The Money Market
and Monetary Policy
Unit 4 Lesson 5
Activity 39-40
Goodman, Jean B. U.S. Naval Academy
Advanced Placement Economics Teacher
Resource Manual. National Council on
Economic Education, New York, N.Y
Objectives
• Define transactions demand for money,
precautionary (liquidity) demand for money and
the speculative demand for money and explain
how each affects the total demand for money.
• Discuss the motives for holding assets as money.
• Identify the factors that cause the demand for
money to shift and explain why the shift occurs.
• Explain how interest rates are determined in the
money market.
• Describe Federal Reserve policy and the interest
rate.
• Explain how interest rates affect monetary policy.
Introduction and Description
• In this lesson, the demand for and supply of
money are brought together in the money
market.
• The effects of the federal Reserve System’s
monetary policy are integrated into the money
market and then linked to aggregate demand.
• In Activity 39, you will practice manipulating the
money market and understand the impact of the
Fed’s actions in this market.
• Activity 40. provides practice in relating monetary
policy to changes in the monetary variables such
as the federal funds rate, the money supply and
velocity.
• Individuals are faced with a simple
decision; how much of their wealth
do they want to hold as money and
how much do they want to hold as
interest-bearing assets?
• If you hold money, you are forgoing
the interest you could earn on the
money in an interest –bearing asset.
Money Demand
There is an opportunity cost of holding money:
The forgone interest
The visual shows that as the
interest rate decreases from r
to r1, the amount of money
held by people increases from
MD to MD1.
• The demand for money also depends on the price
level and on the level of real GDP or real income.
• If prices double, a person will need twice as much
money to buy groceries or other goods and services.
• People are most concerned with the real value of
income: what the income can buy or its purchasing
power. As income rises. The demand for money
increases.
• To complete the money market, we now add the
supply of money, which is determined by the
Federal Reserve through its tools.
• The diagram shows the money market.
• What happens to the
interest rate as prices
rise?
• (MD increases and the
interest rate rises)
• Income increases (MD
increases and the
interest rate rises)
• Or, the money supply
increases (interest
rate decreases)
The Money Market
• The money market consists of the demand
for money and the supply of money.
• We generally assume that the Federal
Reserve determines the supply of money.
Thus, the supply of money is a vertical
line.
• The demand for money is based on a
decision of whether to hold your wealth in
the form of interest bearing assets
(savings accounts, stocks, etc.) or as
money (noninterest bearing).
• The demand for money is a function
of interest rates and income, and is
determined by three motives:
– Transaction demand – the demand
for money to make purchase of goods
and services
– Precautionary demand – the demand
for money to serve as protection against
an unexpected need.
– Speculative demand – the demand for
money because it serves as a store of
wealth.
• The interest rate represents the
opportunity cost of holding money; that is,
the interest rate represents the forgone
income you might have made had you
held an interest-bearing asset.
• Thus, the demand for money has an
inverse relationship with the interest rate.
• The demand curve represents the demand
for money at various levels of the interest
rate for the given income level (GDP).
• The graph of the money market
looks like this:
Activity 39: Money Market
1. Suppose the Federal Reserve increases
the money supply by buying Treasury
securities.
A. What happens to the interest rate?
The interest rate decreases
B. What happens to the quantity of money
demanded?
The quantity of money demanded increases
C. Explain what happens to loans and interest
rates as the fed increases the money supply.
As the Federal Reserve buys treasury securities from
the public, demand deposits in financial institutions
increase. Thus, financial institutions have more
money to make loans. To encourage people to take
out the loans, the financial institutions lower the
interest rate.
If the Federal Reserve increases the money
supply by buying Treasury securities
Interest
Rate
MS
MS1
r
r1
MD
M
M1
Money
2. Suppose the demand for money
increases.
A. What happens to the interest rate?
The interest rate increases
B. What happens to the quantity of
money supplied?
The quantity of money supplied remains
the same as shown by the vertical
money supply curve.
C. If the fed wants to maintain a consent
interest rate when the demand for
money increases, explain what policy the
Fed needs to follow and why.
It must increase the money supply to
meet the increase in the demand for
money.
D. Why might the Fed want to maintain a
constant interest rate?
To stabilize the amount of investment in
the economy.
Suppose the demand for money
increases.
Interest
Rate
MS
r1
MD1
MD
r
M
Money
Alternative Money Demand Curves
3. Suppose there are two money demand
curves – MD and MD1 – and the Fed
increases the money supply from MS to
MS1
Interest
Rate
MS
MS1
r
r1
MD
MD1
M
M1
Money
A. Compare what happens to the
interest rate with each MD curve.
The interest rate declines further with the
more inelastic money demand curve
(MD1) than with the more elastic money
demand curve (MD).
