1. Unit 4: Money, Banking, and Monetary Policy

2. 4.2: The Money Market (Supply and Demand for Money)

3. The Demand for Money
At any given time, people demand a certain amount of liquid assets (money) for two different reasons:
Transaction Demand for Money- People hold money for everyday transactions.
Asset Demand for Money - People hold money since it is less risky than other assets

4. The Demand for Money
What is the opportunity cost of keeping money in your pocket or checking account?
The interest you could be earning from other financial assets like stocks, bonds, and real estate

5. The Demand for Money
1. What happens to the quantity demanded of money when interest rates increase? (Hint: what would you do if tomorrow banks started to pay 20% on interest in savings accounts?)
Quantity demanded falls because individuals would prefer to have interest earning assets instead (the opportunity costs of holding money increased)
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—real estate or stocks may yield a higher return

6. Nominal Interest Rate (ir)
The Demand for Money
Inverse (negative) relationship between interest rates and the quantity of money demanded
Nominal Interest Rate (ir)
Why the nominal interest rate and not the real?
The opportunity cost of holding money includes both:
the real return that could be earned on a bank deposit
the erosion in purchasing power caused by inflation
20% 5% 2% MD
Quantity of Money
(billions of dollars)

7. 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 technology
Nominal Interest Rate (ir)
20% 5% 2%
MD1 MD
Quantity of Money
(billions of dollars) 7

8. 3 Shifters of Money Demand
Change in Aggregate Price Level
If prices go up, you need more money in your wallet or checking account for everyday transactions
If prices go down, you need less so demand for money shifts left
2. Change in Income (real GDP)
As incomes increase, so does the demand for money shifts right
3. Change in Technology or Regulations
For example the wide spread use of credit cards has decreased the demand for money
Or in 1980 when Regulation Q was removed so banks could start paying interest on checking accounts, the demand for money shifted right

9. 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) MS
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% MD
200
Quantity of Money
(billions of dollars)

10. Money Market Graph
Combines the supply of money and the demand for money
(It is one of the 5 key graphs you must know) MS
Interest Rate (ir)
20% 5% 2% MD
200
Quantity of Money
(billions of dollars)

11. The Federal Reserve
Created in 1913, the FED’s job is to regulate banks and make sure people have faith in our financial system 11

12. What are the 3 shifters of the Demand for Money?
Money Demand Shifters
Changes in price level
Changes in income
Changes in technology
Nominal Interest Rate (ir)
20% 5% 2% MD
Quantity of Money
(billions of dollars) 12

13. Are we in an inflationary or recessionary gap
Are we in an inflationary or recessionary gap? What would we need to know when drawing our AS/AD or Phillips Curve?

14. Can a money market graph show inflationary gaps?
Now that we know that the natural rate of unemployment is 4.5 or 5%, draw an AS/AD and Phillips Curve showing our new 4.6% unemployment.
Can a money market graph show inflationary gaps?

15. No.

16. Video: The FED Today

17. Increasing the Money Supply
Interest Rate (ir) MS
MS1
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? MD
200
250
Quantity of Money
(billions of dollars)
Increase money supply
Decreases interest rate
Increases investment
Increases AD

18. Decreasing the Money Supply
Interest Rate (ir)
MS1 MS
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? MD
150
200
Quantity of Money
(billions of dollars)
Decrease money supply
Increase interest rate
Decrease investment
Decrease AD 18

19. Fractional Reserve Banking
When banks hold only a small portion of deposits to cover potential withdrawals and then loans the rest of the money out.
If we all went to the bank to withdrawal money at the same time what would happen?
BANK RUN!

20. Bank Balance Sheets
Demand Deposits- Money deposited in a commercial bank in a checking account
Required Reserves- The percent that banks must hold by law
Excess Reserves- The amount that the bank can loan out
Balance Sheet- A record of a bank’s assets, liabilities, and net worth.
Are demand deposits in a bank an asset or a liability?
Liability for the bank, asset to the depositor

21. Bank Balance Sheet: T-Account
The Simple Case of 100-percent reserve banking
Bank Balance Sheet: T-Account
Assets
Liabilities
Reserves
$100
Deposits
Total Assets
Total Liabilities
No money is being created!!!

22. Fractional Reserve Banking: T-Account
Assets
Liabilities
Loans
$8,000
Demand Deposits
$5,000
Reserves
$500
Owner’s Equity
Treasury Bonds
$1,500
Total Assets
$10,000
Total Liabilities
It is “balanced” because the totals must equal
If the bank is holding no excess reserves, how much is the required reserve ratio?
.1 or 10%

23. Money creation in the banking system
A fractional reserve banking system creates money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.