Money Supply, Central Bank, Inflation and Monetary Policy

1. Money Supply, Central Bank, Inflation and Monetary Policy Money, get awayGet a good job with more pay and your O.K.Money it's a gasGrab that cash with both hands and make a stashNew car, caviar, four star daydream,Think I'll buy me a football teamMoney get backI'm all right Jack keep your hands off my stack … ------- Money, Pink Floyd (The Dark Side of the Moon) Dr. Fidel Gonzalez Department of Economics and Intl. Business Sam Houston State University

2. Money Supply and The Central Bank Now, we are going to analyze the role of money in the economy and how that affects the overall economy. First, we need to define money, its functions and different types. Money: set of assets in the economy that people regularly use to buy goods and services from other people. In other words, anything that you use to buy and sell things is consider a money. For example, a friend of mine in college use to exchange beer for services in our dorm. He would exchange a six pack of shiner bock beer to have a roommate washing his clothes. You can see how the beers in this example are considered money.

3. Money Supply and The Central Bank: functions of money Money has three main functions: • Medium of exchange: use to purchase good and services. • Money as a medium of exchange is very useful because it avoids the double coincidence of wants. • If there is no money, if you want to buy a car you need to find a car salesman that wants the good that you have to offer. For example, I would have to find a salesman that is willing to give a car in exchange for a set of lectures in economics. • That will be very difficult because it requires the double coincidence of wants. I need to want what the salesman has and the salesman needs to want what I have. • Money as a medium of exchange makes trade so much easier and faster. If there is money, all I need to do is find someone that is willing to pay for my economics lectures and later use the money to buy a car.

4. Money Supply and The Central Bank: functions of money 2) Unit of account: money is hoe prices are posted. All goods and services are measured in money terms. This makes comparisons between goods very easy. 3) Store of value: transfer purchasing power from today to the future. Money as a store of value allows you to store value so that in the future you can buy goods and services. For example, if you get paid 100 dollars today you will spend $60 with your friends but you may want to hold on to the remaining $40 so that you can buy food next week. Money allows to store value so that in the future you can buy goods and services. When there is inflation money is not a very good store of value because you can less things in the future.

5. Money Supply and The Central Bank: types of money We are going to consider two types of money • Commodity money: this money that has intrinsic value. What that means is that it is money that is valuable by itself. For example: • Gold: it was used as a currency for many centuries, but gold it is also valuable for its properties as a metal. It has an intrinsic value. • Silver: it was also used as currency in the US, Mexico and other countries. • Cocoa beans: in ancient Mexico, Aztecs and Mayans used cocoa beans as their currency. Cocoa was very valuable because it was consider a delicacy. 2) Fiat money: fiat money is money because the government says so. Fiat means by government decree. So, the fiat money literally means money by government order. Present day currency (bills and coins) are fiat money. They do not have an intrinsic value. A dollar is just a piece of paper. Q: Why do people accept dollar bills in exchange for goods or services? A: Because the know they can use it later on to buy goods and services themselves.

6. Money Supply and The Central Bank: types of money For example: Imagine you go to the Mac Store and get a hundred-dollar bill from your wallet and as a result the store salesman gives you a Ipod. If you think about this is a weird thing. You just exchange a piece of paper that has no intrinsic value for a cool Ipod where you can watch video and listen to music. The reason why the salesman accepts the one hundred-dollar bill in exchange for the Ipod is because he knows that later he can use it to buy other stuff. Moreover, the salesman is required to accept the money as a method of payment for the Ipod. It is required by the government to do it. If you look at a dollar bill of any denomination you will see that in the front of the bill says: “This note is legal tender for all debts, public and private” In other words, the government is saying, this is money because I said so and you have to accept it as a payment for goods and services. In order for this system of fiat money to work people have to trust the government. If they believe that the government can not enforce the law at all then people is not going to accept money. Would you accept a bill that you do not know whether you can exchange it later on for goods and services? A: NO.

