Money Supply Money Demand & Money Market Equilibrium Lecture 17 Jennifer P. Wissink ©2016 Jennifer P. Wissink, all rights reserved. April 4, 2016

Announcements(mAcro)-Spring 2016 u Welcome Back from Spring Break! u Prelim 2 is Thursday April 14, 7:30pm-9:00pm. –Please go to Blackboard and register for Option 1 or Option 2 if you have a Cornell created evening prelim conflict. –NOTE: DO NOT EXPECT ANY REPLY. PRINT YOUR THANKYOU SCREEN AT THE END IF YOU WANT A “RECEIPT”. –See our syllabus for your options. –For all other prelim conflicts/issues you must come and see Prof. Wissink in person ASAP. u Extension on MEL Quiz#08 until Monday night April 4. u MEL Quiz#09 is due on April 9 u MEL Quiz#10 is due on April 11 – a review for everyone

The Federal Funds Rate & OMO u The Federal Reserve Act specifies that the FOMC should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." u At each meeting, the FOMC closely examines a number of indicators of current and prospective economic developments. Then, cognizant that its actions affect economic activity with a lag, it must decide whether to alter the federal funds rate. u By trading government securities, the New York Fed affects the money supply and federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market. u A decrease in the federal funds interest rate stimulates economic growth. u An increase in the federal funds interest rate will curb economic growth.

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Open Market Operations u An open market purchase(buy) of securities from the public by The Fed results in an increase in reserves and an increase in the money supply by an amount equal to the money multiplier times the change in reserves. u An open market sale of securities to the public by The Fed results in a decrease in reserves and a decrease in the money supply by an amount equal to the money multiplier times the change in reserves. u Open market operations are the Fed’s preferred means of controlling the money supply because: –they can be used with some precision –are extremely flexible –are fairly predictable.

An OMO Sale to  M s u Suppose the rrr = 20% u Suppose The Fed sells $5 in securities to the public, namely to Jane Q. Public. –a loss of reserves of $5 (since Jane pays for them w/DD) –so  Reserves = -$5 u Note: with rrr = 20% the K $ = 5 u An OMO sale of $5 in securities to the public leads to a decrease in the money supply of $25. –In this case,  Ms =  DD = (K $ )(  Reserves) –Plugging in you get: -$25 = (5)( -$5) u The Fed's Next Move Is A Delicate One(NPR) –“One of the Federal Reserve's main jobs is creating money. And the central bank has created a lot of it since the financial crisis — more than $3 trillion. One of the next jobs for the Fed is to make that money disappear.” – u Federal Reserve Decides To Keep Interest Rates Low A While Longer – keep-interest-rates-low-a-while-longer

An OMO Sale to  M s, with rrr=20% Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1: the initial situation Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20Reserves $20$100Deposits $5$0Debts $80CurrencyLoans$80$5Net Worth Note: Money supply (M1) = Currency + Deposits = $180. PANEL 2: right after The Fed sells $5 of securities to Jane Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$95Deposits (  $5) $0 Debts $80CurrencyLoans$80Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $175. PANEL 3: after the Commercial Banks get “right” again Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$75Deposits (  $25) Deposits (  $5) $0 Debts $80CurrencyLoans (  $20) $60Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $155.

An OMO Purchase and the K $   M s u Suppose rrr=20%  K $ = 5 u Suppose The Fed buys $70 in securities from Fred Z. Public. u The money supply will increase by $350. –Note:  M s =  DDp=(K $ )(  Reserves) –The $70 purchase increases reserves by $70 –Plugging into  M s  $350 = (5)($70)

Can You Do An OMO Purchase To  M s ? PANEL 1 Federal ReserveCommercial BanksFred Z. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20Reserves $20$100Deposits $5$70Debts $80CurrencyLoans$80Securities $75 $10Net Worth PANEL 2 Federal ReserveCommercial BanksFred Z. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities PANEL 3 Federal ReserveCommercial BanksFred Z. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities

The Money Market u Money Supply (M S ) –Totally determined by The Fed. –So… a vertical line in our graphs. –What we were calling M1. –Now it’s M S. u Money Demand (M D ) –Will make more interesting. –Determined by households’ desires to hold assets as money rather than interest bearing bonds. –Look at motives for holding money, rather than bonds.

