Monetary Policy

• Draw a correctly labeled graph of the Money Market.

• What happens to equilibrium interest rate if the Fed buys bonds from the public?

• Nominal interest rates determine the demand for money.

• What other factors will shift the demand curve for money?

• What determines the Supply of money?• The purpose of monetary policy it to

influence the economy:– Prevent or address extreme economic

fluctuations– Manipulate the money supply

Monetary Policy and the Money Market

• Fed uses MP to influence equilibrium interest rates through the control of bank reserves.

• Expansionary Policy ( recessions)• Contractionary Policy ( inflation)• MP is counter-cyclical• Fed actions translate into changes in money

market, loanable funds market, AS/AD, RGDP

Monetary Policy and the Money Market

Monetary Policy and the Money Market

• Changes in monetary policy will change the money market, which in turn changes AS/AD

• Expansionary: (Fed buys bonds)

• MS i I/C RGDP and PL • Contractionary: (Fed sells bonds) • MS i I/C RGDP and PL

• Activity 4-7

• Nominal rate is the rate that is reported, that you receive or have to pay: current rate or NOW rate

• Real rate is the increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future: adjusted for inflation.

Nominal and Real Interest Rates

Nominal and Real Interest Rates

• Two relationships between real and nominal rates:

• Expected real interest rate– the nominal minus the expected rate of inflation

• Actual real interest rate– nominal minus the actual rate of inflation

• The actual real interest rate will equal the expected real interest rate if the expected rate was accurately anticipated.

• Describes the relationship between real and nominal interest rates

• r = i p• r is the real interest rate• i is the nominal interest rate• p is the inflation rate• In the short run increase in the MS will decrease the

nominal and the real interest rates.• In the long run increase in the MS will result in an

increase in the price level and only the nominal interest rate.

The Fisher Equation

THE QUANTITY THEORY OF MONEY

MV=PQ • The equation of exchange • Defines the relationship between money and economic

activity• Changes in the money supply are translated into changes

in nominal GDP, prices and output

The Quantity Theory of Money

• MV=PQ• M - money supply• V - income velocity• P - price level• Q - real output• “Where’s George”

The Quantity Theory of Money

• The equation of exchange is an accounting definition and is always true.

• Velocity is highly stable evidence suggests, although this is not an undisputed idea.

• Changes in money supply result in changes in nominal GDP (PXQ)

The Quantity Theory of Money

• Depending on the conditions in the economy, the change in the money supply can result in:• Change in P only• Q only• Combination of P and Q

• Factors that may affect velocity:• technology has led to increases in

electronic transfers• How often people are paid

The Quantity Theory of Money

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