7. Money Supply and The Central Bank: types of money In order for this system of fiat money to work people have to trust the government. If they believe that the government can not enforce the law at all then people is not going to accept money. Would you accept a bill that you do not know whether you can exchange it later on for goods and services? A: NO. Clearly the type of money we use today is the Fiat money. However, it was not like that. Money evolve from commodity money to money backed up by silver or gold to fiat money. The next slide shows a very brief history of money.

8. Money Supply and The Central Bank: brief history of fiat money (2) (2) (4) (4) (1) (3) • British guard has gold that weights 3 pounds. • The guard does not like to have the gold laying around because you never know if it can get stolen. So, he takes his gold to this person who promises him that he will put his gold in a safe box and it will be safe. • The British guard asks the safe keeper to give him a receipt that he can use later on to claim his three pounds of gold. The receipt says that the British guard has 3 pounds of gold in the safe. • The British guard now wants to buy a horse. He can go to the place where the gold is stored, get the gold and pay the horse owner; or he can give the horse owner the receipt of the gold so that when the horse owners wants the gold he can claim it. The horse owner is going to prefer the receipt because that way he does not have to walk around with three pounds of gold in his pocket. • This receipt was called a pound, because it represented the amount of gold or silver a person could claim in the bank.

9. Money Supply and The Central Bank: brief history of fiat money This is why all major currencies have names that represent a measurement of weight. For example, the British pound represented one pound of silver. the American dollar represented 24 grams of silver or 1.6 grams of gold the Mexican Peso represented also represented a weight of gold and silver. So how did we go from having currency backed up by silver to fiat money? As you can tell, people with dollar note never went to the bank and claim the amount of silver they were entitled to because they had no use for the silver. It was too much work to go the bank and get a bill. Moreover, the government realized that in order to increase the amount of money, they needed to have more silver. Thus, the amount of currency in circulation was limited by the amount of silver. This became a problem because the economy was growing and more money was needed. Thus, finally governments started to break away from the currency backed up by silver or gold. In the seventies almost all countries did not have currency backed by gold or silver.

10. Money Supply and The Central Bank: measurements of money How much money is there in the economy? Since money can be any asset used to buy and sell goods there are many things that can be considered money we need to find a way to measure them. We are going to consider three measures according to their liquidity. Liquidity refers to the easiness that an assets can be exchange for another asset. We are going to start with the most liquid term of money: • M1= currency (bills and coins) + balance in checking accounts deposits + traveler’s checks. • In this case currency refers to the amount of bills and coins in the hands of the public. For example, currency in the bank is not considered part of M1. • In 2004, the total amount of M1 was equal to $1.4 trillion. • M1 is liquid money because we can very easily use it to buy goods and services.

11. Money Supply and The Central Bank: measurements of money B) M2= M1 + savings deposits + small time deposits + money market accounts. Savings deposits: the balance of people on their savings accounts. These accounts are less liquid because usually you have to pay a penalty (fee) if you suddenly want to use your savings account. Small time deposits: deposits that you have in your bank account that you can not use during a period of time that is less than $100,000 dollars. For example, a certificate of deposit (CD) of $10,000 dollars is consider a small time deposit. Money market accounts: this refers to short-term borrowing and lending. For example, when the US government needs money from people sometimes it issues what is called a Treasury Bill (T-Bill). The T-Bill is an IOU from the government and it is consider a money market account. Short-term borrowing and lending usually refers to less than a year. Also when a firm (say Coca-Cola company) borrows money for less than a year from someone else that is also consider a money market account. Finally, note that M2 INCLUDES M1. However, it also has other things that are less liquid. For example, if you want to use your savings to buy a car you have to pay a fee to used your savings and that makes it less liquid than cash. In 2004, M2=$6.6 trillion.

