recent economic experience during the 2007–10 time period. Section
13-5 has experienced little changes. Figure 13-2 in 11th edition as been relabeled as Figure 13-1 in
12th edition. The pie diagram in the The IP Box has been modified with new information for the
year 2008. Section 13-7 of the 11th edition has been deleted. New Section 13-6 (Section 13-8 in the
11th edition) has changed very little with deletion of the introductory paragraph and relabeling the
figure.
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Summary and the concepts sections have also undergone moderate changes.

Answers to Questions in Textbook
1. M1 consists of currency, transactions accounts (demand deposits and other checkable deposits), and
traveler’s checks. M2 is M1 plus savings deposits, time deposits, and money-market mutual funds.
The main difference between M1 and M2 is that M1 consists exclusively of those assets that serve as
media of exchange. Although M2 contains some assets that may serve as media of exchange, namely,
money-market deposit accounts and money-market mutual funds, it also contains assets that serve
solely as stores of value.
2. For each definition of money, the money multiplier is (1+ c)/(e + c). Now, take the case of M1 versus
M2. The former does not include savings deposits, time deposits, or money market mutual funds, but
the latter does. If individuals with holdings in these types of accounts keep different proportions in
cash than other components of M2, then c will change and so may the money multiplier. Alternatively,
the institutions involved may hold different reserve ratios for these types of accounts, and again the
money multiplier may change.
3. High-powered money consists of those assets that can support a multiplier expansion of money. Bank
reserves fit this description, for a bank receiving additional reserves can loan out the new “excess”
part of the reserves, thus beginning the expansion process. Cash held by the public also fits this
description, for it has the potential to support an expansion. If the cash were deposited in a bank, it
would become new reserves and could support an expansion.
4. The required conditions for money creation are: (1) the equivalence of cash and deposits for purposes
of spending, (2) the willingness of people to deposit the funds they receive when the proceeds of a
bank loan are spent in an account at the bank that made the loan, (3) the existence of a fractional
reserve held by the banks, and (4) the existence of people willing to borrow funds at a cost that covers
the expenses of a banker. In the Great Depression, Condition 2 was only marginally met and
Condition 4 was in many instances completely absent. Also affecting the operation of the banking
system at that time was the fact that banks chose to hold a higher fraction of their deposits in reserves.
5. The Fed purchases $200 million worth of bonds in the open market. If a bank is selling the bonds, this
action immediately increases its reserves by $200 million. If a bank is not selling the bonds, it gets
involved when whoever is selling them deposits the proceeds of the sale in an account at the bank. At
that time, some of the $200 million will be held as reserves to support that new deposit, and the rest of
it will be “excess.” In either case, the amount of high-powered money has increased by $200 million
and there will be a multiple expansion of the money supply.
6. In both cases, the limit to the expansion of money or income is determined by the marginal leakages
involved. For both types of multipliers, the expansion terminates only when the amount of money
leaking out of the system is equal to the initial injection. For both, we find that the real world
multipliers are smaller than would be expected by simple formulas because the number and types of
leakages are complex. In the case of the money multiplier, for example, we also have to take into
account the flow of high-powered money into cash as well as reserves.
7. a. The money supply will decline because banks will have fewer reserves to lend. There is no change
in H, high-powered money, but an increase in the public’s currency holding increases the cashholding ratio c, which causes the money multiplier M/H to decrease. This occurs because when c
rises, a smaller portion of H is in the banking system to be multiplied through the process of bank
lending.
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b. The money supply will rise because the public’s cash-holding ratio c will decrease. The money
multiplier will rise and, with a given H, so will the money supply.
c. Discount loans from the Fed increase H and increase the money supply, ceteris paribus.
d. The money supply falls because e, banks’ reserve-holding ratio, increases. The money multiplier is
lowered because of a decrease in banks’ lending volume.
8. There are three major sources of changes in the money supply. First is the quantity of reserves. The
Fed can control these through open-market operations as well as establishing the required reserve ratio
(e). It can also affect the amount of reserves through its discounting operations. The other major
determinant of the money supply is the cash-holding ratio. One reason that the Fed found it difficult to
control the money supply was that people continuously switched their holdings of cash between bank
deposits (M1) and near money assets (e.g., M2). Equally important, however, was the unwillingness of
the Fed to allow interest rates and nominal income to swing as violently as would have been necessary
to meet the money supply growth rate targets.
9. Baumol and Tobin showed that the interest sensitivity of the demand for money is based on a
transactions motive shared by almost everyone. This was an improvement over the speculation-based
theory suggested by Keynes. Thus, the theoretical underpinnings of the positively sloped LM curve
were placed on solid grounds.
