Transcript chapter 12 - University of San Diego Home Pages

CHAPTER 13
Role of money
Chapter Outline
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Measures of money supply
Deposit multiplier
Tools of monetary policy
Equilibrium in money markets
Measures of money supply
M1 = Currency + Checking at deposits +
traveler’s checks
M2 = M1 + Saving acounts + Small time
deposits + money market mutual funds
M3 = M2 + Large time deposits +
institutional money funds + purchase
agreements + euro dollars
Table 13-1 pg. 384 (read the details)
Deposit multiplier
Deposit Multiplier = 1/rr
Where rr = reserve requirements
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The higher the reserve requirements
the smaller the deposit multiplier
Tools of monetary policy
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Discount rate
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Higher discount rate results in lower money
supply and contraction in the economy
Other important rates
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Prime rate
Federal funds rate
Tools of monetary policy
Cont…
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Open market operations (OMOS)
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OMOS are carried out by federal open
market committee (FOMC) by selling and
buying government securities
Selling of government securities by the
FED, will reduce money supply in the
economy
Tools of monetary policy
Cont…
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Reserve requirements
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Raising reserve requirements has a
contractionary effect on the economy
This tool is used with a lot of caution
because it results in a significant change in
money-supply and affects financial markets
Tools of monetary policy
Cont…
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Discount rate
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Discount rate refers to the rate the federal
reserve bank charges banks who borrow
reserves at the Fed’s discount window
Discount rate is set by the Fed
An Increase in discount rate
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Makes borrowing by the banks more expensive
and reduces bank reserves
Results in a contractionary monetary policy
Tools of monetary policy
Cont…
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Other rates
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Federal funds rate - interest rate that commercial
banks charge each other for loans of reserves to
meet their minimum reserve requirements
Federal funds rate is targeted by Fed. Fed’s
actions (open market operations) affect the
federal funds rate. This rate affects other shortterm rates
Prime rate – The interest rate that banks charge
on loans to their best customers. It is based on
the discount rate set by the Fed.
Equilibrium in money markets
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Supply of money
Real money supply = Nominal money supply = Ms
Price level
P
RLMS = f(r,MS, P)
r
MS/P
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Real money – supply does not change with
the changes in real interest rate
Demand for Money
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RLMD = MD/P = f [r,y]
r
MD/P
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Interest rate represents the opportunity cost
of holding money. At higher interest rates,
people hold less money and vice versa
Equilibrium
MS
E
r
Md
O
Price of Bond is inversely related to interest rate
Changes in Equilibrium
Real Ms
Change in
Money Supply
r1
r2
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Real Ms’
E1
E2
Real Md
Increase in money supply creates excess money supply i.e.
demand for money is less than the amount of money supplied
D - for bonds increases
P - of bonds increase
Interest rate goes down
Changes in Equilibrium
Real Ms
Change in
Demand for
money
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r2
r1
E2
E1
Md2
Md1
Increase in demand for money results from an increase in real
income (Y).
People want to hold more of their assets as money
They sell their bonds. This results in lower bond prices and
higher interest rates.