Supply: banks, Fed

Money

io

Federal Funds Rate

Banks increase lending as interest rates rise because it is more profitable

The Fed manipulates the amount of reserves in the system.

Supply increases

when the Fed injects

reserves

Banks lend more when the interest

rate increases

Wealth can be held in two forms

Wealth

Assets that earn a return

(bonds)

Assets that do not earn a

return (cash/Deposit

s)

The Demand for Money

Tells us “how much of our wealth we want to hold as cash/Deposits

banks”

The Interest Rate

Represents the Cost of holding cash balances…

what you give up…

The Demand for MoneyInterest Rate The higher the i,

the higher the opportunity cost of holding cash/ reserves

The lower the amount of desired cash (deposits)/reserves

i 0

Md0

The Demand for MoneyInterest Rate

The larger the amount of desired cash (Deposits)/reserves.

As the i falls, the opportunity cost of holding cash/reserves decreases

i 1

Md1

The Federal Funds Rate

Supply: banks + Fed

Demand: Public

Money

io

Federal Funds Rate

As interest rate rises bank’s

quantity demanded drops

The Federal Funds Rate

Supply= excess reserves + Fed

changes

Demand = Banks in need of

reserves

Money

io

Federal funds RateBanks need

more reserves when Deposits

increase

Deposits/ Demand for

reserves increase with

more transactions

Deposits/ Demand for

reserves increase when prices increase

What Determines How Much Money we Want to hold as Deposits?

Prices +We need to hold more cash for more expensive transactions

Real Income +We buy more things: we need more cash for more transactions.

Interest rate -The higher the interest rate the less money we want to hold as cash

The higher prices and Income, the higher the need for cash

The higher the interest rate, the lower the demand for cash

Shifts in the Demand for Money

Increase in prices or Incomes (GDP): shift demand to the rightDecrease in prices or incomes (GDP): shift the demand to the left

When Prices Increase

More expensive transactions require larger cash holdings

The demand for money shifts to the right

i 0

Md0

i 1

Md1

At each i we hold more cash than

before

The demand for bank reserves shifts to the right

When Real Income Increases

We engage in MORE transactions which require larger cash holdings.

The demand for bank reserves shifts to the right

i =5%

500 bill.

i =3%

800700 bill.

900

The Federal Reserve Bank ‘Controls’ the Supply of Money

Open Market Operations.

Changes in the Discount Rate

Changes in the required reserve ratio.

The amount of money in circulation is managed by the fed

Supply

Demand

Quantity Bank Reserves

io

Federal Funds Rate Msi

$

The Public ‘controls’ the Demand for money

When prices increase the demand for money increases

When incomes increase the demand for money increases.

Msi

$

Md

Monetary Policy

The Fed determines the “desired level” for the interest rate

The Fed adjusts the Money Supply until the rate hits the target. Via Open Market Operations. Via changes in required reserves. Via changes in discount rate. Via changes in margin requirements. Via moral suasion.

Relationship Between Bond Prices and the Interest Rate

Bond PPrice:$100

Interest Rate: 5%Interest: $5

Peter purchased this

bond

Bond APrice:$100

Interest Rate: 8%Interest: $8

A month later a new bond “A”Is issued into

the market

Which Bond would you buy?

Peter’s? The new bond “A”?

Bond PPrice:$100

Interest Rate: 5%Interest: $5

Bond APrice:$100

Interest Rate: 8%Interest: $8

Clearly A is better than P: same price but higher interest

What price should Peter ask for to convince you to purchase his bond rather than A?

A Price that would make Peter’s bond more attractive

A price so low, that the interest you earn on Peter’s bond is higher than 8%

Peter’s Bond

If you pay $100 for Peter’s Bond

You receive $105 at maturity

Interest Rate = (105 – 100)/100 = 5%

If you pay $90 for Peter’s Bond

You receive $105 at maturity

Interest Rate = (105 – 90)/ 90 = 16.7%

The lower the price, the

higher the interest rate

What price will give us exactly 8% for Peter’s bond?

If you pay $X for Peter’s Bond

You receive $105 at maturity

Interest Rate = (105 – X)/ X

0.08 X = 105 - X

8% = (105 – X)/ X

X(1.08) = 105

0.08 X + X = 105X(0.08 + 1) = 105

X = $97.22

If Peter needs to sell his bond

It must sell it for LESS than

$97.22 to make i >8%

Since he paid $100 for it, he must sell at a loss….

What does this mean?