12. Money Supply and The Central Bank: measurements of money C) M3= M2 + large time deposit account (over $100,000) + banks’ repurchase agreements + Eurodollars. Large time deposit account: deposits that you have in your bank account that you can not use during a period of time that is over $100,000. Banks’ repurchase agreements: when a bank (say Bank of America) lends money to another bank (say Chase), Bank of America gets an IOU from Chase saying that it will pay back. That IOU is a Bank’s repurchase agreement, it is usually very short term lending. Eurodollars: dollar denominated accounts in countries other than the US. For example if you have a 20,000 dollar account in France that is consider a Eurodollar. It does not have to be in Europe as long as the account is located outside of the US it is considered a Eurodollar. In 2004, M3=$10 trillion. M3 is the less liquid of the all three M’s. The most common measurements of money are M1 and M2.

13. Money Supply and The Central Bank: Money creation by Banks If we look at M1 we see that is composed by currency, balances in checking accounts and traveler’s checks. Now, we are going to see that Banks by lending money can create more checking account deposits and therefore M1 increases (increasing also M2 and M3). To see how banks create more checking account deposits we need to consider the banks T-account For the bank a $1,000 deposit represents a liability to the bank because the banks owes the money to the depositors. However, once someone deposits $1,000 the Banks keeps some money as a reserve just in case the depositor would want some of the money. In the example above the Bank kept a 10% of the deposit as reserves ($100). The remaining $900 dollars are lent to somebody else. That represent an asset to the bank because the borrower owes the money to the bank.

14. Money Supply and The Central Bank: Money creation by Banks Now, lets see what happens when someone deposits $1,000 in the Bank and the bank has a reserve ratio of 10%. Reserve Ratio (RR)= percentage of each deposit that is kept as reserve in the bank. Round 1 : Initial deposit of $1,000. From this $100 are reserves and the other $900 are lent. Round 2 : the borrower of the $900 receives the money on this checking account . As a result the $900 becomes a deposit. From the $900 ten percent is kept as reserve ($90) and the remaining $810 are lent again. Round 3 : again the borrower of the $810 deposits the loan on this checking account . The $810 becomes a deposit. From the $810 ten percent is kept as reserve ($81) and the remaining $729 are lent again. This process continues until there is no more money left to be lent. You can see that the initial deposit of $1000 more deposits. Remember that each deposit (1000, 900, 810, and all the others) is part of the balance in checking account and therefore M1 has increased. That is, M1 increased because the initial deposit of $1000 dollars increases the total amount deposited in the bank and therefore M1 is bigger.

15. Money Supply and The Central Bank: Money creation by Banks Q: What was the total increase in the amount of deposits? A: Round 1: $1,000 Round 2: 1,000 x (1-0.1)= $900 Round 3: 900 x (1-0.1)=$810 Increase in deposits = 1000 + 900 + 810 + all the other deposits. Fortunately, we do not have to go round by round to obtain the total amount of deposits. Using mathematics we obtain that the increase in deposits are the following: An initial deposit of $1,000 increases the amount of checking deposits in $10,000. Q: What happened to M1? M1 also increased by $9,000. Why $9,000 and not $10,000? Because the initial deposit of $1,000 was currency turn into deposit which both of them are part of M1 but the remaining $9,000 created in form of deposits in an increase in M1.

16. Money Supply and The Central Bank: Money multiplier The change in deposits can be generalized as follows: We can divide the change in deposits as follows: That is, the MM tells us by what factor deposits change. In our previous example,

17. Money Supply and The Central Bank: Money multiplier This means, that when RR=0.1 a deposit of 1,000 will produce a change of $10,000 dollars in deposits. Let consider another example: Initial Deposit = $5,000 RR=0.25 Question: What is MM? What is the change in deposits? Answer: Imagine that RR goes down and now RR=0.20 Question: What is MM? What is the change in deposits? Answer:

18. Money Supply and The Central Bank: Money multiplier As you can see when RR decrease the MM increases from 4 to 5. When RR goes down MM increases and also the change in deposits increases. When RR goes up MM decreases and also the change in deposits decreases. The previous two statements make sense. When RR goes down the bank keeps a higher percentage of deposits as reserves. Therefore, less money is lent and the corresponding deposit also goes down. This decreases the total amount of new deposits. When RR goes up the bank keeps a lower percentage of deposits as reserves. Therefore, more money is lent and the corresponding deposit also goes up. This increases the total amount of new deposits. What if the RR=1. This means that every deposit is backed up 100% by reserves in the Bank. In that case, the initial deposit does not create any more deposits. That is, an initial deposit of $5,000 creates a change in deposits of just $5,000.

