Interest Rates and Monetary Policy Chapter 14

1. Interest Rates and Monetary PolicyChapter 14 • Starts with the Demand for money • People demand money for transactions and as an asset • The cost to get money is in terms of interest (NOTE: in the money market we write interest as “i” for “interest paid”, remember that the Investment Demand curve is represented as “r” for “rate of return”)

2. Interest Rates and Monetary PolicyChapter 14 (cont.) • The supply of money is fixed or constant unless The Fed changes it, therefore the supply curve for money is vertical MS i i1 MD Q

3. Interest Rates and Monetary PolicyChapter 14 (cont.) • The Fed can adjust interest rates and, by extension, investment demand through increasing or decreasing the money supply MS2 MS1 MS3 i i2 i1 i3 MD Qm2 Qm1 Qm3 Q

4. Interest Rates and Monetary PolicyChapter 14 (cont.) Money Market Investment Demand MS1 MS2 r i i1 r1 i2 r2 MD ID Qm1 Qm2 Q Qi1 Qi2 Q

5. Interest Rates and Monetary PolicyChapter 14 (cont.) • What are The Fed’s most common ways of manipulating the money supply? • Open-Market Operations • Buying and selling of securities • The Reserve Ratio • The Discount Rate—the interest rate that The Fed charges for banks to borrow from The Fed • The Federal Funds Rate—the interest rate that banks charge one another to borrow money

6. Interest Rates and Monetary PolicyChapter 14 (cont.) • Expansionary Monetary Policy or “Easy Money Policy” • Restrictive Monetary Policy or “Tight Money Policy” • Draw a money market graph and show the result of The Fed selling securities on the market for investment demand • Now show how this change in investment demand impacts the macro-economy currently operating at the full employment level of output