Interest Rates and Monetary PolicyInterest Rates and Monetary PolicyChapter 14Chapter 14

Starts with the Demand for moneyStarts with the Demand for money• People demand money for transactions People demand money for transactions

and as an assetand as an asset• The cost to get money is in terms of The cost to get money is in terms of

interest (NOTE: in the money market we interest (NOTE: in the money market we write interest as “i” for “interest paid”, write interest as “i” for “interest paid”, remember that the Investment Demand remember that the Investment Demand curve is represented as “r” for “rate of curve is represented as “r” for “rate of return”)return”)

Interest Rates and Monetary PolicyInterest Rates and Monetary PolicyChapter 14 (cont.)Chapter 14 (cont.)

The supply of The supply of money is fixed money is fixed or constant or constant unless The Fed unless The Fed changes it, changes it, therefore the therefore the supply curve for supply curve for money is money is verticalvertical

iMS

i1

Q

MD

Interest Rates and Monetary PolicyInterest Rates and Monetary PolicyChapter 14 (cont.)Chapter 14 (cont.)

The Fed can The Fed can adjust interest adjust interest rates and, by rates and, by extension, extension, investment investment demand demand through through increasing or increasing or decreasing the decreasing the money supplymoney supply

iMS1

i1

Q

MD

i2

i3

MS3MS2

Qm1 Qm3Qm2

Interest Rates and Monetary PolicyInterest Rates and Monetary PolicyChapter 14 (cont.)Chapter 14 (cont.)

i MS1

i1

Q

MDi2

MS2

Qm1 Qm2

r

r1

Q

IDr2

Qi1 Qi2

Money Market Investment Demand

Interest Rates and Monetary PolicyInterest Rates and Monetary PolicyChapter 14 (cont.)Chapter 14 (cont.)

What are The Fed’s most common What are The Fed’s most common ways of manipulating the money ways of manipulating the money supply?supply?• Open-Market OperationsOpen-Market Operations

Buying and selling of securitiesBuying and selling of securities

• The Reserve RatioThe Reserve Ratio• The Discount Rate—the interest rate The Discount Rate—the interest rate

that The Fed charges for banks to that The Fed charges for banks to borrow from The Fedborrow from The Fed

• The Federal Funds Rate—the interest The Federal Funds Rate—the interest rate that banks charge one another to rate that banks charge one another to borrow moneyborrow money

Interest Rates and Monetary PolicyInterest Rates and Monetary PolicyChapter 14 (cont.)Chapter 14 (cont.)

Expansionary Monetary Policy or “Easy Expansionary Monetary Policy or “Easy Money Policy”Money Policy”

Restrictive Monetary Policy or “Tight Restrictive Monetary Policy or “Tight Money Policy”Money Policy”

Draw a money market graph and show the Draw a money market graph and show the result of The Fed selling securities on the result of The Fed selling securities on the market for investment demandmarket for investment demand

Now show how this change in investment Now show how this change in investment demand impacts the macro-economy demand impacts the macro-economy currently operating at the full employment currently operating at the full employment level of output level of output