19. Money Supply and The Central Bank: Money multiplier What if the RR=0. This means that every deposit is lent completely. In that case, there an infinite increase in the total level of deposits. That is, an initial deposit of $5,000 creates an infinite change in deposits. • One last thing we have to say about MM. In the real world, the MM is less than the value we obtained in our formula. • There are two reasons for this: • Banks sometimes like to have more reserves than what the reserve ratio says. They do this when the believe something bad is going to happen to the economy. • Not all money lent by the banks is deposited back in the bank, some of it is kept as cash. This reduces the amount of new deposits and the MM.

20. Money Supply and The Central Bank: The Federal Reserve Bank System The federal reserve bank system is very important because it has an important control (although is not perfect) over the money supply. Money supply: is the amount of money available to purchase goods and services. We actually have covered money supply before. M1, M2 and M3 are different measures of the money supply. As we just covered, Banks can change M1 when the RR changes and therefore affect the money supply. On the other hand, also the Federal Reserve Bank can affect the money supply. Before we cover how it can do that, lets see what is the Federal Reserve Bank System. The Federal Reserve Bank System (The Fed) was created in 1914 and is made up by a Board of Governors and has 12 regional branches across the US. The regional branches are located in: Dallas, San Francisco, Atlanta, New York, Richmond, Kansas City, Minneapolis, Chicago, Cleveland, Boston, Philadelphia and St. Louis.

21. Money Supply and The Central Bank: The Federal Reserve Bank System The independence of the Fed is essential for the well being of the economy. Example: (1) (4) • President needs $50 billion to buy warship. • Calls the Fed to print money and give him the cash to buy the warship. • If the Fed is not independent they will do what the president asks and print the $50 billion. • President gets the money and buys ship. • Warship goes to the president (5) $50 billion (3) (2) This creates a big problem, when the government prints more money that creates inflation. Higher inflation means that prices have increase and therefore money is worth less than before.

22. Money Supply and The Central Bank: The Federal Reserve Bank System The reduction is the value of money acts as a tax on the money held by the public. You can think about it this way. You have $20 dollars and can buy 4 beers at $5 dollars each. 1) The government wants $10 of the $20 you have to help pay for the warship. The government can physically force you and take $10 from your wallet. In that case you will be left with $10 which is worth 2 beers. 2) Another option is print money (like in the previous slide). When the government does this prices increase. Lets say that now beer costs $10 dollars. With the $20 dollars in your wallet you can now only afford 2 beers. As you can see in both options you are left with money that can only buy 2 beers. The second option is the inflation option and as you can see inflation acts like a tax because by reducing the value of money you can only afford 2 beers now, same as the government taking $10 from your wallet.

23. Money Supply and The Central Bank: The Federal Reserve Bank System • Inflation tax is a really bad tax because: • Hurts the poor more: poor people tend to have more of their assets in form of money so they suffer bigger losses when there is inflation. • Invisible tax: most people see inflation but they do not know what is going on. • Easy to implement: in contrast with income or sales taxes. The government does not need to go to congress to set taxes. The only thing you have to do is to print money. • The fact that is an invisible tax and that it is easy to implement makes inflation very tempting for a government that needs to buy goods and services.

24. Money Supply and The Central Bank: The Federal Reserve Bank System • Q: What are the functions of the Fed? • The Fed’s main goal is to observe and regulate the financial sector. In particular the Banking system. • This is very important because it ensures that lenders and borrowers follow the law. Banks are specially important because Banks are the most important part of the financial system. Just imagine what would happen if all Banks were bankrupt. Moreover, Banks take money from the public (when you deposit money) and the Fed ensures that Banks do not take unnecessary risks with your money. • 2) Lender: lends money to the banks. In many cases the Fed acts as a lender of last resort. This is an essential feature of the Fed because it reduces Banks panics. • For example imagine that for some reason a lot of people (more than the usual) go to the bank today to withdraw all the money they have in the Bank. The Bank is not going to be able to give everyone their money immediately because most of it has been lent to somebody else. When people realize that they can not get their money they will panic and even more people will go to the bank.