10. Tobin and Friedman make the demand for money a function of both income and wealth. They both
treat the decision to hold money as part of the portfolio-balance process. The principal difference
between them is their identification of alternatives to money. Tobin concentrates on other financial
assets, and Friedman suggests that any category of expenditure may be a substitute for money. This
distinction underlies their different views of the “transmission mechanism” by which monetary policy
affects spending. Tobin concentrates on interest-sensitive goods, such as investment and consumer
durables. Friedman suggests a broader group of goods and services.
11. The money-multiplier shock reduces the growth rate of the money supply. In the short run, this reduces
the real money supply and the LM curve shifts to the left, raising the real interest rate and reducing
real GDP. The shock also reduces the growth rate of nominal GDP, resulting in a movement down
along the SP curve, reflecting decreases in both the output ratio and the inflation rate. In the long run,
when expected inflation adjusts downward in response to lower actual inflation, the SP curve shifts
downward and the output ratio rises. Meanwhile, the lower inflation rate increases the real money
supply and shifts the LM curve to the right, lowering the real interest rate and raising real GDP.
During this episode the real GDP, real interest rate, inflation rate, and output ratio have been unstable.
12. The relative advantages and disadvantages of each type of rule depend on the source of economic
fluctuations. A fixed money supply target prescribed by a money supply rule, compared with an
interest rate target, diminishes the fluctuations in real output that occur when changes in business and
consumer optimism, net exports, and government spending beset the economy with unstable
commodity demand. In this instance, the money supply target is preferable to the interest rate target
but not as desirable as a real GDP target. The disadvantage of a real GDP target is that it is likely to
produce more inflation than a money supply target when real GDP fluctuations are caused by supply
shocks. The interest rate target is most advantageous when unstable money demand causes the LM
curve to shift unpredictably, in which case adherence to a fixed money supply target would produce
larger rather than smaller fluctuations in real output.
13. For the Fed to be able to target real GDP when there is instability in commodity demand, it must
change the interest rate in response to fluctuations in commodity demand. Therefore, the Fed must
decrease the money supply in order to increase the interest rate when commodity demand rises, and it
must increase the money supply in order to lower the interest rate when commodity demand decreases.
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Therefore, the Fed must sell bonds in open market operations when commodity demand increases, and
it must buy bonds when commodity demand decreases.
For the Fed to target real GDP when there is instability in the demand for money, it must stabilize the
interest rate. Therefore, the Fed must increase the money supply when the demand for money rises,
and it must decrease the money supply when the demand for money drops. Therefore, the Fed must
buy bonds in open market operations when the demand for money increases, and it must sell bonds
when the demand for money decreases.
14. There are a number of reasons why American households have moved away from the use of cash and
checks to credit and debit cards. First, many more retail stores now accept them, such as grocery
stores. Second, the use of debit cards means having to go to the bank less often to get cash. Third,
shopping on the Internet or from mail order firms almost always requires the use of a credit card.
Fourth, paying bills with a credit card as opposed to a check means not only saving postage, but also
fewer trips to the post office to buy stamps. Fifth, some credit card purchases allow one to obtain
frequent flier miles even if one isn’t buying an airline ticket.
The use of debit cards instead of checks or cash leaves the demand for money unchanged. A person is
simply altering the method by which money, as opposed to income, is spent. On the other hand, using
credit cards instead of cash or checks can reduce the demand for money, as the following extreme
example illustrates. Persons A and B each spend $2,100 per month. Person A deposits the $2,100 into
her account on the first of the month and spends an equal amount every day, writing checks to pay for
everything. Person A has, on average, $1,050 in her account. Person B buys everything using her
credit card, and has $2,100 in her checking account only on the day that the credit card company
automatically redraws the $2,100 for payment of her credit card bill. The other 29 days of the month
she has the funds in an investment paying a higher rate of interest than the checking account. On
average, person B has $2,100/30 or $70 in her account. Person B, who uses only a credit card, has a
much lower demand for money than person A, who uses only checks.
15. The explosion of excess reserves held by U.S. banks to over a trillion dollars during the Global
Economic Crisis increased the value of e, the fraction of deposits banks hold as reserves, and the
amount of high-powered money, which consists of bank reserves and currency. On the other hand,
since the money multiplier equals
(1 + c)/(e + c), the increase in the value of e reduced the size of the money multiplier.

Answers to Problems in Textbook
1. M1 consists of currency, demand deposits, other checkable deposits, and traveler’s checks. Therefore,
M1 equals $915.0 + 507.0 + 405.2 + 4.7 = $1,831.9 billion. M2 consists of everything in M1, plus
money market mutual funds, savings deposits, and small-denomination time deposits. Therefore, M2
equals $1,831.9 + 711.1 + 5,317.9 + 943.3 = $8,804.2 billion.
