Transcript The Demand for Money

Objectives
At this point, we know
• The Fed uses open market operations to
purchase/sell U.S. Treasury securities in the open
market.
• These open market operations increase or decrease
the money supply, depending upon whether the
Fed is purchasing or selling securities. The amount
the money supply changes for a given open market
purchase or sale will depend upon the money multiplier which,
in turn depends upon the reserve ratio, the currency ratio, …
• These open market operations also will influence the Federal
Funds interest rate by affecting the supply of funds in the
Federal Funds market.
Objectives
The Fed’s monetary policy (i.e., it planned open market
operations) targets the Federal Funds rate (or the money
supply) in order to influence the economy’s price, output,
and employment levels.
The primary objectives of Chapter 11 are to:
•Explain how the Fed’s actions influence spending
plans, real GDP, and the price level in the short run
•Explain how the Fed’s actions influence real GDP and the
price level in the long run
Objectives
Meeting the first objective (i.e., explaining the short-run
consequences of monetary policy) will involve introducing
the “money demand” model into our story.
Meeting the second object (i.e., explaining the long-run
consequences of monetary policy) will involve introducing
the “quantity theory of money” into our story.
The Demand for Money
The Influences on Money Holding
The quantity of money that people plan to hold depends
on four main factors
 The price level
 The interest rate
 Real GDP
 Financial innovation
The Demand for Money
The price level
We assume that a rise in the price level increases the
nominal quantity of money people want to hold (M) but
doesn’t change the real quantity of money that people plan
to hold (M/P).
Nominal money is the amount of money measured in
dollars.
We assume that the quantity of nominal money demanded
is proportional to the price level — a 10 percent rise in the
price level increases the quantity of nominal money
demanded by 10 percent.
The Demand for Money
The interest rate
The interest rate is the opportunity cost of holding wealth
in the form of money rather than an interest-bearing asset.
real return to holding a bond = i – inf,
where i = nominal interest rate, inf = inflation rate
real return to holding money = -inf
So, the real opportunity cost of holding money = (i-inf)-(inf)=i.
A rise in the interest rate decreases the quantity of money
that people plan to hold.
The Demand for Money
Real GDP
Given that there is opportunity cost to holding wealth in the
form of money rather than secure bonds, why do people
hold any money?
To fund current expenditure on goods and services.
An increase in real GDP increases the volume of
expenditure, and we assume that this increases the
quantity of real money that people plan to hold.
The Demand for Money
Financial innovation
Financial innovation that lowers the cost of switching
between money and interest-bearing assets decreases the
quantity of money that people plan to hold to finance a
given level of expenditure on goods and services.
The Demand for Money
The Demand for Money Curve
The demand for money curve is the relationship between
the quantity of real money demanded (M/P) and the
interest rate when all other influences on the amount of
money that people wish to hold remain the same.
The Demand for Money
Figure 11.1 illustrates the
demand for money curve.
The demand for money
curve slopes downward
A fall in the interest rate
lowers the opportunity cost
of holding money and
brings an increase in the
quantity of money
demanded--a movement
downward along the
demand for money curve.
The Demand for Money
A rise in the interest rate
increases the opportunity
cost of holding money and
brings an decrease in the
quantity of money
demanded--a movement
upward along the demand
for money curve.
The Demand for Money
Shifts in the Demand for Money Curve
The demand for money changes and the demand for
money curve shifts if real GDP changes or if financial
innovation occurs.
The Demand for Money
Figure 11.2 illustrates an
increase and a decrease in
the demand for money.
A decrease in real GDP or
a financial innovation
decreases the demand for
money and shifts the
demand curve leftward.
An increase in real GDP
increases the demand for
money and shifts the
demand curve rightward.
Interest Rate Determination
Money Market Equilibrium
The Fed determines the quantity of money supplied and
on any given day, that quantity is fixed.
The supply of money curve is vertical at the given quantity
of money supplied.
Money market equilibrium determines the interest rate.
Interest Rate Determination
Figure 11.4 illustrates the
equilibrium interest rate.
Interest Rate Determination
If the interest rate is
above the equilibrium
interest rate, the quantity
of money that people are
willing to hold is less than
the quantity supplied.
They try to get rid of their
“excess” money by
buying financial assets.
This action raises the
price of these assets and
lowers the interest rate.
Interest Rate Determination
If the interest rate is below
the equilibrium interest
rate, the quantity of money
that people want to hold
exceeds the quantity
supplied.
They try to get more
money by selling financial
assets.
This action lowers the
price of these assets and
raises the interest rate.
Interest Rate Determination
Changing the Interest
Rate
Figure 11.5 shows how the
Fed changes the interest
rate.
If the Fed conducts an
open market sale, the
money supply decreases,
the money supply curve
shifts leftward, and the
interest rate rises.
Interest Rate Determination
If the Fed conducts an
open market purchase, the
money supply increases,
the money supply curve
shifts rightward, and the
interest rate falls.