Monetary Policy

Money Market A model showing the total supply of and demand for money in a nation. The liquid money available in a nation, including cash, checking deposits, and money in savings accounts.

Nominal Interest Rate Cost of money Price of money ◦Borrower  The interest you will pay above and beyond the amount you borrowed ◦Saver  The percentage you will receive on your savings on an annual basis The US Money Market Nominal Interest Rate Q$Q$ Nominal / real??????

Supply of Money Function of US monetary policy and is not related to the interest rate in the economy. Perfectly inelastic and determined by central bank policy. ◦Vertical line labeled S m The US Money Market Nominal Interest Rate SmSm Q$Q$

Money Demand The demand among the households and firms for money as an asset. ◦A private person can choose to hold onto money or invest in other assets such as stocks and bonds, real estate, gold, etc. ◦The asset demand for money is inversely related to the nominal interest rate.  Downward sloping curve The US Money Market Nominal Interest Rate DmDm SmSm Q$Q$

Determinant for Supply of Money Level of output and income in the economy. ◦At higher income levels or economic growth, the demand for money increases, and at lower income levels the demand for money decreases.  Increase money supply = right shift and lower interest rates Inflation / Deflation? Output? The US Money Market Nominal Interest Rate DmDm SmSm Q$Q$ ir e S m1 ir 1

Determinant for Supply of Money Level of output and income in the economy. ◦At higher income levels or economic growth, the demand for money increases, and at lower income levels the demand for money decreases.  Decrease money supply = left shift and higher interest rates Inflation / Deflation? Output? The US Money Market Nominal Interest Rate DmDm SmSm Q$Q$ ir e S m1 ir 1

Monetary Policy Supply of money is determined by the monetary policy of the central bank. Monetary policy is not determined by the interest rate Monetary policy determines the interest rate The demand for money is determined by the interest rate ◦When rates are high, opportunity cost of holding onto money as an asset is high, demand is low ◦When rates are low, opportunity cost of holding onto money as an asset is low, demand is high

Monetary Policy Central bank determines monetary policy In the US, the central bank is the Federal Reserve Bank (FED) ◦Responsibilities  Government’s bank  Regulating banking industry FED 12 Districts Member Banks

US Federal Reserve

Commercial Banks Most money is held in commercial banks. Banks hold money as assets in cash and bonds. ◦Bonds are “illiquid” These are both owned by households

Tools - Reserve Requirement Required reserve ratio (RRR) Not commonly used to manipulate Q s ◦The percentage of the bank’s total household deposits that must be held in reserve at the Federal Reserve Bank.  10% historically Lower RRR makes money more available ◦Increases money supply ◦Lowers interest rate Higher RRR makes money less available ◦Raises interest rate

Reserve Required Ratio

Tools – Open Market Operations Open market operations (OMO) Most commonly used to manipulate Q s ◦Buying or selling bonds from/to commercial banks/households to increase or decrease money supply Bonds are illiquid and cannot be used on goods and services ◦Held for a extended period of time Increase money supply = FED buys bonds Decrease money supply = FED sells bonds ◦Excess supply of bonds leads to lower bond price  Interest rate received to buyer goes up ◦ Better asset choice

Tools – Open Market Operations

Tools – Discount Rate Discount rate Not commonly used to manipulate Q s ◦Interest rate charged by the FED to the banks for short term loans to banks  Banks borrow from FED as lender of last resort  Banks MUST meet RRR and will borrow if short  Discount rate makes it less expensive to borrow from FED, therefore will lend money and borrow from FED ◦Lower rate = increase money supply ◦Higher rate = decrease money supply ◦A lower rate makes it cheaper for households to borrow money

Tools – Discount Rate