CHAPTER 13

Role of money

Chapter Outline

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

The higher the reserve requirements the smaller the deposit multiplier

Tools of monetary policy

Discount rate Higher discount rate results in lower

money supply and contraction in the economy

Other important rates Prime rate Federal funds rate

Tools of monetary policy Cont…

Open market operations (OMOS) 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…

Reserve requirements 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…

Discount rate 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

Makes borrowing by the banks more expensive and reduces bank reserves

Results in a contractionary monetary policy

Tools of monetary policy Cont… Other rates

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 short-term 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 Supply of money

Real money supply = Nominal money supply = Ms

Price level PRLMS = f(r,MS, P)

r

MS/P

Real money – supply does not change with the changes in real interest rate

Demand for Money

RLMD = MD/P = f [r,y]

Interest rate represents the opportunity cost of holding money. At higher interest rates, people hold less money and vice versa

r

MD/P

Equilibrium

Price of Bond is inversely related to interest rate

MS

O

r

Md

E

Changes in Equilibrium

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

Real Ms

E2

E1r1

r2

Real Ms’

Real Md

Change in Money Supply

Changes in Equilibrium

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.

E1

E2

Md1

Md2r1

r2

Real Ms

Change in Demand for money