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Understanding Monetary Policy & Money Market Equilibrium

Learn how the Fed adjusts the money supply through open market operations, the role of T-bills, the money multiplier effect, and shifts in supply & demand in the money market. Discover the relationship between interest rates, real GDP, and inflation. Practice interpreting shifts in the loanable funds market in various economic scenarios.

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Understanding Monetary Policy & Money Market Equilibrium

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  1. Warm-Up The Fed wishes to decrease the money supply from $353 billion to $303 billion by open market operations (assuming a 10% required reserve ratio). • Will the Fed buy or sell T-bills? • What is the money multiplier? • What is the value of T-bills that need to be bought/sold?

  2. Fed and M1 Summary

  3. The Money Market Chapter 31: Monetary Policy (pages 832-841)

  4. Demand for Money • Downward sloping

  5. Supply of Money • Fixed in the short run • Vertical line at M* MS Interest Rate (r) Quantity of Money M*

  6. Money Market • Short-run interest rates • Determined by S&D for money • Assumes: • Opportunity cost of money = interest rate • Inflation = 0% • Money supply fixed in short-run

  7. Money Market Equilibrium

  8. Shifts in Demand • Changes in aggregate prices • prices = need for money • Shifts MD to the  • Changes in Real GDP • GDP = consumption • Shifts MD to the 

  9. Shifts in Supply • Open Market Committee sets target • Adjusts MS to help reach target MS1 MS2 r E1 r1 E2 r2 MD1 Quantity of $ M1 M2

  10. BRAIN BREAK!!

  11. Loanable Funds Market Chapter 26: Savings, Investment, and the Financial System (pages 678-684)

  12. Loanable Funds Market • Price is the REAL INTEREST RATE • Determined by supply and demand Interest Rate (r) Quantity of Loanable Funds

  13. Demand for Loanable Funds • Based on RATE OF RETURN •  r =  profit =  funds demanded

  14. Supply of Loanable Funds • Represents forgone consumption •  r =  funds supplied

  15. Equilibrium …

  16. Shifts of Demand • D business opportunities • D government borrowing

  17. Shifts of Supply • D private savings • D capital inflows

  18. Practice… • Draw correctly-labeled graphs if: • Fed chairman testifies that he expects the economy to significantly improve soon • Households fear an imminent recession and cut back on discretionary spending • Federal government announces a budget surplus • Flow of foreign financial capital into American financial markets decreases

  19. Putting Things Together… • Interest rates in the short run… S1 MS1 MS2 r r S2 E1 E1 r1 r1 E2 E2 r2 r2 MD1 D Quantity of $ Quantity of $ M1 M2 Q1 Q2 Changes in MS = Changes in r

  20. Putting Things Together… • Interest rates in the long run… S1 MS2 r r S2 E3 E1 r1 r1 MD2 E2 E2 r2 r2 MD1 D Quantity of $ Quantity of $ M2 Q1 Q2 Changes in MS ≠ Changes in r

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