25. Money Supply and The Central Bank: The Federal Reserve Bank System So, who are you gonna call? The Fed. The Fed will be the lender of last resort and lend money to the bank so that when the initial group of people go to the Bank there is enough money to pay them back and nobody panics. 3) Affect the Money Supply: the Fed has the monopoly in the creation of currency. That is the Fed can print more dollars bills increasing M1 and the money supply. Nobody else can create currency and if they do they go to jail. The Fed is the most important monopoly in the world.

26. Money Supply and The Central Bank: The Federal Reserve Bank System • But how does the Fed actually affects the money supply? • The Fed uses three different instruments: • Open Market Operations (OMO): these are places when the Fed buys or sells bonds in the open market. • Reduce money supply: when the Fed wants to reduce the money supply all the have to do is to SELL bonds in the open market. By selling bonds the public gives the Fed money in exchange for a Treasury Bill and the total amount of money in the hands of the public goes down (now they have a bond instead of cash). • For example, imagine that you have $1 million dollars in cash. This will be part of M1 and M2 and therefore part of the money supply. • Now assume that the Fed SELLS you a bond for $1 million dollars. This transaction implies that you give the Fed your $1 million dollars in cash and in return you get an IOU that says that the Fed owes you $1 million dollars. Now the $1 million dollars is in a vault at the Fed and therefore is not part of M1 anymore. (Remember that only currency in the hands of the public is part of M1). The money supply decreased by $1 million dollars.

27. Money Supply and The Central Bank: The Federal Reserve Bank System Increase money supply: when the Fed wants to increase the money supply all the have to do is to BUY bonds in the open market. By buying bonds the public gives the Fed a paper (a bond) in exchange for cash and the total amount of money in the hands of the public goes up (now they have a cash instead of a bond). For example, imagine that you now have a bond worth $1 million dollars. This will NOT be part of M1 or M2 and therefore is NOT part of the money supply. Now assume that the Fed BUYS the bond form you and pays you $1 million dollars in cash. This transaction implies that you give the Fed your bond and you get $1 million dollars in cash. Now the $1 million dollars in cash is in the public hands and it is part of M1. The money supply increased by $1 million dollars. Therefore using OMO’s the Fed buy or sells bonds which increases or decreases the money supply. Remember: Buy Bonds means money supply increases Sell Bonds means money supply decreases

28. Money Supply and The Central Bank: The Federal Reserve Bank System 2) Discount Policy: the Fed lends money to the banks. These loans are called discount loans and the interest rate charged to the Bank is called the discount interest rate. When the Fed lowers the discount rate Banks borrow more from the Fed because it is cheaper to borrow money. Higher borrowing from the Fed increases the amount of reserves the Banks have and therefore it increases the amount of loans made to firms and households. Higher lending increases the number of checking deposits and therefore the money supply increases. When the Fed increases the discount rate then the money supply increases: As of today the Federal Discount Rate is 5%

29. Money Supply and The Central Bank: The Federal Reserve Bank System 3) Reserve Requirement: the Fed as the agent in charge of regulating Banks usually sets a reserve requirement that all Banks need to follow. The reserve requirement is the minimum of reserve ratio that Banks need to have. Banks do not like having reserves because that is money that is not lent and therefore they are not making money out of it. It is money just sitting in their vault. In most cases the Banks’ reserve ratio is just equal to the reserve requirement. That is, Banks have the minimum reserve requirement that the Fed tells them they must have. In some circumstances, when there is a lot of uncertainty, Banks have more reserves than the reserve requirement set by the Fed, this extra reserves are called “excess” reserves. Reserve Ratio = Reserve Requirement Ratio + Excess Reserves Ratio From before, it follows that in general Excess Reserve Ratio =0 but not always. Thus, when the Fed increases the reserve requirement the reserve ratio increases, the money multiplier decreases and the money supply goes down. When the Fed increases the reserve requirement the reserve ratio decreases, the money multiplier increases and the money supply goes down. Currently, the Reserve Requirement is 10%

