1. ECON Macro McEachern 2010-2011 16 CHAPTER Monetary Theory and Policy Designed by Amy McGuire, B-books, Ltd. 1

2. The Demand for Money • Demand for money • Interest rate • How much money people want to hold • People demand money • Pay for purchases • Money • Carry out economic transactions • Easily • Efficiently LO1 2

3. The Demand for Money • More active economy • More goods and services exchanged • More money demanded • The higher the price level • Greater the demand for money • Money • Medium of exchange • Store of value • Liquidity LO1 3

4. The Demand for Money • Opportunity cost of holding money • Interest forgone • Quantity of money demanded • Inversely: market interest rate • Money demand curve • Downward slope • The lower interest rate • The lower opportunity cost of holding money LO1 4

5. 0 Quantity of money Exhibit 1 LO1 Interest rate Demand for Money Dm The money demand, Dm, slopes downward. As the interest rate falls, other things constant, so does the opportunity cost of holding money; the quantity of money demanded increases. 5

6. The Supply of Money • Supply of money • Stock of money • In economy • A particular time • Determine by the Fed • Vertical line • Independent of interest rate LO1 6

7. The Supply of Money • Equilibrium interest rate • Demand for money • Supply of money • Interest rates • Above equilibrium • Higher opportunity cost of holding money • Below equilibrium • Lower opportunity cost of holding money LO1 7

8. The Supply of Money • Given money demand curve • Increase money supply • Lower interest rate • Decrease money supply • Higher interest rate LO1 8

9. S’m Sm b a Quantity of money Exhibit 2 0 M M’ LO1 Interest rate Effect of an Increase in the Money Supply i Because the money supply is determined by the Federal Reserve, it can be represented by a vertical line. i’ Dm At point a, the intersection of the money supply, Sm, and the money demand, Dm, determines the market interest rate, i. Following an increase in the money supply to S’m, the quantity of money supplied exceeds the quantity demanded at the original interest rate, i. People attempt to exchange money for bonds or other financial assets. In doing so, they push down the interest rate to i’, where quantity demanded equals quantity supplied. This new equilibrium occurs at point b. 9

10. Money and Aggregate Demand in the Short Run • Short run: Money affects the economy • Through changes in interest rate • The Fed: stimulate output; employment • Open-market purchases • Money supply – increase • Interest rate – reduce • Investment – stimulate • Aggregate demand – increase • Real GDP – increase LO2 10

11. S’m Sm b b b a a a Exhibit 3 0 0 0 Real GDP Money I Y M I’ Y’ M’ LO2 Investment Price level Interest rate Interest rate Effects of an Increase in the Money Supply on Interest Rates, Investment, and Aggregate Demand AD’ P i i AD Dm (c) Aggregate demand (b) Demand for investment (a) Supply and demand for money DI i’ i’ This sets off the spending multiplier process, so the aggregate output demanded at price level P increases from Y to Y ‘ An increase in the money supply drives the interest rate down to i'. With the cost of borrowing lower, the amount invested increases from I to I‘. 11

12. Money and Aggregate Demand in the Short Run • The Fed: cool down the economy • Open-market sale • Money supply – decrease • Interest rate – increase • Investment – reduce • Aggregate demand – decrease • Real GDP - decrease LO2 12

13. Adding the Short-Run Aggregate Supply Curve • Contractionary gap • Output < potential • Price level < expected • Wages > negotiated • The Fed: expansionary monetary policy • Stimulate AD • Increase money supply • Equilibrium LO2 13

14. SRAS130 Potential output a b Price level Real GDP (trillions of dollars) 0 Exhibit 4 13.8 14.0 LO2 LRAS Contractionary gap Expansionary Monetary Policy to Correct a Contractionary Gap 130 AD’ At a, the economy is producing less than its potential in the short run, resulting in a contractionary gap of $0.2 trillion. AD 125 If the Federal Reserve increases the money supply by just the right amount, the aggregate demand curve shifts rightward from AD to AD’. A short-run and long-run equilibrium is established at b, with the pride level at 130 and output at the potential level of $14.0 trillion 14

15. Money and Aggregate Demand in the Long Run • Equation of exchange • Buyer: exchanges money for goods • Seller: exchanges goods for money • M – quantity of money in economy • V – velocity of money • P – average price level • Y – real GDP LO3 15

16. Targets for Monetary Policy • Short-run • Interest rate • Long-run • Price level • Money market: equilibrium • Increase money demand curve • The Fed – target money supply • Does nothing • Increase interest rate • The Fed – target interest rate • Increase money supply LO4 16

17. S’m Sm e e’ e’’ Exhibit 7 Quantity of money 0 M M’ LO4 i’ Targeting Interest Rates Versus Targeting the Money Supply Interest rate D’m Dm i An increase in the price level or in real GDP, with velocity stable, shifts rightward the money demand curve from Dm to D'm. If the Federal Reserve holds the money supply at Sm, the interest rate rises from i (at point e) to i ' (at point e'). Alternatively, the Fed could hold the interest rate constant by increasing the supply of money to S'm. The Fed may choose any point along the money demand curve D'm. 17

18. Targets for Monetary Policy • Targets before 1982 • Stabilize interest rates • October 1979: target money aggregates • Volatile interest rates • Sharp reduction in money growth, 1981 • Recession, 1982 • Declining inflation • Rising unemployment LO4 18