AP Macro 4-2 Money Market and Monetary Policy
Unit 4:
Money and
Monetary Policy
1
The Money Market
(Supply and Demand for Money)
2
The Demand for Money
At any given time, people demand a certain amount of liquid assets (money) for everyday purchases
The Demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded
1. What happens to the quantity demanded of money when interest rates increase?
Quantity demanded falls because individuals would prefer to have interest earning assets instead
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
3
The Demand for Money
Inverse relationship between interest rates and the quantity of money demanded
Nominal
Interest Rate
(ir)
20%
5%
2%
0
D
Money
Quantity of Money
(billions of dollars) 4
The Demand for Money
What happens if price level increase?
Nominal
Interest Rate
(ir)
20%
Money Demand Shifters
1. Changes in price level
2. Changes in income
3. Changes in taxation that affects investment
5%
2%
0
D
Money1
D
Money
Quantity of Money
(billions of dollars) 5
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)
S
Money
20%
5%
The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy
This is called Monetary
Policy.
2%
200
D
Money
Quantity of Money
(billions of dollars)
6
Monetary Policy
When the FED adjusts the money supply to achieve the macroeconomic goals
7
Interest
Increasing the Money Supply
Rate (ir)
S
M
S
M1
If the FED increases the money supply, a temporary
10%
5% surplus of money will occur at 5% interest.
The surplus will cause the interest rate to fall to 2%
2%
Increase money supply
200
How does this affect AD?
D
M
250
Quantity of Money
(billions of dollars)
Decreases interest rate
Increases investment
Increases
AD
8
Decreasing the Money Supply
Interest
Rate (ir)
S
M1
S
M
If the FED decreases the
10%
5% money supply, a temporary shortage of money will occur at 5% interest.
The shortage will cause the interest rate to rise to 10%
2%
How does this affect AD?
D
M
150
Decrease money supply
200
Quantity of Money
(billions of dollars)
Increase interest rate
Decrease investment
Decrease AD
9
10
Video: The FED Today
11
2007B Practice FRQ
12
2007B Practice FRQ
13
2007B Practice FRQ
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