# The money market FED open market operations

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```					•Demand and supply of money
•The supply of money and the equilibrium
interest rate
•The monetary transmission mechanism
•The Quantity theory of money
•The record of monetary policy
Earlier we said that the interest rate
(i) influences aggregate spending—
specifically investment and
consumption. However, we have yet
to develop a theory of the interest
rate

The interest rate is
governed by the
demand and supply of
money.
1. To make planned
expenditures/payments
2. To be prepared for unexpected
expenditures/payments.
3. To store wealth.
The higher the interest rate,
the more interest I give up by
holding my wealth in money-
- as opposed to an interest-
bearing asset.
The money demand, Dm, slopes
Interest rate

downward. As the interest rate
falls, other things constant, so
does the opportunity cost of
holding money; the quantity of
money demanded increases.

Dm

0            Quantity of money

5
Demand for Money
Nominal Interest Rate (%)
•As we move along MD, the price
level and real GDP are held constant.
•The movement from point E to F is
E
a change in the demand for money
as a store of value in reaction to a
6%                            decrease in the yield of bonds.

F
3%

MD

0                 1.0       1.2                           Money
(\$Trillions)
Effect of a Change in Price Level (P) or Real
GDP (Y)

MD1 MD2
•Increase in P, ceteris paribus.
•Increase in Y, ceteris paribus
Nominal Interest Rate (%)

E        G
6%

F              H
3%

MD2
MD1

0         1.0    1.12    1.2       1.5                Money
(\$Trillions)
Bond Prices and the Rate Of Interest

Bond prices and
interest rates (or
yields), move
inversely
Suppose you paid \$800 for a bond that promises to pay \$1,000 to its
holder one year from today. What is the interest rate or percentage yield of
the bond? Notice first that your interest income would be equal to \$200.
Hence to compute the yield, use the following equation:
Yield (%) = (interest income/price of the bond)  100
Thus, we have:
Yield (%) = (200/800)  100 = 25 percent
Now suppose, instead of paying \$800 for the bond, you paid \$900. What is
the yield now?
Yield (%) = (100/900)  100 = 11 percent
We assume that the Fed (or
central banks generally)
determines the supply of
money
Effect of an increase in the money supply

Because the money supply is
determined by the Federal Reserve,
Interest

Sm        S’m
it can be represented by a vertical
rate

line.
At point a, the intersection of the
a                                money supply, Sm, and the money
i
demand, Dm, determines the market
b                         interest rate, i.
i’
Following an increase in the money
Dm          supply to S’m, the quantity of money
supplied exceeds the quantity
demanded at the original interest
Quantity of
0       M         M’                          rate, i.
money

People attempt to exchange money for bonds or other financial assets. In doing so,
they push down the interest rate to i’, where quantity demanded equals quantity
supplied. This new equilibrium occurs at point b.
11
Effects of an increase in the money supply on
interest rates, investment, and aggregate
demand
(a) Supply and demand                        (b) Demand for                       (c) Aggregate demand

Interest rate
Interest rate

for money                                    investment
Sm

Price level
S’m

i                        a                   i                    a
b
b                                      b           P
i’                                           i’                                                     a
Dm                                                                                 AD’
AD
DI

0         M         M’ Money     0     I     I’                                          0            Y   Y’       Real GDP
An increase in the money              Investment                                   This sets off the spending
supply drives the interest With the cost of borrowing                              multiplier process, so the
rate down to i'.           lower, the amount invested                              aggregate output demanded at
increases from I to I‘.                                 price level P increases from Y to
12
Y‘
M↑→i↓→I↑→AD↑→Y↑
Fed open market purchase injects reserves into the
banking system

Commercial banks, thrifts, etc. expand loans and
deposits

The money supply increases

The equilibrium interest rate decreases

Consumption and investment increase

Real GDP, employment, and (perhaps ) the price level
increase
Expansionary monetary policy to correct a
contractionary gap
Potential output                     At a, the economy is producing less
LRAS                            than its potential in the short run,
resulting in a contractionary gap of
level
Price

SRAS130
\$0.2 trillion.

If the Federal Reserve increases the
money supply by just the right
130                     b                          amount, the aggregate demand
curve shifts rightward from AD to
a
AD’. A short-run and long-run
125
equilibrium is established at b, with
AD’       the pride level at 130 and output at
the potential level of \$14.0 trillion
AD

0      13.8       14.0                  Real GDP
(trillions of dollars)
Contractionary gap                                                         15
The FOMC sets a
target for the “federal
funds” rate, which is
the rate that banks
charge other banks for
“borrowed” reserves.
Recent ups and downs in the federal funds rate

Rate increased to slow red-
hot economy

Global financial                       Rate increase to        Rate cuts
crisis prompts                         head off inflation       to limit
rate cuts                                                      impact of
Rate cuts                                mortgage
to combat                               defaults on
recession                                economy

Since the early 1990s, the Fed has pursued monetary policy primarily through changes in
the federal funds rate, the rate that banks charge one another for borrowing and lending
excess reserves overnight.                                                          17
The Equation of Exchange