The Demand Function for Money u Simple model that asks: What determines how much of a person’s assets/wealth will be held as non-interest earning balances, i.e., money? u Note, a households assets include: –money balances »0 interest and perfectly liquid –bonds/securities »+ interest and imperfectly liquid –claims on real capital (physical assets) »most of the time we will ignore this 3 rd category

Bond Price and Interest Rate u Suppose I, Jennifer P. Wissink, offer to sell you a bond/security/promissory note where I promise to give you $1,000 in exactly two years from today. –No inflation. –No risk! u What would you be willing to pay me (ok, loan me) for this promise? –What “price” would you pay?

u What is $1,000 in T=2 years from today worth today, if r = 4%=.04? u Ask, how much would you have to put in the bank today, $PV, to have a balance or Face/Future Value, $FV, of $1,000 two years from today, at r = 4%=.04 in each year? u So, after one year: $PV + $PV·r u And after two years: ($PV + $PV·r) + ($PV + $PV·r) ·r –So, $FV = $PV + $PV·r + $PV·r + $PV·r 2 –So, $FV = $PV(1+2r+r 2 ) –So, $FV = $PV(1+r) 2 u So, solving for the present value you then get –$PV = $FV/(1+r) 2 u So, the present value of $1,000 in 2 years at r=4%=.04 is –$PV = $1,000/(1.04) 2 = $ u General Formula: –The $PV of $X in T periods from now at interest rate r is $PV = $X/(1+r) T Bond Price and Interest Rate

i>clicker questions Suppose the interest rate increased to r=5%=.05, holding everything else the same. The $PV of the promise to get $1,000 in two years would A.Increase. B.Decrease C.Stay the same Suppose the interest rate stayed at 4%=.04 but now you had to wait until 4 years to get the $1,000, holding everything else the same. The $PV of the promise would A.Increase. B.Decrease C.Stay the same

Bond Price and Interest Rate u So there is an inverse relationship between bond prices ($P B ) and the market interest rate (r). u If r , then $P B  u If r , then $P B 

Households and the Transaction Motive for Money u There is a trade-off between the liquidity of money and the interest income offered by other kinds of assets. u The transaction motive is the main reason that people hold money—to buy things. –inventory analysis –synchronization problems u Lots of interesting work on this. u Pioneered by William Baumol and James Tobin. u Get a money demand function: M D = f(interest rate, income, price level, other stuff) –if r   M D  and if r   M D  –if Y   M D  and if Y   M D  –if PL   M D  and if PL   M D 

Speculators and the Speculative Motive for Money u Very Important: Recall there is an inverse relationship between the market value of bonds ($P B ) and the market interest rate (r). u So... when interest rates are high, speculators may wish to hold bonds (rather than money), with the hope of selling their bonds when the interest rate falls & bond prices rise. –“What goes up, must come down” –So quantity of money demanded by speculators at high interest rates is low. u Likewise... when interest rates are low, speculators may wish to hold money (rather than bonds), with the hope of buying bonds when the interest rate rises & bond prices fall. –“What goes down, must come up” –So quantity of money demanded by speculators at low interest rates is high. u So… supports the idea that there is a negative relationship between the interest rate, r, and the quantity of money demanded.

The Money Demand Curve u Hold Y & PL constant at some “exogenous” level and vary r. u Changing r  movement along money demand curve. u Changing Y and/or PL  shift in money demand curve.

The Money Market u Money Supply (M S ) –Totally determined by The Fed. –So… a vertical line in our graphs. –What we were calling M1. –Now it’s M S. u Money Demand (M D ) –Transaction Motive –Speculative Motive –M D = f(interest rate, income, price level, other stuff) »if r   M D  and if r   M D  »if Y   M D  and if Y   M D  »if PL   M D  and if PL   M D 

The Equilibrium Interest Rate

When r > r* u At r 1, the amount of money in circulation is higher than households and firms wish to hold. u They will attempt to reduce their money holdings by buying bonds. u $Pbonds   r 

When r < r* u At r 2, households & firms don’t have enough money to facilitate ordinary transactions. u They will shift assets out of bonds and into their checking accounts. u $Pbonds   r 

Recall: How The Federal Reserve Controls M S u Changing the required reserve ratio –  rrr   M S –  rrr   M S u Changing the discount rate –  discount rate   M S –  discount rate   M S u Engaging in open market operations –OMO sale of securities to public (Fed sells securities)   M S –OMO purchase of securities from the public (Fed buys up securities)   M S

How a Change in the Money Supply Impacts the Interest Rate u An increase in the money supply lowers r*. u Do the opposite story for yourself.

How a Change in Y Impacts the Interest Rate u An increase in aggregate output (income), Y, will... u...shift the money demand curve which… u...raises the equilibrium interest rate.

Putting It Together: The Goods Market (AE d ) & The Money Market u The goods market is the market in which goods and services are exchanged and in which the equilibrium level of aggregate output Y is determined. –and Y feeds back into money market via shifts in M Demand u The money market is the market in which financial instruments are exchanged and in which the equilibrium level of the interest rate r is determined. –and r feeds back into the goods market via desired Investment

The Goods Market (AE d ) & The Money Market u From Money Market we get r* where M D (r, Y, PL) = M S u From G&S market we get: AE d = C(Y d ) + I d (r) + G + EX – IM u In equilibrium we solve for Y* where Y* = AE d (Y*) u Two new reality wrinkles: –I d depends negatively on the equilibrium interest rate r »Why? Projects have lower present value and look less attractive –M D depends positively on Y&PL and depends negatively on r u Now we have ties (r, Y and PL) that bind the Money Market to the Goods&Services Market! u Now we can talk about Monetary Policy and about Fiscal Policy again, too!