30. Money Supply and The Central Bank: The Federal Reserve Bank System That is,

31. Money Supply and The Central Bank: Quantity Theory of Money During the 70’s a new Theory of Money was introduced in Macroeconomics. This school of thought was called The Monetarist. They introduced the Quantity Money Equation shown below: M V = P Y M = amount of money in the economy (M1 or M2) V = velocity of money (this is the average number of purchases that one dollar makes during a year). For example, if V=4 that means that a dollar in average is used four times during a year to buy good and services. P = price level (remember this is the average price level in the economy) Y = real GDP Therefore, MV = amount of money x velocity = total amount of purchases in the economy PY = price x real GDP = nominal GDP

32. Money Supply and The Central Bank: Quantity Theory of Money The quantity of money Equation is an identity, it is always true. Monetarists transformed the quantity money equation in percentage change and they obtained that: In addition, they said the V (velocity) is usually constant. That is, V does not change much because it depends on people’s customs and people do not change their behavior that much. For example, in 2004 V=8.6, Monetarists would say that V will not change in 2005 (still will be 8.6). Therefore if V does not change then: % change in V = 0 The percentage change equation is modified to the following: This is one of the most important concepts in Macroeconomics : when the amount of money increases either P increases or Y increases or both.

33. Money Supply and The Central Bank: Quantity Theory of Money For example, imagine that the Fed decides to increase M by 8%: This is one of the most bitter and contentious issues in Macroeconomics. Why? Remember that Y (Real GDP) : Y=f(K,L, NR). That is, real GDP depends on capital, labor and natural resources. It does NOT depend on M. Therefore, some economist say that when M increases there is no reason for Y to change, therefore: % change in Y = 0 The percentage change equation is now: This means that an increase in the money stock produces an equal percentage change in the price level. In other words, the inflation rate ( which is the % change in P) is equal to percentage change in the quantity of money.

34. Money Supply and The Central Bank: Quantity Theory of Money • In the previous example an increase of 8% in M only produces a 8% increase in prices and real GDP does not change. • Q: Why is this result so important? • A: Because it gives one possible explanation of inflation. • Remember that in the AD and AS model we established that prices can increase because AD shits right (positive demand shock) or AS shifts left (negative supply shock). Now, we have another reason for the existence of inflation. • Summarizing inflation takes place because: • AD shifts right (positive demand shock) • AS shifts left (negative supply shock) • The Fed increases the money supply M

35. Money Supply and The Central Bank: Quantity Theory of Money However, some economist do not agree with the fact that Y is completely independent of M. They say that when M increases P goes up BUT when firms see P increases they work more. This in turn will increase Y. Q: Why people will work more if P increases? Imagine that the Fed increases M which in turn increase P. Some economists think that when P goes up the firms believe that higher prices are a result of an increase in the AD (positive demand shock). Well, if the AD increases that means that consumers are buying more things so it makes sense for firms to produce more. However, firms eventually realized that they have been fooled: the increase in P was not due to higher AD but to higher M. If the increase in P is due to higher M then firms have no reason to produce more, the demand for their has not increase, it was just an illusion. So where does these leaves us? What is the relationship between M and Y? The general consensus is that in the short-run there is small but positive relationship between M and Y. However, in the long run there is NO relationship between M and Y.

36. Money Supply and The Central Bank: Quantity Theory of Money For example, % change M =8% In the short-run: % change Y=2% and % change in P =6% In the long-run: % change Y =0% and % change in P =8% That is, in the short-run an increase in M produces some inflation but also a small increase in real GDP. However, in the lung-run the increase in M produces only inflation in the equal proportion as the change in M.

