Ch 15 Monetary policy

How does a change in money supply affect the economy?

Relevant reading: Ch 13Monetary policyThe central bank of the United StatesThe Federal Reserve SystemClearing checks between private banksHolding bank reservesProviding currencyProviding loans

Functions of the FedReserve requirementDiscount ratesOpen market operationsMonetary toolsThe legal minimum amount of reserves a bank is required to hold; equal to required reserve ratio times depositsRequired reservesrd increases excess reserves decreases and money multiplier decreases money supply decreasesrd decreases excess reserves increases and money multiplier increases money supply increasesRequired reserve ratio and money supplyThe rate of interest the Fed charges for lending reserves to private banksDiscount rate increasesexcess reserves decreases money supply increasesDiscount rate decreases excess reserves increasesmoney supply decreases

Discount rateOpen market purchase- the operation in which the Fed purchases government securities from the public to increase bank reserves

Open market sale- the operation in which the Fed sells government securities to the public to decrease bank reserves

Open market operationsThe Fed buys $1000 worth of government securities from the public. The Fed writes a check to pay for the purchase. The seller deposits the check into the banking system

Example: Open market purchaseAssuming rd= 0.1Change in money supply= $1,000 x 1/0.1= $1,000 x 10 = $10,000

Example: Open market purchaseThe Fed sells $1000 worth of government securities from the public. The buyer withdraws money from the banking system to pay for the securitiesExample: Open market saleAssuming rd= 0.1Change in money supply= -$1,000 x 1/0.1= -$1,000 x 10 = -$10,000

Example: Open market saleOpen market purchase- excess reserves increases , money supply increasesOpen market sale- excess reserves decreases , money supply decreases

Open market operation and money supplyMoney marketMoney demand The quantity of money people are willing to hold at alternative interest rates, holding other things constant.

Money supply- money stock available in an economy.Money demandInterest rates as the price of money

Other determinants of money demand 1WealthIncomeLiquidity of alternative assetsRisk of other assetsPayment technologyOther determinants of money demand 2As wealth decreases, money demand decreasesAs income decreases, money demand decreasesAs liquidity of alternative assets increases, money demand decreasesAs risk of other assets decreases, money demand decreasesAs payment technology allows transaction to be carried out without money, money demand decreases. Example: credit cardsChange in Money Demand 1Households wealth increases

Change in Money DemandPeople become less risk averse to alternative assets such as stocks

Money SupplyAssumed as exogenous

E.g. an open market purchase (to increase the money supply)

Money market equilibrium

Example: An increase in wealth

i1Example: The Fed raises the discount rate

Example: The Fed lowers required reserve ratio

Example: The Fed carries out open market purchase

Interest rates and the economyInterest rates decreases investment increases AD increases

Interest rates increases investment decreases AD decreases

The effect of an expansionary policy-increasing money supply

The effect of a contractionary policy-decreasing money supply

MDInterest rateQuantity of money, M

Quantity of moneyInterest rate

Quantity of moneyInterest rate

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Interest rateQuantity of moneyMs 1Ms 2

MeieInterest rateMSQuantity of money, M

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Real output, YAD2PAD1AS

MS0Interest rateMS1Quantity of money, Mi1M1M0MDi0

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