The Money Market Graph and the 3 Policy Tools that Change the Money

Supply

Monetary Policy

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

This graph is known as THE MONEY MARKET GRAPHWhen the Federal Reserve conducts a Monetary Policy this Is the FIRST market that is affected.

Notice that the Money Supply (MS*) curve is VERTICAL

This is because the Quantity of Money in circulation is FIXED At any given time. This measure of the Quantity of Money is The M1 Money Supply

The M1 Money Supply is the MOST liquid form of The Money Supply (Cash, Checkable Deposits, Travelers Checks). IMPORTANT NOTE!!!When the Federal Reserve conducts a Monetary PolicyIt is changing, either INCREASING or DECREASING, The M1 Money Supply!!

The M1 Money Supply is the MOST liquid form of The Money Supply (Cash, Checkable Deposits, Travelers Checks). IMPORTANT NOTE!!!When the Federal Reserve conducts a Monetary PolicyIt is changing, either INCREASING or DECREASING, The M1 Money Supply!!

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

The Money Market graph is used to Illustrate SHORT-TERM Interest Rates.

SHORT-TERM interest rates are established , well, in The short-term, so Inflation (in terms of the interest Rate) is not a factor.

Hence, we call this Interest Rate the NOMINAL INTEREST RATE.

There are MANY short-term interest rates in the financial system, but we will be concerned with only one: The FEDERAL FUNDS RATE

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

The FEDERAL FUNDS RATE is ONE of TWO interest rates that the Federal Reserve has DIRECT control over. It is defined as the Interest Rate Banks charge EACH OTHER to BORROW money from EACH OTHER.

It is also know as the Overnight Lending Rate.

For our purposes, equate the Nominal Interest Rate with the Federal Funds Rate: When The Nominal Interest Rate changes so does the Federal Funds Rate.

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

First we are going to examine what shifts the Money Supply Curve in the Money Market

ANY OF THE FOLLOWING MONETARY POLICIES CAN SHIFT THE MONEY SUPPLY CURVE:

1.Open Market Operations (OMO’s)1. Buy Bonds – Federal Reserve

buys (purchases) bonds on the open market. This INCREASES the Money Supply

i1

Qms1

The result of this OMO DECREASES the Nominal Interest Rate(Federal Funds Rate). Borrowing between banks is now Less expensive. More money in flowing into the financialSystem. This sends a POWERFUL signal to the financial System that the supply of money has INCREASED and they Should adjust their interest rates LOWER.

MS1

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

First we are going to examine what shifts the Money Supply Curve in the Money Market

ANY OF THE FOLLOWING MONETARY POLICIES CAN SHIFT THE MONEY SUPPLY CURVE:

1.Open Market Operations (OMO’s)1. Sell Bonds – Federal Reserve

sells bonds on the open market. This DECREASES the Money Supply

i1

Q1

The result of this OMO INCREASES the Nominal Interest Rate(Federal Funds Rate). Borrowing between banks is now MORE expensive. More money in flowing OUT of the financialSystem. This sends a POWERFUL signal to the financial System that the supply of money has DECREASED and they Should adjust their interest rates HIGHER.

MS1

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

First we are going to examine what shifts the Money Supply Curve in the Money Market

ANY OF THE FOLLOWING MONETARY POLICIES CAN SHIFT THE MONEY SUPPLY CURVE:

2.Change the DISCOUNT RATEThe Discount Rate is the Interest

Rate theFederal Reserve charges banks to

BORROWFROM the Federal Reserve.

i1

MS1

Qms1If the Federal Reserve DECREASES the DiscountRate then Banks will tend to BORROW MORE From the Federal Reserve. This money will Go into the banks EXCESS RESERVES to be loanedOut and the money supply will INCREASE.