2. Since the amount of the money supply equals the money multiplier times the amount of high-powered
money, the amount of high-powered money equals the amount of the money supply divided by the
money multiplier. The money multiplier equals (1 + c)/(e + c), where c is the fraction of deposits that
people want to hold in cash, and e is the fraction of deposits that banks hold in the form of reserves.
Therefore, the money multiplier equals (1 + 0.08)/(0.07 + 0.08) = 1.08/15 = 7.2. Therefore, the
amount of high-powered money necessary for the Fed to have a money supply equal to $6,228 billion
equals $6,228/7.2 = $865 billion.
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3. a. The money multiplier equals (1 + c)/(e + c), where c is the fraction of deposits that people want to
hold in cash, and e is the fraction of deposits that banks hold in the form of reserves. Therefore, the
money multiplier equals (1 + 0.1)/(0.15 + 0.1) = 1.1/0.25 = 4.4.
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b. The amount of the money supply equals the money multiplier times the amount of high-powered
money. Therefore, the money supply equals 4.4($1,500) = $6,600 billion.
c. The money supply increases because the amount of high-powered money increases when the Fed
buys bonds. The amount of the increase equals 4.4($30) = $132 billion. If banks borrow fewer
reserves from the Fed, the money supply decreases due to a decline in the amount of high-powered
money. The amount of the decrease in the money supply equals 4.4($6) = $26.4 billion.
d. The money supply must decrease by $6,660 – $6,424 = $176 billion. In order to decrease the
money supply, the Fed needs to reduce the amount of high-powered money, which it can do by
selling bonds. It needs to sell $176/4.4 = $40 billion in bonds.
4. a. Your average demand for money will be C/2, where C = [(2)(2)(2400)/0.05] = $438, and thus your
average money holding is $219.
b. If the interest rate rises to 10 percent, your average money holding will decline to $310/2 = $155.
This change is consistent with expectations, as people are expected to hold less money as the
interest rate rises, ceteris paribus.
5. a. To find each of the points on the IS curve, substitute the value of the interest rate into the equation
for the IS curve. The points are: (11,750, 3); (11,500, 4); (11,250, 5); (11,000, 6); and (10,750, 7).
To find each of the points on the LM curve, substitute the value of the interest rate into the equation
for the LM curve. The points are: (10,750, 3); (11,000, 4); (11,250, 5); (11,500, 6); and (11,750, 7).
b. The equilibrium level of income and the equilibrium interest rate are where both the commodity
and money markets are in equilibrium, which occurs at the intersection of the IS and LM curves. At
that point, income equals 11,250 and the interest rate equals 5.
c. The fall in housing prices would cause household wealth to drop, resulting in a decline in
consumption expenditures and therefore, a fall in autonomous planned spending. A decline in the
value of the dollar would result in a rise in exports and a fall in imports, resulting in increases in
net exports and therefore, autonomous planned spending.
d. If autonomous planned spending drops by 200 billion, then the new equation for the IS curve is
Y = 2.5(4,800) – 250r or Y = 12,000 – 250r. The points on the IS curve IS are: (11,250, 3); (11,000,
4); (10,750, 5); (10,500, 6); and (10,250, 7).
If autonomous planned spending increases by 200 billion, then the new equation for the IS curve is
Y = 2.5(5,200) –250r or Y = 13,000 – 250r. The points on the IS curve IS are: (12,250, 3); (12,000,
4); (11,750, 5); (11,500, 6); and (11,250, 7).
e. Monetary policymakers maintain the interest rate at 5 percent under the first option. Therefore, real
GDP varies between 10,750 and 11,750 as autonomous planned spending varies between 4,800 and
5,200, respectively.
Under the second monetary policy option, both the interest rate and real GDP rise and fall as
autonomous planned spending increases and decreases, respectively. Graphically, the increases and
decreases in real GDP and the interest rate are shown by movements up and down the LM curve as
the IS curve shifts due to changes in planned expenditures. The LM curve does not change because
monetary policymakers do not change the real money supply when autonomous planned
expenditures change. The fluctuations in real GDP range between 11,000, where the IS curve IS
intersects the LM curve, and 11,500, where the IS curve IS intersects the LM curve. The
fluctuations in the interest rate range between 4, where the IS curve IS intersects the LM curve, and
6, where the IS curve IS intersects the LM curve.
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Monetary policymakers increase and decrease the real money supply in order to lower or raise the
interest rate so as to maintain real GDP equal to 11,250, natural real GDP, when autonomous
planned spending falls and rises, respectively, under the third policy option. Therefore, the interest
rate varies between 3 and 7 as autonomous planned spending fluctuates between 4,800 and 5,200,
respectively.
f. The first policy is the least desirable because it results in the largest fluctuations in real GDP.