Interest
Rate
MS
MS1
r
r1
MD
MD1
M
M1
Money
B.
Explain the effect of the change in the money supply on
C, I, real output and P. Would there be a difference in the
effects under the two different money demand curves? If
so, explain.
With either demand curve, the increase in supply will
cause interest rates to decline and investment and
consumption – and us real output – to increase. AD
increases, so prices are likely to increase (or decrease)
with a greater decrease (or increase) in the interest
rate.
For example: a large
Interest
Rate
decrease in interest rates
MS1
MS
will usually lead to a
greater increase in
investment. The increase in
r
investment will increase AD.
Then, the increase in the
money supply will lead to
r1
MD
an increase in AD, which
MD1
will lead to an increase in
Money
real output and in prices.
M
M1
C. How would you describe, in economic
terms, the difference between the two
money demand curves?
MD1 is more interest inelastic than MD
Interest
Rate
MS
MS1
r
r1
MD
MD1
M
M1
D. If the federal Reserve is trying to get the
economy out of a recession, which money
demanded curve would it want to represent the
economy? Explain.
The fed would prefer the more inelastic
money demand curve because a given
increase in the money supply will lead to
a grater decrease in interest rates, which
should stimulate the economy.
Interest
Rate
MS
MS1
r
r1
MD
MD1
M
M1
The Money Market, Investment
and Aggregate Demand
• Given the demand for money, by
controlling the money supply, the
Federal Reserve controls the interest
rate in the short run.
• The interest rate affects the level of
investment and a portion of the level
of consumption.
• An increase in the money supply (MS
to MS1) causes the interest rate to
decrease (r1 to r) and investment (I
to I1) and consumption to increase.
• In turn, AD increases (AD to AD1)
• Explain step-by-step what happens in the
economy once the federal Reserve decides
to increase (decrease) the money supply.
(Note: An increase in bond prices leads to
a decrease in the interest rate.)
Fed purchases Treasury securities → bond prices
increase to entice households and businesses to
sell Treasury securities → Money supply
increases and interest rate decreases →
Investment increases (and interest-sensitive
components of consumption increase) → AD
increases → Output increases and the price level
increases.
The Federal Reserve: Monetary Policy
and Macroeconomics: Activity 40
1. What is monetary policy?
Monetary policy is action by the federal
Reserve to increase or decrease the
money supply to influence the economy.
2. From 1998 to 2002, what was the
dominant focus of monetary policy
and why?
From 1998 to 2001, the focus of monetary
policy was to slow the growth of the
economy to prevent an increase in
inflation. In 2001 and 2002, the focus
was to stimulate the economy w/out
stimulating inflation. (Much like 2009!)
3. Explain why the money supply and
short-term interest rates are
inversely related.
When the fed buys Treasury securities from
the public, bank reserves increase. To
decrease excess reserves and make loans,
banks lower the interest rate to entice
consumers and businesses to borrow
4. What are some reasons for lags and
imperfections in data used by
central banks?
Financial institutions report at specified
periods, and the reporting time is not
necessarily when the central bank can use
the data. For short periods of time, the
central bank collects data from only a
sample of banks, and this leads to a certain
amount of error in the data.
5. Why do many economists believe
that central banks have more
control over the price level than
over real output?
Many economists believe that real output
is determined by the level of capital stock
and the productivity of workers. Thus,
changes in the money supply affect prices
more than real output.
6. What might cause velocity to
change?
Some factors that might cause velocity to
change are changes in how money is
transferred (institutional changes),
changes in interest rates and changes in
the price level.
7. If velocity were extremely volatile,
why would this complicate the job
of making monetary policy?
One of the rules of monetary policy is
stabilization of the price level. Thus,
based on the equation of exchange (MV =
PQ), changes in the money supply will
yield a given change in PQ if velocity (V)
is constant. If velocity is volatile,
changes in the money supply may be
either too small or too large, leading to
inflation.
8. What role does the money
multiplier play in enabling the Fed
to conduct monetary policy?
The money multiplier times the change in
excess reserves yields the change in the
money supply. Thus, if the Fed wants to
change the money supply by a given
amount, the money multiplier indicates by
how much the excess reserves need to be
changed.
9. What is the fed funds rate?
The interest rate that financial
institutions charge other financial
institutions for short-term borrowing
10.What happens to the fed funds rate
if the fed follows a contractionary
(tight money) policy?
The federal funds rate increases.
11.What happens to the fed funds rate
if the Fed follows an expansionary
(easy money) policy?
The federal funds rate decreases.
12.Why do observers pay close
attention to the federal funds rate?
It is an early indicator of monetary policy
and provides a forecast of the direction
for other interest rates and the Fed policy.