Unit 4: Money and

Monetary Policy

1

The Money Market(Supply and Demand for Money)

2

3

Interest Rates are important

• Way to protect our money from the effects of inflation

• Opportunity cost for holding money (keeping money in our wallets) is the interest your money would have earned if you put it in the bank.

• Interest rates that banks pay you for your deposits are related to the interest rates that banks charge when they loan money out.

• When we look at the relationship between the demand for money and interest rate we are looking at short-term rates

4

The Demand for MoneyAt 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 demanded1. What happens to the quantity demanded of money when interest rates increase?

Quantity demanded falls because individuals would prefer to have interest earning assets instead2. What happens to the quantity demanded when interest rates decrease?Quantity demanded increases. There is no incentive

to convert cash into interest earning assets 5

Nominal Interest Rate

(ir)

Quantity of Money(billions of dollars)

20%

5%

2%

0

DMoney

Inverse relationship between interest rates and the quantity of money demanded

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The Demand for Money

Quantity of Money(billions of dollars)

20%

5%

2%

0

DMoney

What happens if price level increase?

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The Demand for Money

DMoney1

Money Demand Shifters1. Changes in price level2. Changes in income/ Changes in Real

GDP3. Changes in taxation that affects

investment4. Changes in banking technology (ATMs)5. Changes in banking institutions (interest

on checking)

Nominal Interest Rate

(ir)

200

DMoney

SMoneyThe FED is a nonpartisan

government office that sets and adjusts the money supply to

adjust the economy

This is called Monetary Policy.

The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED)

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The Supply for Money

20%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

Supply and Demand is important

• The equilibrium interest rate is determined by the supply and demand for money

• This is called the liquidity preference model of the interest rate

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Monetary Policy

10

When the FED adjusts the money supply to achieve the macroeconomic goals

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%

Increasing the Money Supply

Increase money supply

Decreases interest rate

Increases investment

Increases AD 11

200

DM

SM

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

How does this affect AD?

250

SM1

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%

Decreasing the Money Supply

Decrease money supply

Increase interest rate

Decrease investment

Decrease AD 12

200

DM

SM

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

How does this affect AD?

150

SM1

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2007B Practice FRQ (Do a. and b. only)

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2007B Practice FRQ

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2007B Practice FRQ

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