How does a change in money supply affect the economy? Relevant reading: Ch 13 Monetary policy

The central bank of the United States The Federal Reserve System

Clearing checks between private banks Holding bank reserves Providing currency Providing loans Functions of the Fed

Reserve requirement Discount rates Open market operations Monetary tools

The legal minimum amount of reserves a bank is required to hold; equal to required reserve ratio times deposits Required reserves

rd increases  excess reserves decreases and money multiplier decreases  money supply decreases rd decreases  excess reserves increases and money multiplier increases  money supply increases Required reserve ratio and money supply

The rate of interest the Fed charges for lending reserves to private banks Discount rate increases  excess reserves decreases  money supply increases Discount rate decreases  excess reserves increases  money supply decreases Discount rate

Open market purchase- the operation in which the Fed purchases government securities from the public to increase bank reserves Open market sale- the operation in which the Fed sells government securities to the public to decrease bank reserves Open market operations

The Fed buys $1000 worth of government securities from the public. The Fed writes a check to pay for the purchase. The seller deposits the check into the banking system Example: Open market purchase

Assuming rd= 0.1 Change in money supply = $1,000 x 1/0.1 = $1,000 x 10 = $10,000 Example: Open market purchase

The Fed sells $1000 worth of government securities from the public. The buyer withdraws money from the banking system to pay for the securities Example: Open market sale

Assuming rd= 0.1 Change in money supply = -$1,000 x 1/0.1 = -$1,000 x 10 = -$10,000 Example: Open market sale

Open market purchase- excess reserves increases, money supply increases Open market sale- excess reserves decreases, money supply decreases Open market operation and money supply

Money market Money demand – The quantity of money people are willing to hold at alternative interest rates, holding other things constant. Money supply- money stock available in an economy.

Money demand Interest rates as the price of money

Other determinants of money demand 1 Wealth Income Liquidity of alternative assets Risk of other assets Payment technology

Other determinants of money demand 2 As wealth decreases, money demand decreases As income decreases, money demand decreases As liquidity of alternative assets increases, money demand decreases As risk of other assets decreases, money demand decreases As payment technology allows transaction to be carried out without money, money demand decreases. Example: credit cards

Change in Money Demand 1 Households’ wealth increases

Change in Money Demand People become less risk averse to alternative assets such as stocks

Money Supply Assumed as exogenous

E.g. an open market purchase (to increase the money supply)

Money market equilibrium

Example: An increase in wealth i1

Example: The Fed raises the discount rate

Example: The Fed lowers required reserve ratio

Example: The Fed carries out open market purchase

Interest rates and the economy Interest rates decreases  investment increases  AD increases Interest rates increases  investment decreases  AD decreases

The effect of an expansionary policy- increasing money supply

The effect of a contractionary policy- decreasing money supply