14.1 The Money Market

• Money market: The market for money in which the amount supplied and the amount demanded meet to determine the nominal interest rate.

The Demand for Money

• Interest rates affect money demands

  • Stocks are shares in the ownership of a corporation.

  • Bonds are loans that are repaid with interest.

  • Money facilities transactions

• Transaction demand for money: The demand for money is based on the desire to facilitate transactions.

• Principle of Opportunity Cost: The opportunity cost of something is what you sacrifice to get it.

• As interest rates increase in the economy, the opportunity cost of holding money also increases.

• The quality demanded of money will decrease with an increase in interest rates.

• The price level and GDP affect money demand

  • Demand for money depends on

    • The overall price level in the economy

    • The level of real GDP or real income

• Other components of money demand

  • Illiquid: Not easily transferable to money

  • Liquidity demand for money: The demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs.

  • Speculative demand for money: The demand for money that arises because holding money over a short period is less risky than holding stocks or bonds.

• Individuals hold money for three motives:

  • To facilitate transactions

  • To provide liquidity

  • To reduce risk

14.2 How the Federal Reserve Can Change the Money Supply

Open Market Operations

• Open Market Operations: The purchase or sale of U.S> government securities by the Fed. Open Market Purchases: The Fed’s purchase of government bonds from the private sector. Open Market Sales: The Fed’s sale of government bonds to the private sector.

• The Fed can write checks against itself to purchase government bonds without having any explicit “funds” in its account for the purchase.

Other Tools of the Fed

• Ways in which the Fed can change the supply of money:

  • Changing Reserve Requirements

  • Paying Interest on Reserves

  • Changing the Discount Rate

    • Discount Rate: The interest rate at which banks can borrow from the Fed.

    • Federal Funds Market: The market in which banks borrow and lend reserves to and from one another.

    • Federal Funds Rate: The interest rate on reserves that banks lend each other.

  • Quantitative Easing: Purchasing long-term securities

14.3 How Interest Rates Are Determined: Combining the Demand and Supply of Money

Interest Rates and Bond Prices

• Price of bond = promised payment/(1 + interest rate)

• How Open Market Operations Directly Affect Bond Prices

  • As the Fed buys bonds, it increases the demand for bonds and raises their price.

  • Interest rates rise following an open market sale of bonds by the Fed. With an increase in the supply of bonds, the price of bonds will fall.

• Good News for the Economy is Bad News for Bond Prices

  • When real GDP increases, the demand for money will increase.

  • Increased money demand will increase interest rates. Bond prices move in the opposite direction from interest rates.

  • Good news for the economy is bad news for the bond market.

14.4 Interest Rates and How They Change Investment and Output (GDP)

• The Fed’s ultimate goal is to change output by either slowing or speeding the economy by influencing aggregate demand.

• When the Fed increases the money supply, it leads to lower interest rates and increased investment spending.

• A higher level of investment spending will ultimately lead to a higher level of GDP.

Monetary Policy and International Trade

• Exchange rate: The price at which currencies trade for one another in the market.

• Depreciation of a currency: A decrease in the value of a currency.

• As the exchange rate for the U.S. dollar falls, U.S. goods become cheaper and foreign goods become more expensive. The United States then exports more goods and imports fewer goods. Net exports increase, in other words. This increase in net exports increases the demand for U.S. goods and increases GDP.

• Appreciation of a currency: An increase in the value of a currency.

• An increase in interest rates will reduce both investment spending (including consumer durables) and net exports. A decrease in interest rates will increase investment spending and net exports.

14.5 Monetary Policy Challenges for the Fed

Lags in Monetary Policy

• Inside lags are the time it takes for policymakers to recognize and implement policy changes.

• Outside lags are the time it takes for policy to actually work.

• The inside lags for monetary policy are relatively short compared to those for fiscal policy.

• The outside lags related to monetary policy, however, are quite long.

Influencing Market Expectations: From the Federal Funds Rate to Interest Rate on Long-Term Bonds

• In fact, when the Fed makes its decisions on monetary policy, it really decides what the rate should be in the federal funds market—the market in which banks trade reserves overnight.

• The Fed can directly control the federal funds rate and other short-term interest rates.

• The Fed can also monitor the public’s expectations of its future policies in the financial markets.