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CHAPTER 13

CHAPTER 13. Role of money. Chapter Outline. Measures of money supply Deposit multiplier Tools of monetary policy Equilibrium in money markets. Measures of money supply. M 1 = Currency + Checking at deposits + traveler’s checks

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CHAPTER 13

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  1. CHAPTER 13 Role of money

  2. Chapter Outline • Measures of money supply • Deposit multiplier • Tools of monetary policy • Equilibrium in money markets

  3. Measures of money supply M1 = Currency + Checking at deposits + traveler’s checks M2 = M1 + Saving acounts + Small time deposits + money market mutual funds M3 = M2 + Large time deposits + institutional money funds + purchase agreements + euro dollars Table 13-1 pg. 384 (read the details)

  4. Deposit multiplier Deposit Multiplier = 1/rr Where rr = reserve requirements • The higher the reserve requirements the smaller the deposit multiplier

  5. Tools of monetary policy • Discount rate • Higher discount rate results in lower money supply and contraction in the economy • Other important rates • Prime rate • Federal funds rate

  6. Tools of monetary policy Cont… • Open market operations (OMOS) • OMOS are carried out by federal open market committee (FOMC) by selling and buying government securities • Selling of government securities by the FED, will reduce money supply in the economy

  7. Tools of monetary policy Cont… • Reserve requirements • Raising reserve requirements has a contractionary effect on the economy • This tool is used with a lot of caution because it results in a significant change in money-supply and affects financial markets

  8. Tools of monetary policy Cont… • Discount rate • Discount rate refers to the rate the federal reserve bank charges banks who borrow reserves at the Fed’s discount window • Discount rate is set by the Fed • An Increase in discount rate • Makes borrowing by the banks more expensive and reduces bank reserves • Results in a contractionary monetary policy

  9. Tools of monetary policy Cont… • Other rates • Federal funds rate - interest rate that commercial banks charge each other for loans of reserves to meet their minimum reserve requirements • Federal funds rate is targeted by Fed. Fed’s actions (open market operations) affect the federal funds rate. This rate affects other short-term rates • Prime rate – The interest rate that banks charge on loans to their best customers. It is based on the discount rate set by the Fed.

  10. Equilibrium in money markets • Supply of money Real money supply = Nominal money supply = Ms Price level P RLMS = f(r,MS, P) r MS/P • Real money – supply does not change with the changes in real interest rate

  11. Demand for Money • RLMD = MD/P = f [r,y] • Interest rate represents the opportunity cost of holding money. At higher interest rates, people hold less money and vice versa r MD/P

  12. Equilibrium MS Price of Bond is inversely related to interest rate E r Md O

  13. Changes in Equilibrium Real Ms Real Ms’ • Increase in money supply creates excess money supply i.e. demand for money is less than the amount of money supplied • D - for bonds increases • P - of bonds increase • Interest rate goes down Change in Money Supply E1 r1 E2 r2 Real Md

  14. Changes in Equilibrium Real Ms • Increase in demand for money results from an increase in real income (Y). • People want to hold more of their assets as money • They sell their bonds. This results in lower bond prices and higher interest rates. E2 r2 Change in Demand for money E1 Md2 r1 Md1

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