Money as an assetThe Money Market

The Money MultiplierMonetary Policy

1. Medium of exchange – usable for buying and selling goods

2. Unit of account - dollar value of goods and services

3. store of value - transfer of purchasing power from the present to future

At the core of monetary policy is the regulation of the money supply.

M1 – currency, checkable deposits M2 – Near money (savings, small time

deposits, MMMF)

Federal Reserve Notes are token money (fiat) Checkable deposits are large component Currency held by the FED, thrift, banks are

excluded

Money helps satisfy wants and is also an asset Transaction Demand – As nominal GDP rises,

people demand more money to buy goods and services If nominal GDP is $1000 and each dollar is spend an

average of four times each year, money demand for transactions would be $1000/4 = $250.

What happens if nominal GDP raises to $1200

Asset Demand – Money can be held as an asset at very little risk.

Total Demand – Plotted against the nominal interest rate, the transaction demand for money is a constant MDt.

John Maynard Keynes – Theory of Liquidity Preference

How is the Money Market Different from the Market for Loanable Funds? (extremely important to know the difference Breadth of scope Different Philosophies (Classical vs. Keynesian) Graphing: “Loanable funds are REAL-ly fun”

When we talk about monetary policy we are really talking about money supply policy. Increase/Decrease in the money supply

How does this work? Tips:

Increase - lowers interest rates as surplus money moves into the bond market, increasing bond prices

Decrease - increases interest rates as a shortage of money creates a sell-off of bonds, decreasing the bond prices

best way to see money creation is to create a t-account or balance sheet (assets and liabilities of the bank) Asset – anything owned by the bank or owed to the bank;

cash on reserve is an asset as well as loans made to citizens

Liability – anything owned by depositors or lenders to the bank; checking deposits or loans made to the bank

measures the maximum amount of new checking deposits that can be created by a single dollar of excess reserves idea and math is identical to the spending multiplier M = 1/(reserve ratio) = 1/rr (=1/.10 = 10 in our example)

3 tools Open Market Operations Discount Rate Reserve Ratio

Expansionary Policy Longer path to impact than fiscal policy

Contractionary Policy

Open Market Operations – (Federal Open Market Committee) can buy and sell securities on the open market “B”uying “B”onds = “B”igger “B”ucks “S”elling “B”onds = “S”maller “B”ucks Federal Funds Rate

Discount rates act like the real interest rates

Rates change in lockstep with the federal funds rate

Rarely used Lowering the reserve ratio increases excess reserves

in commercial banks and expands the money supply Increasing the reserve ratio decreases excess

reserves in commercial banks and contracts the money supply

(pull in Table 16.1)

Monetary policy DOES NOT affect government spending!

In a deep recessionary gap expansionary monetary policy used to assist expansionary

fiscal policy - risk inflation burst In a mild recessionary gap

contractionary monetary policy could be used to offset expansionary fiscal policy - risk rising interest rates

In an inflationary gap contractionary monetary policy could be used to assist

contractionary fiscal policy - risk rising unemployment

increasing the money supply has no effect on real GDP; but only serves to increase the price level.

MV = PQ or V = PQ/M