M V  P  Y
Where
•M is the quantity of money
•V is the velocity of circulation
•P is the price level
•Y is real GDP
What is velocity (V)?
Velocity (V) is the average number of times
per year a unit of money is spent for new goods
and services. Let

V  (P Y )  M
(P  Y) is nominal GDP. Let P = 1.25; Y = \$8 trillion;
and M= \$2 trillion. Thus:

V  (1.25  \$8 trillion)  \$2 trillion
Or, V = 5
Money and Aggregate Demand in LR
• Velocity depends on
– Customs and convention of commerce
• Innovations facilitate exchange
• Higher velocity
– Frequency
• The more often workers get paid
– Higher velocity
– Stability (store of value)
• The better store of value
– Lower velocity

21
Equation of Exchange is Always True

The equation simply states that
what is spent for new goods
and services (M  V) is equal to
the market value of new goods
and services produced (P  Y).
Illustration
Using the numbers on a preceding slide, we can see that

P Y  1.25 \$8 trillion  \$10 trillion

and
M V  \$2 trillion  5  \$10 trillion
thus

M V  P Y  \$10 trillion
“Monetarist” interpretation
of the equation of exchange
The monetarists believe
that price level changes
(hence inflation) can be
explained by changes in
quantity of money

“Inflation is always and everywhere a monetary
phenomenon.”
Example

Assume that V = 5 and is
constant. Y is \$8 trillion
(also assumed to be
constant). Initially, let M =
\$2 trillion
Our basic equation can be rearranged as follows:
P  ( M V )  Y
Now solve for the price level (P):

P  (\$2 trillion  5)  \$8 trillion  1.25
Now let the money supply increase to \$2.4 trillion. Notice
that:
(\$2.4 trillion - \$2 trillion) 100  \$2 trillion  20 percent
Thus we have:
P  (\$2.4 trillion  5)  \$8 trillion  1.50
Notice that:
(1.5 - 1.25)100 1.25  20 percent
Hence a 20 percent
increase in the money
supply causes the price
level to increase by 20
percent. Monetarists put
the blame for inflation
squarely at the doorstep of
the monetary authorities
(in the U.S., the FED).
In the long run, an increase in the money
supply results in a higher price level, or
inflationPotential output
LRAS
Price level

The quantity theory of money
predicts that if velocity is stable, then
an increase in the supply of money in
the long run results in a higher price
140                             b                            level, or inflation. Because the long-
run aggregate supply curve is fixed,
increases in the money supply affect
130                             a                            only the price level, not real output.
AD’

AD

0                    14.0                  Real GDP
(trillions of dollars)
28
(a) Velocity of M1

M1 velocity fluctuated so much during the 1980s that M1 growth was abandoned
as a short-run policy target.
29
(b) Velocity of M2

M2 velocity appears more stable than M1 velocity, but both are now considered by the Fed
as too unpredictable for short-run policy use.
30
German Hyperinflation and Money
Record indicates that nations with high rates of
monetary growth also suffer high rates of inflation

• A decade of annual inflation and money
growth in 85 countries (average annual
percent)

34
Targeting interest rate vs. targeting the money
supply
An increase in the price level or in real GDP,
Sm        S’m                   with velocity stable, shifts rightward the money
demand curve from Dm to D'm.

If the Federal Reserve holds the money supply
e’                          at Sm, the interest rate rises from i (at point e)
i’
Interest rate

to i ' (at point e').
e             e’’                       Alternatively, the Fed could hold the
i
interest rate constant by increasing the
D’m       supply of money to S'm. The Fed may
Dm             choose any point along the money
demand curve D'm.

0    M         M’         Quantity of money

35
The Fed pulled on the string
big time beginning in
1979—it was an anti-
inflation strategy under
Chairman Paul Volcker
Modeling Contractionary Monetary Policy

Price Level
Potential
GDP       AS

AD2

AD1
0             Y1                       Real GDP
20
Rec es s i ons are s haded
18

16

14

12

10

8
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01

Federal Funds
Conventional 30 year
20
Recessions are shaded
18

16

14

12

10

8

6
80       82       84       86       88         90   92

Mortgage Interest Rates

www.economagic.com
Monthly payments on a \$110,000
30 year mortgage note
Mortgage rate         Monthly
Payment1
8%            \$807.14

10%              \$965.33

12%             \$1,131.47

14%             \$1,303.36

16%             \$1,479.23

1 Does not include prorated insurance or
property taxes.
2400                                  Data in thousands of units
R ecessions are shaded

2000

1600

1200

800

400
80      82       84        86       88        90      92

Monthly Housing Starts
www.economagic.gov
More recently, the
Fed raised the federal
funds rate six times
between May 1999
and May 2000—from
4.75% to 6.5 %.
Evidently
unemployment was
getting “too low.”
The FOMC reversed course
in July 2000 and cut the
funds rate 17 times, to a low
of 1.00 percent in July 2003.
Beginning in 2004, and until
summer of 2007, the FED
was mainly concerned
about inflation.

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 views: 2 posted: 10/21/2012 language: English pages: 44