Slide 1OVERVIEW / Questions of the Day19.1 The money marketMONEY MARKETMoney Market: Money DemandWhat does ‘Money Demand’ mean?Money Market: Money DemandMoney Market: Money DemandMoney Market: Money SupplyMoney Market: Money SupplyMoney Market: EquilibriumMoney Market: Equilibrium19.2 Monetary PolicyMONETARY POLICYMONETARY POLICYThe Money Market and the FedThe Fed and Monetary PolicyMonetary PolicyMonetary PolicyExpansionary Monetary Policy: Behind the ScenesHistorical U.S. Money Supply (M1)Expansionary Monetary PolicyMoney Supply and The Economy19.3 Quantity theory of moneyQUANTITY THEORY OF MONEYVelocity EquationVelocity Equation: ExampleVelocity EquationQuantity Equation: The Role of MoneyQuantity Equation: The Role of MoneyQuantity Equation: ExampleThe Neutrality of MoneySlide 33Fiscal and Monetary PolicyKey Terms and ConceptsHyperinflation Around the WorldHyperinflation Around the WorldTOPIC 19:SMOOTHING GROWTH-MONETARY THEORY AND POLICYThe Role of Money and Prices in the Economy1OVERVIEW / Questions of the DayWhat role does money play in our economy?•Does it matter if M2 is $5 trillion or $10 or 20 trillion?•Does having a larger or smaller money supply affect the economy?•Does it affect interest rates? Output/GDP? Employment? Prices?1. What determines interest rates?2. How does Monetary Policy work?•How does the Federal Reserve conduct monetary policy3. What causes inflation?•What does an increasing money supply do to the economy?219.1 THE MONEY MARKETDetermining equilibrium value of interest rates3MONEY MARKET•Money is an asset, and like any other asset it has a supply and demand•Like any other asset, the supply and demand for it form a market, and this market determines its value4Money Market: Money DemandMoney Demand (Md) •the desire to hold assets in their most liquid form - cash, checking (even savings for M2) rather than other less liquid forms (stocks, real estate, etc.) •What affects the desire for the public (either consumers of businesses) to hold cash?•What affects the desire for the public to hold an extra $300 in their checking (savings) account, rather than in stocks or bonds?5What does ‘Money Demand’ mean?6$500 disposable money left over at end of monthWhat do you do with it?Put in retirement/stocks/home improvement (somewhere illiquid)Put in checkings/savings account (somewhere liquid)This is MdMoney Market: Money Demand Why do people/businesses hold money?1. Transactions Demand•‘walking around money’•Have money on hand to pay for everyday items and purchases2. Speculative Demand•‘betting money’•Have money on hand to take advantage of investment opportunities3. Precautionary Demand (Justin money)• ‘mattress money’•Have money on hand as preparation for unexpected events7Money Market: Money Demand8iQ (m)There is a ‘cost’ of holding moneyYou can’t invest it and earn interestThe ‘price’ of holding moneyMdThe higher the interest rate, the less money people want to holdMd is negatively related to interest ratesThe amount of money the public wishes to holdMoney Market: Money SupplyMoney Supply (Ms)•the amount of money (M1 or M2) available in the economy•IT IS DETERMINED BY THE FED, and therefore does not depend on any factors such as i, P, or Y•therefore is •Ms is simply whatever amount the Fed wants it to be9Money Market: Money Supply10iMsQ (m)plotting Ms against nominal interest rates:The Fed can increase or decrease the Ms at will through 1 of their 3 tools; causing the Ms to shift left or rightIncrease the MsDecrese the MsMoney Market: Equilibrium 11Q (m)iTheory of Liquidity Preference – theory that i adjusts to equilibrate Md and Ms (same as P adjusts in other markets to equilibrate demand and supply)Md and Ms together form the money marketMsMdThe interest rate adjusts until it reaches i* where Ms = MdMs = Mdi*Money Market: Equilibrium 12MdQ (m)Msii*Md and Ms together form the money marketSurplus of moneyMs > MdMarket forces will try to drive i downShortage of moneyMd > MsMarket forces will try to drive i up19.2 MONETARY POLICYHow the Federal Reserve can smooth business cycles and influence the macro-economy (P, U, and Y)13MONETARY POLICYMonetary Policy: deliberate manipulation of AD by the Federal Reserve in order to achieve some macroeconomic goal (inflation or unemployment)•Expansionary monetary policy: policy pursued by Fed to increase AD•Decreasing nominal interest rates (i) by increasing MS•Contractionary monetary policy: policy pursued by Fed to decrease AD•Increasing nominal interest rates (i) by decreasing MSMONETARY POLICYQ. How can the Fed affect aggregate demand? Q. What is the link between the money supply and aggregate demand?A. Money Market•The Fed controls the money supply, and by manipulating MS they can manipulate ADMdii*Q of moneyMsThe Money Market and the FedWhen the Fed wants to increase interest rates, they decrease the MsWhen the Fed wants to decrease interest rates, they increase the MsThe Fed and Monetary PolicyThe Fed increases MSThis decreases interest ratesThis makes borrowing cheaperThis increases I (and C)This increases AD (shifts AD to the right)The Fed decreases MSThis increases interest ratesThis makes borrowing more expensiveThis decreases I (and C)This decreases AD(shifts AD to the left)Contractionary Policy Expansionary PolicyASADpotential GDPŶPPOutputMonetary Policy18AD’•Output is down, sales are down, profits are down•Unemployment is up•What could the Fed do to help?•Increase or decrease Ms?•Increase or decrease interest rates?•Buy or sell bonds?•Goals: •Push output back to the potential level•Push unemployment down back to the natural rateP’YA significant fall in C & I has reduced ADASpotential GDPŶPOutputMonetary Policy19ADWhat should the Federal Reserve do?Work backwards•Fed should decrease interest rates•To do this, they should increase Ms•To do this, they should buy bonds•This will shift AD (right)•This will increase Y and P, decrease UP’YA significant fall in C & I has reduced ADExpansionary Monetary Policy: Behind the ScenesMS0MDQ of Mii0AD0Real GDPPP0Y0Y1When the Fed ↑ the money supply, it causes a ↓ in interest ratesThe ↓ in interest rates causes an ↑ in C and I, and this causes an ↑ in aggregate demandASMoney MarketAD – AS modelHistorical U.S. Money Supply (M1)$0$200$400$600$800$1,000$1,200$1,400$1,600$1,800$2,00021Note: Money Supply in Billions; Source: St. Louis Federal