The Demand for Money At any given time, people demand a certain amount of liquid assets (money) for two different reasons: 1.Transaction Demand for Money- People hold money for everyday transactions. **Perfectly inelastic – Q D is the same at all interest rates 2.Asset Demand for Money - People hold money since it is less risky than other assets **Q D is inversely related to interest rates What is the opportunity cost of hold keeping money in your pocket or checking account? The interest you could be earning from other financial assets like stocks, bonds, and real estate 1 Copyright ACDC Leadership 2015

The Demand for Money 1. What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets instead 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 There is a inverse relationship between the interest rate and the quantity of money demanded 2 Copyright ACDC Leadership 2015

Nominal Interest Rate (ir) Quantity of Money (billions of dollars) 20% 5% 2% 0 MD Inverse relationship between interest rates and the quantity of money demanded 3 The Demand for Money Copyright ACDC Leadership 2015

Quantity of Money (billions of dollars) 20% 5% 2% 0 MD What happens if price level increase? 4 The Demand for Money MD 1 Money Demand Shifters 1.Changes in price level 2.Changes in RGDP Nominal Interest Rate (ir) Copyright ACDC Leadership 2015

200 MD MS The FED can change the money supply. This is called Monetary Policy. The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) What does the MS curve look like? Why? 5 The Supply for Money 20% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) Copyright ACDC Leadership 2015

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% Increasing the Money Supply Increase money supply Decreases interest rate Increases investment Increases AD MD MS 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 250 MS 1 Copyright ACDC Leadership 2015

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% Decreasing the Money Supply Decrease money supply Increase interest rate Decrease investment Decrease AD MD MS 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 150 MS 1 Copyright ACDC Leadership 2015

2007B Practice FRQ 8 Copyright ACDC Leadership 2015

2007B Practice FRQ 9 Copyright ACDC Leadership 2015

2007B Practice FRQ 10 Copyright ACDC Leadership 2015

2007B Practice FRQ

HOW DOES THE FED CHANGE THE MONEY SUPPLY???

How the Government Stabilizes the Economy 13 Copyright ACDC Leadership 2015

How the FED Stabilizes the Economy 14 These are the three main tools of monetary policy. Copyright ACDC Leadership 2015

3 Shifters of Money Supply 15 Copyright ACDC Leadership 2015

TOOLS OF MONETARY POLICY Open Market Operations – WHAT IS IT? Buying and selling securities (mostly treasury bonds) Used to influence the money supply The reserve ratio – WHAT IS IT? Changes the money multiplier AND excess reserves The discount rate – WHAT IS IT? The Fed as lender of last resort Short term loans 33-16

Using Open Market Operations Open Market Operations is when the FED buys or sells government bonds (securities). This is the most important and widely used monetary policy To increase the Money supply, the FED should _________ government securities, adding checkable deposits to the banking system To decrease the Money supply, the FED should _________ government securities, subtracting checkable deposits from the banking system How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply BUY SELL 17 Copyright ACDC Leadership 2015

Using The Reserve Requirement 1. If there is a recession, what should the FED do to the reserve requirement? (Explain the steps.) If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.) Decrease the Reserve Ratio 1. Banks hold less money and have more excess reserves 2. Banks create more money by loaning out excess 3. Money supply increases, interest rates fall, AD up Increase the Reserve Ratio 1. Banks hold more money and have less excess reserves 2. Banks create less money 3. Money supply decreases, interest rates up, AD down Copyright ACDC Leadership 2015

Practice Don’t forget the Monetary Multiplier!!!! 1.If the reserve requirement is 50% and the FED sells $10 million of bonds, what will happen to the money supply? 2.If the reserve requirement is 10% and the FED buys $10 million bonds, what will happen to the money supply? 3.If the FED decreases the reserve requirement from.50% to 20%what will happen to the money multiplier? 19 Copyright ACDC Leadership 2015

Using The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. If Bank of America needs $10 million to meet their reserve requirement, they may need to borrow it from the U.S. Treasury (which the FED controls) but they must pay it back with interest. The lower the rate of interest, the more lending banks will do, accepting the risk of potentially needing to use the discount window To increase the Money supply, the FED should _________ the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should _________ the Discount Rate (Tight Money Policy). DECREASE INCREASE 20 Copyright ACDC Leadership 2015

HOMEWORK Review pgs Monetary Policy Packet Review Free Response Questions

2012 Exam

Term auction facility – WHAT IS IT? Introduced December 2007 Banks bid for the right to borrow reserves Only used a few times during the height of the crisis Interest on Reserves– More on this later… OTHER TOOLS OF MONETARY POLICY