THE NOMINAL INTEREST RATE WILL DECREASE

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

i1

Q1 If the Federal Reserve INCREASES the DiscountRate then Banks will tend to BORROW LESS From the Federal Reserve. This money will DECREASE the money in the banking systems EXCESS RESERVES . There will be LESS money toBe loaned out. The money supply will DECREASE

THE NOMINAL INTEREST RATE WILL INCREASE

If the Federal Reserve INCREASES the DiscountRate then Banks will tend to BORROW LESS From the Federal Reserve. This money will DECREASE the money in the banking systems EXCESS RESERVES . There will be LESS money toBe loaned out. The money supply will DECREASE

THE NOMINAL INTEREST RATE WILL INCREASE

First we are going to examine what shifts the Money Supply Curve in the Money Market

ANY OF THE FOLLOWING MONETARY POLICIES CAN SHIFT THE MONEY SUPPLY CURVE:

2.Change the DISCOUNT RATEThe Discount Rate is the Interest

Rate theFederal Reserve charges banks to

BORROWFROM the Federal Reserve.

MS1

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

First we are going to examine what shifts the Money Supply Curve in the Money Market

ANY OF THE FOLLOWING MONETARY POLICIES CAN SHIFT THE MONEY SUPPLY CURVE:

3. Change the Required Reserve Ratio The Required Reserve is the amount that banks are required to with-hold from EACH deposit they receive . Expressed as a percentage.

i1

Qms1 If the Federal Reserve DECREASES the Required Reserve Ratio then banks will have LESS in R.R. and MORE in EXCESS RESERVES. This money will go into the banks EXCESS RESERVES to be loaned out and the money supply will INCREASE.

THE NOMINAL INTEREST RATE WILL DECREASE

MS1

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money

i1

Q1

First we are going to examine what shifts the Money Supply Curve in the Money Market

ANY OF THE FOLLOWING MONETARY POLICIES CAN SHIFT THE MONEY SUPPLY CURVE:

3. Change the Required Reserve Ratio The Required Reserve is the amount that banks are required to with-hold from EACH deposit they receive . Expressed as a percentage.

If the Federal Reserve INCREASES the Required Reserve Ratio then banks will have MORE in R.R. and LESS in EXCESS RESERVES. This will DECREASE the money in EXCESS RESERVES to be loaned out and the money supply will DECREASE.

THE NOMINAL INTEREST RATE WILL INCREASE

MS1

Monetary Policy and the Money Market Graph

If the Economy is in a Recession the Federal Reserve would do the following to DECREASE the Nominal Interest Rates (Federal Funds Rate)BUY BONDS, DECREASE THE REQUIRED RESERVE RATIO,

DECREASE THE DISCOUNT RATEThese all serve to INCREASE the money supply in the banking

system

The Federal Reserve is pursuing an EXPANSIONARY MONETARY POLICY

DECREASING the Nominal Interest Rate sends a powerful signal to the bankingSystem that they should DECREASE their interest rates. This will encourage consumers to borrow money to buy houses, cars, other consumer goods, etc. It will encourage businesses to borrow money to buy or replace capital equipment, expand facilities, build new facilities, etc (thus ADDING to the Capital Stock It will DEPRECIATE the dollar in the FOREX, making EXPORTS LESS expensive for foreigners to buy.

REAL GDP WILL INCREASE

Monetary Policy and the Money Market Graph

If the Economy is experiencing Inflation the Federal Reserve would do the following to INCREASE the Nominal Interest Rates (Federal Funds Rate)SELL BONDS, INCREASE THE REQUIRED RESERVE

RATIO, INCREASE THE DISCOUNT RATEThese all serve to DECREASE the money supply in

the banking systemThe Federal Reserve is pursuing a CONTRACTIONARY MONETARY POLICY

INCREASING the Nominal Interest Rate sends a powerful signal to the bankingSystem that they should INCEASE their interest rates. This will DISCOURAGE consumers from borrowing money to buy houses, cars, other consumer goods, etc. It will DISCOURAGE Businesses from borrow money to buy or replace capital equipment, expand facilities, Build new facilities, etc (thus SUBTRACTING from the Capital Stock It will APPPRECIATE the dollar in the FOREX, making EXPORTS MORE expensive for foreigners to buy.

REAL GDP WILL DECREASE

Money Market

MS*

i*

Money Demand (MD*)

Q*ms

NominalInterestRate

Quantity of Money