Zara Mahmood Nov 14 2013 EC102 Lecture 16 Money Market Equilibrium in the Money Market Interest rate is not related to money supply Interest rate is related to money demand o Higher interest rate lower quantity demanded Money demand is inversely related to interest rate Fed buys bonds expansionary Money supply shifts right interest rate goes down Fed sells bonds contractionary Money supply shifts left interest rate goes up Target Fed Funds Rate Target Fed Funds Rate rate that banks charge each other to borrow reserves Fed is consistent in keeping rate where they want it Why does the fed target I instead of M o i is easier to control than M o i is more closely related to the economic variables the Fed ultimately cares about Inflation Unemployment Monetary Policy Monetary Policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals 4 main goals of monetary policy o Price stability Rising prices erode value of money o High employment Unemployment and unused factories lower GDP below potential o Stability of financial markets and institutions Promise stability so efficient flow of funds from savers to borrowers occurs o Economic growth Stable growth allows households and firms to plan accurately and encourage long run investment Monetary Policy Targets Fed tries to keep both unemployment and inflation low but cannot directly change variables Fed has two main monetary policy targets o Money supply and interest rates o Typically uses interest rates Zara Mahmood Nov 14 2013 EC102 Demand for Money Demand curve for money is downward sloping Interest rate is opportunity cost of holding money When interest rates are low opportunity cost of holding is low o Quantity money demanded will be high When interest rates are high opportunity cost of holding is high o Quantity money demanded will be low Shifts in the Money Demand Curve Demand curve for money is drawn holding variables constant except for interest rate Changes in variables other than interest rate cause curve to shift o Increase in real GDP money demand curve shifts right Buying and selling of goods increases Money held by firms and households increases o Decrease in real GDP money demand curve shifts left Money needed to buy and sell goods increases Money held by firms and households decreases Equilibrium in the Money Market Fed affects both money supply and interest rate Money supply vertical Fed has complete control o Changes in interest rate have no effect Equilibrium occurs when money demand and supply curves intersect When Fed increases money supply the short term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money Rising short term interest rate increases the opportunity cost of holding money Zara Mahmood Nov 14 2013 EC102 Two Interest Rates Loanable funds model is concerned with long term real rate of interest Money market model is concerned with short term nominal rate of interest o Relevant interest rate when conducting monetary policy o Most affected by changes in the money supply Choosing a Monetary Policy Target Fed can use either money supply or interest rate as its monetary policy target Fed targets interest rate known as federal funds rate Federal Funds Rate The interest rate banks change each other for overnight loans Every bank must keep 10 of its checking account deposits above a certain threshold Fed pays bank interest for reserve deposits so banks have incentive to keep excess reserves o Rate is determined by supply of reserves relative to demand o Fed can increase decrease supply of bank reserves and set a target for federal funds rate Usually come very close to hitting it Expansionary Buying bonds Contractionary Selling bonds Total Deposits Initial in reserves x 1 R E R E is called money multiplier Money Supply Total Deposits Cash held by public When FED is involved cash held by public is 0 Relationship Between Inflation and Unemployment Recessionary Gap YACTUAL YPOTENTIAL Price Level goes down Unemployment Natural Rate Inflationary Gap YACTUAL YPOTENTIAL Price Level goes up Unemployment Natural Rate The Long Run Phillips Curve Long run o Economy at potential GDP o Economy at natural rate of unemployment In the long run monetary policy ONLY affects the price level Zara Mahmood Nov 14 2013 EC102 Short run as actual o Expected rate of inflation in the same at every point may not be same o Point of intersection expected and actual are equal Economy is in equilibrium Revising expectation shifts short run Phillips curve In the short run it can affect unemployment and GDP How Interest Rates Affect Aggregate Demand Changes in interest rates affect aggregate demand total level of spending in economy Consumption o Lower interest rate increased spending Lowers interest payments on loans cars Reduce return to saving households spend more o Higher interest rate decreased spending Higher interest payments on loans cars Investment Increase return to saving households save more o Higher interest rate more expensive to borrow Firms undertake fewer investment projects o Lower interest rate less expensive to borrow Firms undertake more investment projects Increase investment through their effects on stock prices Stocks become more attractive investment Net Exports o Value of dollar rises export less and import more Foreign firms people will pay more for US goods US people firms pay less for foreign goods o Value of dollar falls export more and import less Foreign firms people will pay less for US goods US people firms pay more for foreign goods Zara Mahmood Nov 14 2013 EC102 During recessionary gap use expansionary monetary policy Expansionary Monetary Policy Actions which increase the money supply Increase in real GDP Increase in Money supply Fed buys bonds o Interest rate o Consumption o Investment o Net Exports Aggregate Demand National Income Unemployment Contractionary Monetary Policy Actions which decrease the money supply Fed sells bonds o Interest rate o Consumption o Investment o Net Exports Aggregate Demand National Income Unemployment Consequence sooner or later Inflation Consequence sooner or later Inflation Money supply decreases Real GDP decreases During inflationary gap use contractionary monetary policy Zara Mahmood Nov 14 2013 EC102 Quantity Equation Levels Form Velocity of Money The average number of times each dollar in the money supply is used to purchase goods and services