TOOLS OF MONETARY POLICY Which tool is most used? Open market operations most important Reserve ratio last changed 1992 Limits for each tranche change yearly Discount rate was a passive tool Aggressive during credit crisis Term auction facility ( ) Allowed the Fed to lend at a rate BELOW the discount rate Guaranteed amount lent by the Fed Anonymous 33-27

THE FEDERAL FUNDS RATE Rate charged by banks on overnight loans FED can’t directly control this… banks decide Targeted by the Federal Reserve Most monetary policy revolves around Federal Funds Rate FOMC conducts open market operations to achieve the target What does the demand curve for Federal Funds look like? Why? What does the supply curve for Federal Funds look like? Why? 33-28

THE FEDERAL FUNDS RATE Federal Funds Rate, Percent 3.5 Quantity of Reserves DfDf Sf3Sf Sf1Sf1 Sf2Sf2 Qf3Qf3 Qf1Qf1 Qf2Qf2 Using Open Market Operations 33-29

Federal Funds Rate 30 Explain the differences between 1979 and 2007 Copyright ACDC Leadership 2015

PRIME INTEREST RATE Reference point used by banks Tied to Federal Funds Rate – about 3% difference

What is the Federal Funds Rate right now?

TAYLOR RULE - BRIEFLY Rule of thumb for tracking actual monetary policy Assumes Fed has 2% target inflation rate If real GDP = potential GDP and inflation is 2% then target federal funds rate is a nominal 4% (real=2%) Target varies as inflation and real GDP vary For every 1% increase above potential GDP -- or -- above inflation target, Fed should increase real federal funds rate by ½% 33-34

READ PGS Answer the following question in at least 200 words: Based upon what you know and what you’ve read, do you think the Federal Reserve did a good job responding to the financial crisis? What would you have done differently and why? What risks are we currently facing due to the FED’s actions?

PRE-PODCAST QUESTION Why hasn’t the $4.5 Trillion created by the FED since 2008 created rapid hyperinflation?

POTENTIAL REASONS… International demand for the dollar results in the extra cash being held internationally, reducing it’s usage at home Fear = Savings Banks are using the cash to speculate instead of lending to “Main Street” But if lending does pick up we will run the risk of high inflation, so what do we do?

38 Wait, why would the FED ever want to slow down the economy? To fight inflation The role of the Fed is to “take away the punch bowl just as the party gets going” Copyright ACDC Leadership 2015

HOMEWORK: Podcast Due Friday Read pgs and complete Loanable Funds and Crowding Out packet

2014 AP® MACROECONOMICS FREE-RESPONSE QUESTIONS 2. The Federal Reserve can influence the supply of money. (a) Assume that the Federal Reserve targets a lower federal funds rate. (i) What open market operation can the Federal Reserve use to achieve the lower target? (ii) Given your answer to part (a)(i), what will happen to the price of government bonds? (b) Using a correctly labeled graph of the money market, show the effect of the open market operation from part (a)(i) on the nominal interest rate. (c) Assume that the Federal Reserve buys government bonds from commercial banks. Based only on this transaction, will the level of required reserves in the commercial banks increase, decrease, or remain the same? (d) Another monetary policy action involves changing the discount rate. Define the discount rate.

EXPANSIONARY MONETARY POLICY Problem: unemployment and recession Fed buys bonds, lowers reserve ratio, or lowers the discount rate Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises CAUSE-EFFECT CHAIN 33-42

Investment DemandS&D of Money The FED increases the money supply to stimulate the economy… DMDM SMSM 10% 5% 2% Quantity M Interest Rate (i) 250 S M1 DIDI Quantity of Investment 10% 5% 2% Interest Rate (i) AD/AS QeQe AD AS GDP R PL AD 1 Q1Q1 PL e PL 1 1.Interest Rates Decreases 2.Investment Increases 3.AD, GDP and PL Increases Copyright ACDC Leadership 2015

RESTRICTIVE MONETARY POLICY Problem: inflation Fed sells bonds, increases reserve ratio, or increases the discount rate Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines CAUSE-EFFECT CHAIN 33-44

Investment DemandS&D of Money The FED decreases the money supply to slow down the economy… DMDM SMSM 10% 5% 2% Quantity M Interest Rate (i) 175 S M1 DIDI Quantity of Investment 10% 5% 2% Interest Rate (i) AD/AS QeQe AD AS GDP R PL AD 1 Q1Q1 PL e PL 1 1.Interest Rates increase 2.Investment decreases 3.AD, GDP and PL decrease Copyright ACDC Leadership 2015

MONETARY POLICY Advantages over fiscal policy Speed and flexibility Isolation from political pressure Recent U.S. monetary policy Problems and complications Recognition lag Operational lag Cyclical asymmetry 33-46