Therefore, if monetary policymakers try to maintain a fixed interest rate, unemployment would rise
the most when autonomous planned spending falls, and inflation would also rise the most when
autonomous planned spending increases.
The third policy option is the most desirable since by maintaining output equal to natural real GDP,
neither unemployment nor inflation change as autonomous planned spending fluctuates.
g. A decline in autonomous planned spending would put downward pressure on the interest rate as the
fall in income would reduce the demand for money. Therefore, to maintain the interest rate at its
current level, monetary policymakers would have to sell Treasury bills in open market operations in
order to reduce the real money supply.
An increase in autonomous planned spending would put upward pressure on the interest rate as the
rise in income would cause an increase in the demand for money. Therefore, to maintain the
interest rate at its current level, monetary policymakers would have to buy Treasury bills in open
market operations in order to increase the real money supply.
Under the second option, monetary policymakers would only have to engage in open market
operations as needed to maintain the real money supply at its current level.
The third option requires monetary policymakers to increase the real money supply when
autonomous planned spending decreases in order to reduce the interest rate and stimulate planned
spending in an effort to keep output equal to natural real GDP. Therefore, monetary policymakers
must buy Treasury bills in open market operations when autonomous planned spending declines.
The third option also requires monetary policymakers to decrease the real money supply when
autonomous planned spending increases in order to increase the interest rate and reduce planned
spending in an effort to keep output equal to natural real GDP. Therefore, monetary policymakers
must sell Treasury bills in open market operations when autonomous planned spending rises.
6. a. Given that (M/P)d = .25Y – 50r, then at Y =10,000 and r = 0, the demand for money equals
.25(10,000) – 50(0) = 2,500, which is the amount of the real money supply. At Y =10,400 and r = 2,
the demand for money equals .25(10,400) – 50(2) = 2,600 – 100 = 2,500, which is the amount of
the real money supply. The same calculations reveal that the demand for money and the real supply
of money are equal at the other two points listed as being on the LM curve LMA.
b. Given that (M/P)d = .2Y – 40r, then at Y =12,500 and r = 0, the demand for money equals
.2(12,500) – 40(0) = 2,500, which is the amount of the real money supply. At Y =12,900 and r = 2,
the demand for money equals .2(12,900) – 40(2) = 2,580 – 80 = 2,500, which is the amount of the
real money supply. The same calculations reveal that the demand for money and the real supply of
money are equal at the other two points listed as being on the LM curve LMB.
c. The equilibrium level of income and the equilibrium interest rate are where both the commodity
and money markets are in equilibrium, which occurs at the intersection of the IS and LM curves.
Given that (M/P)d = .25Y – 50r, the IS curve intersects the LM curve LMA at Y = 11,400 and r = 7.
At that point, income equals 11,250 and the interest rate equals 5. Given that (M/P)d = .2Y – 40r,
the IS curve intersects the LM curve LMB at Y = 12,900 and r = 2.
d. When the demand for money is (M/P)d = .25Y – 50r, equilibrium income is 11,400, which is less
than natural real GDP, 12,000. Therefore, unemployment is too high. When the demand for money
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162
Chapter 13
Money, Banks, and the Federal Reserve
is (M/P)d = .2Y – 40r, equilibrium income is 12,900, which exceeds natural real GDP, 12,000.
Therefore, the inflation rate not only rises, but since real GDP is greater than natural real GDP,
inflation is higher than expected, which as shown in Chapter 9, would cause a further rise in
inflation, all other things being equal.
e. To find the interest rate that monetary policymakers must target, set natural real GDP equal to the
equation of the IS curve to get 12,000 = 13,500 – 300r. Adding 300r to and subtracting 12,000 from
both sides yields 300r = 1,500. Dividing both sides by 300 yields that 5 is the interest rate that
monetary policymakers must target in order to keep real GDP equal to natural real GDP.
To find what monetary policymakers must set the real money supply equal to in order to reach its
interest rate target, given the demand for money is .25Y – 50r, compute the demand for money at
Y = 12,000 and r = 5. The demand for money equals .25(12,000) – 50(5) = 3,000 – 250 = 2,750.
Therefore, in order to reach its target, monetary policymakers must set the real money supply equal
to 2,750, given the demand for money is .25Y – 50r.
To find what monetary policymakers must set the money supply equal to in order to reach its target,
given the demand for money is .2Y – 40r, compute the demand for money at Y = 12,000 and r = 5.
The demand for money equals .2(12,000) – 40(5) = 2,400 – 200 = 2,200. Therefore, in order to
reach its target, monetary policymakers must set the real money supply equal to 2,200, given the
demand for money is .2Y – 40r.
©2012 Pearson Education, Inc. Publishing as Addison Wesley