When interest rates rise: when new bonds come into the market with higher interest

rates…I can still sell old bonds for cash, but I will lose money in the transaction.

When interest

rates rise, bond bond prices drop

The Relationship Between Bond Prices and the Interest Rate

Bond PPrice:$100

Interest Rate: 10%Interest: $10

Peter purchased this

bond

Bond APrice:$100

Interest Rate: 5%Interest: $5

A month later a new bond “A”Is issued into

the market

Clearly P is better than A: same price but higher interest

What price will give us exactly 5% for Peter’s bond?

If you pay $X for Peter’s Bond

You receive $110 at maturity

Interest Rate = (110 – X)/ X

0.05 X = 110 - X

5% = (110 – X)/ X

X(1.05) = 110

0.05 X + X = 110X(0.05 + 1) = 110

X = $104.76

If Peter needs to sell his bond

He can now sell it for MORE than $100

Since he paid $100 for it, he will make a profit ….

When interest

rates fall, bond prices

increase

What does this mean?

When interest rates fall: when new bonds come into the market with lower interest rates…I can sell my bonds at a profit.

Bond MarketSupply of bonds

Demand for bonds

P0

Bond Market: Fed Sells BondsSupply of bonds

Demand for bonds

P0

P1

Bond Price falls: Interest

Rates Increase

Bond Market: Fed Buys BondsSupply of bonds

Demand for bonds

P0

P1

Bond Price rises: Interest

Rates Decrease

Monetary Policy

Changing the Money Supply in order to affect Aggregate

Spending

The Effect of an Increase in the Money Supply

The fed increases Ms by:• Reducing the required reserve ratio (r)• Buying bonds in the Open Market• Reducing the Discount Rate (d)An increase in Ms is represented as a rightward shift in the Money Supply line

i

$

Ms0 Ms

1

When the Fed Wants to Reduce Unemployment

Use Expansionary Monetary Policy

Increase the Money Supply

Decrease the interest rate.

Increase demand for goods and services

The Effect of a Decrease in the Money Supply

The fed decreases Ms by:• Increasing the required reserve ratio (r)• Selling bonds in the Open Market• Increasing the Discount Rate (d)A decrease in Ms is represented as a leftward shift in the Money Supply line

i

$

Ms0Ms

1

When the Fed Wants to Reduce Inflation

Use Contractionary Monetary Policy

Decrease the Money Supply

Increase the interest rate.

Decrease Aggregate Demand

Supply

Demand

Quantity Bank Reserves

ffro

Federal Funds Rate Ms

i

$

Md

Supply of bonds

Demand for bonds

P0

i

Questions to prepare for the testUse a diagram to show the effect on reserves, the money

supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step.

1. The fed increases/decreases the required reserve ratio

2. The fed buys/sells bonds in the open market

3. Fed increases/decreases the discount rate.

4. Prices increase/decrease

5. Incomes decrease/decrease

EventDemand

for Reserves

Supply of Reserves

Federal Funds Rate

BanksLoan

sDeposits Md/Ms

Interest Rate(i)

Increase in Required Reserve Ratio (r)

b       1     Ms    

Decrease in Required Reserve Ratio (r)

b     2      Ms   

Buy Bonds   b    3      Ms  

Sell Bonds   b    4     Ms    

Increase in Discount Rate

  b    5       Ms  

Decrease in Discount Rate

  b     6       Ms  

Increase in Prices   same     7      Md  

Decrease in Prices   same    8      Md  

Increase in Incomes (GDP) An economic Expansion

  same     9      Md   

Decrease in Incomes (GDP) Economic Recession

  same     10      Md    

1. More banks in need of reserves, fewer banks with excess reserves, banks try to beef up their reserves by making fewer loans thus decreasing deposits and the money supply.

2. Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply.

3. Fed injects more reserves: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply.

4. Fed erases reserves from the system: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply.

5. Banks borrow less from fed more from other banks (increase demand for reserves); banks beef up their reserves (instead of using expensive fed loans for emergencies) (decrease in supply): decrease loans, deposits and money supply.

6. Banks borrow more from fed less from other banks (decrease demand for reserves); banks decrease their excess reserves (instead of using their own, they use cheap fed loans for emergencies) (increase in supply): increase loans, deposits and money supply.

7. Increase in demand for reserves, increase in demand for money.8. Decrease in demand for reserves, decrease in demand for money9. Increase in demand for reserves, increase in demand for money.10. Decrease in demand for reserves, decrease in demand for money.