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THE FEDERAL RESERVE SYSTEM: PART II

THE FEDERAL RESERVE SYSTEM: PART II. Chapter 12 (pgs 364-374). Money Supply and Money Demand: Overview. Changes in the supply of money (MS) interact with the demand for money (MD) to determine the nominal interest rate (i). Changes in the nominal rate of interest (i)

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THE FEDERAL RESERVE SYSTEM: PART II

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  1. THE FEDERAL RESERVE SYSTEM:PART II Chapter 12 (pgs 364-374)

  2. Money Supply and Money Demand: Overview Changes in the supply of money (MS) interact with the demand for money (MD) to determine the nominal interest rate (i).

  3. Changes in the nominal rate of interest (i)  changes in consumption and investment  changes in GDP

  4. Money Supply (MS) MS is under the control of the Federal Reserve. Because the Federal Reserve sets MS, we draw the MS function as a vertical line.

  5. MS Function

  6. where M = quantity of money i = nominal rate of interest

  7. The Federal Reserve can shift MS 1) open market operations 2) changes in the discount rate 3) changes in required reserve ratios

  8. Suppose the Federal Reserve makes an open market purchase of bonds.  MS  MS function shifts outward

  9. MS shift

  10. An open market sale, by the Federal Reserve, will reduce MS. Open market sale  MS  MS function shifts inward

  11. Money Demand Portfolio Allocation Decision—the decision about the forms in which to hold wealth. Demand for Money—the amount of wealth an individual chooses to hold in the form of money—M1.

  12. The money demand curve relates the aggregate quantity of money demanded (MD) to i.

  13. Define MD = demand for nominal money P = the price level (GDP deflator) Y = real income (real GDP) i = nominal rate of interest

  14. MD = f(i,Y,P)

  15. i = nominal interest rate on bonds 1)There are many assets which individuals may hold in place of money (M). 2)We lump together all non-M assets and call them bonds. 3)i is the rate of return on alternative assets.

  16. 4) The higher i, the higher the opportunity cost of holding M.

  17. There is an inverse relationship between i and M. a)  iM b)  i M

  18. Money Demand (MD) Function

  19. The downward sloping MD function shows an inverse relationship between MD and i.

  20. Shifts in MD 1) Changes in Y. 2) Changes in P.

  21. Y—real income 1)MD depends on the level of spending.  spending  MD 2)The level of spending depends mainly on Y. a)  Y  MD b)  Y  MD 3)Changes in Y shift MD.

  22. ↑ Y

  23. P—price level 1) MD depends on the level of spending. 2) The level of spending depends partly on P. a)  P  MD b) P  MD 3) Changes in P shift MD.

  24. ↑ P

  25. Money Market Equilibrium The money market is in equilibrium when the QD for M = QS of M. This is the point where MD and MS intersect.

  26. Money Market Equilibrium

  27. Changes in Money Market Equilibrium 1) MD--- ΔY or ΔP2) MS—Fed actions

  28. Y

  29.  P

  30. MS

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