Unit 4: Money, Banking, and Monetary Policy

1. Unit 4: Money, Banking, and Monetary Policy

2. 4.2: The Money Market(Supply and Demand for Money) 2

3. The Demand for Money At any given time, people demand a certain amount of liquid assets (money) for two different reasons: • Transaction Demand for Money- People hold money for everyday transactions. • Asset Demand for Money - People hold money since it is less risky than other assets

4. The Demand for Money What is the opportunity cost of keeping money in your pocket or checking account? The interest you could be earning from other financial assets like stocks, bonds, and real estate

5. The Demand for Money 1. What happens to the quantity demanded of money when interest rates increase? (Hint: what would you do if tomorrow banks started to pay 20% on interest in savings accounts?) Quantity demanded falls because individuals would prefer to have interest earning assets instead (the opportunity costs of holding money increased) 2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increases. There is no incentive to convert cash into interest earning assets—real estate or stocks may yield a higher return

6. The Demand for Money Inverse (negative) relationship between interest rates and the quantity of money demanded Nominal Interest Rate (ir) • Why the nominal interest rate and not the real? • The opportunity cost of holding money includes both: • the real return that could be earned on a bank deposit • the erosion in purchasing power caused by inflation 20% 5% 2% 0 MD Quantity of Money (billions of dollars)

7. The Demand for Money What happens if price level increase? Money Demand Shifters • Changes in price level • Changes in income • Changes in technology Nominal Interest Rate (ir) 20% 5% 2% 0 MD1 MD Quantity of Money (billions of dollars) 7

8. 3 Shifters of Money Demand • Change in Aggregate Price Level If prices go up, you need more money in your wallet or checking account for everyday transactions If prices go down, you need less so demand for money shifts left 2. Change in Income (real GDP) As incomes increase, so does the demand for money shifts right 3. Change in Technology or Regulations For example the wide spread use of credit cards has decreased the demand for money Or in 1980 when Regulation Q was removed so banks could start paying interest on checking accounts, the demand for money shifted right

9. The Supply for Money The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) Interest Rate (ir) MS The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy This is called Monetary Policy. 20% 5% 2% MD Quantity of Money (billions of dollars) 200

10. Money Market Graph Combines the supply of money and the demand for money (It is one of the 5 key graphs you must know) MS Interest Rate (ir) 20% 5% 2% MD Quantity of Money (billions of dollars) 200

11. The Federal Reserve Created in 1913, the FED’s job is to regulate banks and make sure people have faith in our financial system 11

12. What are the 3 shifters of the Demand for Money? Money Demand Shifters • Changes in price level • Changes in income • Changes in technology Nominal Interest Rate (ir) 20% 5% 2% 0 MD Quantity of Money (billions of dollars) 12

13. Are we in an inflationary or recessionary gap? What would we need to know when drawing our AS/AD or Phillips Curve?

14. Now that we know that the natural rate of unemployment is 4.5 or 5%, draw an AS/AD and Phillips Curve showing our new 4.6% unemployment. Can a money market graph show inflationary gaps?

15. No.

16. Video: The FED Today

17. Increasing the Money Supply Interest Rate (ir) MS MS1 If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% 10% 5% 2% How does this affect AD? MD 250 200 Quantity of Money (billions of dollars) Increase money supply Decreases interest rate Increases investment Increases AD

18. Decreasing the Money Supply Interest Rate (ir) MS1 MS If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% 10% 5% 2% How does this affect AD? MD 150 200 Quantity of Money (billions of dollars) Decrease money supply Increase interest rate Decrease investment Decrease AD 18

19. Fractional Reserve Banking When banks hold only a small portion of deposits to cover potential withdrawals and then loans the rest of the money out. If we all went to the bank to withdrawal money at the same time what would happen? BANK RUN!

20. Bank Balance Sheets Demand Deposits- Money deposited in a commercial bank in a checking account Required Reserves- The percent that banks must hold by law Excess Reserves- The amount that the bank can loan out Balance Sheet- A record of a bank’s assets, liabilities, and net worth. Are demand deposits in a bank an asset or a liability? Liability for the bank, asset to the depositor

21. The Simple Case of 100-percent reserve banking Bank Balance Sheet: T-Account No money is being created!!!

22. Fractional Reserve Banking: T-Account It is “balanced” because the totals must equal If the bank is holding no excess reserves, how much is the required reserve ratio? .1 or 10%

23. A fractional reserve banking system creates money, but it doesn’t create wealth: Bank loans give borrowers some new money and an equal amount of new debt. Money creation in the banking system