Supply: banks, Fed Money ioio Federal Funds Rate Banks increase lending as interest rates rise because it is more profitable The Fed manipulates the amount of reserves in the system. Supply increases when the Fed injects reserves Banks lend more when the interest rate increases

Wealth can be held in two forms Wealth Assets that earn a return ( bonds ) Assets that do not earn a return ( cash/Deposits )

The Demand for Money Tells us “how much of our wealth we want to hold as cash/Deposits banks”

The Interest Rate Represents the Cost of holding cash balances… what you give up…

The Demand for Money Interest Rate The higher the i, the higher the opportunity cost of holding cash/ reserves The lower the amount of desired cash (deposits)/reserves i 0 i 0 Md 0

The Demand for Money Interest Rate The larger the amount of desired cash (Deposits)/reserves. As the i falls, the opportunity cost of holding cash/reserves decreases i 1 i 1 Md 1

The Federal Funds Rate Supply: banks + Fed Demand: Public Money ioio Federal Funds Rate As interest rate rises bank’s quantity demanded drops

The Federal Funds Rate Supply= excess reserves + Fed changes Demand = Banks in need of reserves Money ioio Federal funds Rate Banks need more reserves when Deposits increase Deposits/ Demand for reserves increase with more transactions Deposits/ Demand for reserves increase when prices increase

What Determines How Much Money we Want to hold as Deposits? Prices + We need to hold more cash for more expensive transactions Real Income + We buy more things: we need more cash for more transactions. Interest rate - The higher the interest rate the less money we want to hold as cash The higher prices and Income, the higher the need for cash The higher the interest rate, the lower the demand for cash

Shifts in the Demand for Money Increase in prices or Incomes (GDP): shift demand to the right Decrease in prices or incomes (GDP): shift the demand to the left

When Prices Increase More expensive transactions require larger cash holdings The demand for money shifts to the right i 0 i 0 Md 0 i 1 i 1 Md 1 At each i we hold more cash than before The demand for bank reserves shifts to the right

When Real Income Increases We engage in MORE transactions which require larger cash holdings. The demand for bank reserves shifts to the right i =5% 500 bill. i =3% bill. 900

The Federal Reserve Bank ‘Controls’ the Supply of Money Open Market Operations. Changes in the Discount Rate Changes in the required reserve ratio. The amount of money in circulation is managed by the fed Supply Demand Quantity Bank Reserves ioio Federal Funds Rate Ms i $

The Public ‘controls’ the Demand for money When prices increase the demand for money increases When incomes increase the demand for money increases. MsMs i $ MdMd

Monetary Policy The Fed determines the “desired level” for the interest rate The Fed adjusts the Money Supply until the rate hits the target. Via Open Market Operations. Via changes in required reserves. Via changes in discount rate. Via changes in margin requirements. Via moral suasion.

Relationship Between Bond Prices and the Interest Rate Bond P Price:$100 Interest Rate: 5% Interest: $5 Peter purchased this bond Bond A Price:$100 Interest Rate: 8% Interest: $8 A month later a new bond “A” Is issued into the market

Which Bond would you buy? Peter’s? The new bond “A”? Bond P Price:$100 Interest Rate: 5% Interest: $5 Bond A Price:$100 Interest Rate: 8% Interest: $8 Clearly A is better than P: same price but higher interest

What price should Peter ask for to convince you to purchase his bond rather than A? A Price that would make Peter’s bond more attractive A price so low, that the interest you earn on Peter’s bond is higher than 8%

Peter’s Bond If you pay $100 for Peter’s Bond You receive $105 at maturity Interest Rate = (105 – 100)/100 = 5% If you pay $90 for Peter’s Bond You receive $105 at maturity Interest Rate = (105 – 90)/ 90 = 16.7% The lower the price, the higher the interest rate

What price will give us exactly 8% for Peter’s bond? If you pay $X for Peter’s Bond You receive $105 at maturity Interest Rate = (105 – X)/ X 0.08 X = X 8% = (105 – X)/ X X(1.08) = X + X = 105 X( ) = 105 X = $97.22

If Peter needs to sell his bond It must sell it for LESS than $97.22 to make i >8% Since he paid $100 for it, he must sell at a loss….