37. Money Supply and The Central Bank: Phillips Curve In 1958 a British economist called Alban W. Phillips graphed the relationship between inflation and unemployment in England from 1861 to 1957. He found that the relationship is negative. In the following graph I did the same thing as Phillips but for the US from 1950 to 1969.

38. Money Supply and The Central Bank: Phillips Curve As you can tell the graphs shows a negative relationship between inflation and unemployment. The relationship between unemployment and inflation is known as the Phillips curve. In this case the Phillips curve shows a negative relationship between them. Q: What creates this Phillips curve with a negative relationship between unemployment and inflation? A: Q:But didn’t we just said that higher M produces slightly higher Y only in the short-run? A: Yes, and that is exactly what happened. American learned that from 1950 to 1969 the Fed was increasing M and therefore the increase in P was due to higher M and not to a higher AD. So following graph shows you what happened after 1969.

39. Money Supply and The Central Bank: Phillips Curve After 1969, once people learned about the Fed trying to fool them the negative relationship between unemployment and inflation became actually a little positive.

40. Money Supply and The Central Bank: Phillips Curve As someone once said: “fool me once shame on you; fool me twice shame on me.” Thus, the Phillips curve is going to look differently in the long-run than in the short-run. Inflation Inflation Short-Run Phillips Curve Long-Run Phillips Curve Unemployment Unemployment In the short-run the Phillips curve shows a negative relationship between inflation and unemployment. In the long-run the Phillips curve shows no relationship or small positive relationship between inflation and unemployment

41. Money Supply and The Central Bank: Monetary Policy Monetary policy = actions by the Fed to manage the money supply and interest rate to pursue economic objectives The money supply (MS) affects the interest rate because the “price” of money is the interest rate. Money Market The demand for money has a negative slope because the higher the interest rate the less money you want to have and the more savings that pay r you want. Similarly when r is low you do not want to save much and instead you use it to buy things so the demand for money increases The MS does not depend by the interest rate because is set by the Fed and the money multiplier (MM). Price of money (r) MS r* MD M* Amount of money (M) The purpose of the monetary policy is to affect MS to: 1) price stability (low inflation), 2) high employment, 3) economic growth and 4) stable financial markets.

42. Money Supply and The Central Bank: Monetary Policy Monetary Policy affects the equilibrium in the AD and AS model: 1) Monetary Policy: the Fed can increase or decrease the money supply. The money supply will affect the aggregate demand in three different ways: A) Wealth: an increase in money supply lowers prices increase the real wealth of households, stimulating consumption. B) Interest Rate: an increase in money supply lowers interest rates stimulating investment and consumption of durable goods. C) Exchange Rate: an increase in money supply lowers interest rates reducing the demand for dollars, the value of the dollar depreciates and that stimulates exports and reduces imports.

43. 3 1 2 Monetary Policy Next, the Fed sells bonds in the open market Money Market Total Economy AS-LR P AS-SR1 MS MS1 Assume the economy is at long-run equilibrium r AS-SR P1* P*-SR r* P* r1* AD1 MD AD Q* Q*-SR Q M* M1* M 1) Money supply increases producing a decrease in the interest rate and an increase in prices. 2) A drop in the interest rates, increases consumption (in particular durable goods) and investment. Hence, AD goes up. When the AD increases, the production increases in the short-run to Q*-SR and P*-SR. 3) Since the economy is producing above the full employment level, firms need to pay higher prices for their inputs. Higher input prices, increases the cost of the firms, reduces profits and the supply goes down. At the new equilibrium point, we have the long-run output but higher prices

44. Monetary Policy • A: If the economy is below full employment Money Market Total Economy AS-SR AS-LR P MS MS1 Q: Why the Fed will increase the money supply? r P1* P* r* r1* AD1 MD AD Q-SR* Q* Q M* M1* M Increasing money supply shifts the AD so that the economy reaches the long-run equilibrium Prices increase but real GDP also goes up.