CHAPTER 13 Role of money

Chapter Outline Measures of money supply Deposit multiplier Tools of monetary policy Equilibrium in money markets

Measures of money supply M1 = Currency + Checking at deposits + traveler’s checks M2 = M1 + Saving acounts + Small time deposits + money market mutual funds M3 = M2 + Large time deposits + institutional money funds + purchase agreements + euro dollars Table 13-1 pg. 384 (read the details)

Deposit multiplier Deposit Multiplier = 1/rr Where rr = reserve requirements The higher the reserve requirements the smaller the deposit multiplier

Tools of monetary policy Discount rate Higher discount rate results in lower money supply and contraction in the economy Other important rates Prime rate Federal funds rate

Tools of monetary policy Cont… Open market operations (OMOS) OMOS are carried out by federal open market committee (FOMC) by selling and buying government securities Selling of government securities by the FED, will reduce money supply in the economy

Tools of monetary policy Cont… Reserve requirements Raising reserve requirements has a contractionary effect on the economy This tool is used with a lot of caution because it results in a significant change in money-supply and affects financial markets

Tools of monetary policy Cont… Discount rate Discount rate refers to the rate the federal reserve bank charges banks who borrow reserves at the Fed’s discount window Discount rate is set by the Fed An Increase in discount rate Makes borrowing by the banks more expensive and reduces bank reserves Results in a contractionary monetary policy

Tools of monetary policy Cont… Other rates Federal funds rate - interest rate that commercial banks charge each other for loans of reserves to meet their minimum reserve requirements Federal funds rate is targeted by Fed. Fed’s actions (open market operations) affect the federal funds rate. This rate affects other short-term rates Prime rate – The interest rate that banks charge on loans to their best customers. It is based on the discount rate set by the Fed.

Equilibrium in money markets Supply of money Real money supply = Nominal money supply = Ms Price level P RLMS = f(r,MS, P) r MS/P Real money – supply does not change with the changes in real interest rate

Demand for Money RLMD = MD/P = f [r,y] Interest rate represents the opportunity cost of holding money. At higher interest rates, people hold less money and vice versa r MD/P

Equilibrium Price of Bond is inversely related to interest rate MS E r Md O

Changes in Equilibrium Real Ms Real Ms’ Change in Money Supply E1 r1 E2 r2 Real Md Increase in money supply creates excess money supply i.e. demand for money is less than the amount of money supplied D - for bonds increases P - of bonds increase Interest rate goes down

Changes in Equilibrium Real Ms E2 r2 Change in Demand for money E1 Md2 r1 Md1 Increase in demand for money results from an increase in real income (Y). People want to hold more of their assets as money They sell their bonds. This results in lower bond prices and higher interest rates.