Unit 4: Money and Monetary Policy 1

The Money Market (Supply and Demand for Money) 2

The Demand for Money At any given time, people demand a certain amount of liquid assets (money) for everyday purchases The Demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded 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

Nominal Interest Rate (ir) The Demand for Money Inverse relationship between interest rates and the quantity of money demanded Nominal Interest Rate (ir) 20% 5% 2% DMoney Quantity of Money (billions of dollars)

What happens if price level increase? Nominal Interest Rate (ir) The Demand for Money What happens if price level increase? Money Demand Shifters Changes in price level Changes in income Changes in taxation that affects investment Nominal Interest Rate (ir) 20% 5% 2% DMoney1 DMoney Quantity of Money (billions of dollars) 5

This is called Monetary Policy. The Supply for Money The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) Interest Rate (ir) SMoney The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy This is called Monetary Policy. 20% 5% 2% DMoney 200 Quantity of Money (billions of dollars)

Monetary Policy When the FED adjusts the money supply to achieve the macroeconomic goals 7

Increasing the Money Supply Interest Rate (ir) SM SM1 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% 10% 5% 2% How does this affect AD? DM 200 250 Quantity of Money (billions of dollars) Increase money supply Decreases interest rate Increases investment Increases AD

Decreasing the Money Supply Interest Rate (ir) SM1 SM 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% 10% 5% 2% How does this affect AD? DM 150 200 Quantity of Money (billions of dollars) Decrease money supply Increase interest rate Decrease investment Decrease AD 9

4.2

Homework Your Homework assignment is on the class Edmodo (Oligopoly review quiz.) You’ll also find attached to this lecture, a FRQ from the 2007 AP exam. Give it a try and see how you do.

2007B Practice FRQ 13