What does this mean? When interest rates rise: when new bonds come into the market with higher interest rates…I can still sell old bonds for cash, but I will lose money in the transaction. When interest rates rise, bond bond prices drop

The Relationship Between Bond Prices and the Interest Rate Bond P Price:$100 Interest Rate: 10% Interest: $10 Peter purchased this bond Bond A Price:$100 Interest Rate: 5% Interest: $5 A month later a new bond “A” Is issued into the market Clearly P is better than A: same price but higher interest

What price will give us exactly 5% for Peter’s bond? If you pay $X for Peter’s Bond You receive $110 at maturity Interest Rate = (110 – X)/ X 0.05 X = X 5% = (110 – X)/ X X(1.05) = X + X = 110 X( ) = 110 X = $104.76

If Peter needs to sell his bond He can now sell it for MORE than $100 Since he paid $100 for it, he will make a profit …. When interest rates fall, bond prices increase

What does this mean? When interest rates fall: when new bonds come into the market with lower interest rates…I can sell my bonds at a profit.

Bond Market Supply of bonds Demand for bonds P0P0

Bond Market: Fed Sells Bonds Supply of bonds Demand for bonds P0P0 P1P1 Bond Price falls: Interest Rates Increase

Bond Market: Fed Buys Bonds Supply of bonds Demand for bonds P0P0 P1P1 Bond Price rises: Interest Rates Decrease

Monetary Policy Changing the Money Supply in order to affect Aggregate Spending

The Effect of an Increase in the Money Supply The fed increases M s by: Reducing the required reserve ratio (r) Buying bonds in the Open Market Reducing the Discount Rate (d) An increase in M s is represented as a rightward shift in the Money Supply line i $ Ms0Ms0 Ms1Ms1

When the Fed Wants to Reduce Unemployment Use Expansionary Monetary Policy Increase the Money Supply Decrease the interest rate. Increase demand for goods and services

The Effect of a Decrease in the Money Supply The fed decreases M s by: Increasing the required reserve ratio (r) Selling bonds in the Open Market Increasing the Discount Rate (d) A decrease in M s is represented as a leftward shift in the Money Supply line i $ Ms0Ms0 Ms1Ms1

When the Fed Wants to Reduce Inflation Use Contractionary Monetary Policy Decrease the Money Supply Increase the interest rate. Decrease Aggregate Demand

Supply Demand Quantity Bank Reserves ffr o Federal Funds Rate MsMs i $ MdMd Supply of bonds Demand for bonds P0P0 i

Questions to prepare for the test Use a diagram to show the effect on reserves, the money supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step. 1. The fed increases/decreases the required reserve ratio 2. The fed buys/sells bonds in the open market 3. Fed increases/decreases the discount rate. 4. Prices increase/decrease 5. Incomes decrease/decrease

Event Demand for Reserves Supply of Reserves Federal Funds Rate Banks Loan s DepositsM d /M s Interest Rate ( i ) Increase in Required Reserve Ratio (r) b 1 M s Decrease in Required Reserve Ratio (r) b 2 Ms Ms Buy Bonds b 3 Ms Ms Sell Bonds b 4 M s Increase in Discount Rate b 5 M s Decrease in Discount Rate b 6 Ms Ms Increase in Prices same 7 Md Md Decrease in Prices same 8 Md Md Increase in Incomes (GDP) An economic Expansion same 9 Md Md Decrease in Incomes (GDP) Economic Recession same 10 M d

1. More banks in need of reserves, fewer banks with excess reserves, banks try to beef up their reserves by making fewer loans thus decreasing deposits and the money supply. 2. Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply. 3. Fed injects more reserves: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply. 4. Fed erases reserves from the system: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply. 5. Banks borrow less from fed more from other banks (increase demand for reserves); banks beef up their reserves (instead of using expensive fed loans for emergencies) (decrease in supply): decrease loans, deposits and money supply. 6. Banks borrow more from fed less from other banks (decrease demand for reserves); banks decrease their excess reserves (instead of using their own, they use cheap fed loans for emergencies) (increase in supply): increase loans, deposits and money supply. 7. Increase in demand for reserves, increase in demand for money. 8. Decrease in demand for reserves, decrease in demand for money 9. Increase in demand for reserves, increase in demand for money. 10. Decrease in demand for reserves, decrease in demand for money.