Eco 6351Economics for Managers

Chapter 14. Monetary Policy

Prof. Vera Adamchik

In Chapter 14 we will focus on:

• The Demand for Money

• Interest Rate Determination

• Controlling the Money Supply

• Monetary Policy

The Demand for Money• Money is a stock - an inventory.

• There is a limit to how much money we want to hold.

• The quantity of real money that people plan to hold depends on the interest rate.

• The quantity of money demanded varies inversely with the interest rate.

• Figure shows the demand for money curve.

• A change in the interest rate brings a movement along the demand curve.

The Demand for Money

• The Federal Reserve Bank determines the supply of money.

• At any given point of time, the supply of money is fixed. It is represented by the vertical line labeled MS.

The Supply of Money

• The interest rate is determined such that the quantity of money demanded equals the quantity supplied.

Interest Rate Determination

The Federal Reserve System

• The Central Bank of the U.S. is the Federal Reserve System.

• A central bank is a bank’s bank; it is not a citizens’ bank.

• The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation.

• The Fed uses three main policy tools to achieve its objectives. They are:– required reserve ratios

– discount rate

– open market operations

• A decrease in the money supply raises interest rates.

• An increase in the money supply lowers interest rates.

Monetary Policy Tools

Influencing Interest Rates

• Initially, the money supply curve is MS0.

• The interest rate is 5 percent.

Influencing Interest Rates

• Suppose the Fed increases the money supply MS1.

• The interest rate falls to 3 percent.

Influencing Interest Rates

• Suppose the Fed decreases the money supply MS2.

• The interest rate rises to 7 percent.