4 Macroeconomics LESSON 5 The Money Market and Monetary Policy Introduction and Description In this lesson, the demand for and supply of money are brought together in the money market. The effects of the Federal Reserve System s monetary policy are integrated into the money market and then linked to aggregate demand. The lesson then discusses the resulting impact on equilibrium output and price level. In Activity 39, the students practice manipulating the money market and understanding the impact of the Fed s actions in this market. Activity 40 provides practice in relating monetary policy to changes in the monetary variables such as the federal funds rate, the money supply and velocity. Objectives 1. Define transactions demand for money, precautionary (liquidity) demand for money and the speculative demand for money and explain how each affects the total demand for money. 2. Discuss the motives for holding assets as money. 3. Identify the factors that cause the demand for money to shift and explain why the shift occurs. 4. Explain how interest rates are determined in the money market. 5. Describe Federal Reserve policy and the interest rate. 6. Explain how interest rates affect monetary policy. Time required Two class periods or 90 minutes Materials 1. Activities 39 and 40 2. Visuals 4.1, 4.2, 4.3 and 4.4 Procedure 1. Project Visual 4.1 and discuss the sources of the demand for money. The students should recognize that individuals are faced with a simple decision: how much of their wealth do they want to hold as money and how much do they want to hold as interest-bearing assets? If you hold money, you are forgoing the interest you could earn on the money in an interest-bearing asset. There is an opportunity cost of holding money: the forgone interest. Visual 4.1 shows that as the interest rate decreases from r to r 1, the amount of money held by people increases from MD to MD 1. 2. Project Visual 4.2. Explain that the demand for money also depends on the price level and on the level of real GDP or real income. If prices double, a person will need twice as much money to buy groceries or other goods and services. People are most concerned with the real value of income: what the income can buy or its purchasing power. As income rises, the demand for money increases. 3. To complete the money market, we now add the supply of money, which is determined by the Federal Reserve through its tools. Visual 4.3 shows the money market. Explore what happens to the interest rate as prices rise (MD increases and the interest rate rises), income increases (MD increases and the interest rate rises) or the money supply increases (interest rate decreases). 4. Have the students complete Activity 39. Review the answers with the students. 5. Given the demand for money, by controlling the money supply, the Federal Reserve controls the interest rate in the short run. The interest rate affects the level of investment and a portion of the level of consumption. Using Visual 4.4, show how an increase in the money supply (MS to MS 1 ) causes the interest rate to decrease (r 1 to r) and investment (I to I 1 ) and consumption to increase. In turn, aggregate demand increases (AD to AD 1 ). 560 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.
4 Macroeconomics LESSON 5 6. Have the students explain step-by-step what happens in the economy once the Federal Reserve decides to increase (decrease) the money supply. (Be sure the students understand why an increase in bond prices leads to a decrease in the interest rate.) Fed purchases Treasury securities Bond prices increase to entice households and businesses to sell Treasury securities Money supply increases and interest rate decreases Investment increases (and interest-sensitive components of consumption increase) Aggregate demand increases Output increases and the price level increases. 7. Explain the factors that affect the income velocity. 8. Have the students complete Activity 40. Review the answers with the students. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 561
4 Macroeconomics LESSON 5 ACTIVITY 39 Answer The Money Market Figure 39.1 The Money Market MS INTEREST RATE MD QUANTITY OF MONEY 1. Suppose the Federal Reserve increases the money supply by buying Treasury securities. (A) What happens to the interest rate? The interest rate decreases. (B) What happens to the quantity of money demanded? The quantity of money demanded increases. (C) Explain what happens to loans and interest rates as the Fed increases the money supply. As the Federal Reserve buys Treasury securities from the public, demand deposits in financial institutions increase. Thus financial institutions have more money to make loans. To encourage people to take out the loans, the financial institutions lower the interest rate. 2. Suppose the demand for money increases. (A) What happens to the interest rate? The interest rate increases. (B) What happens to the quantity of money supplied? The quantity of money supplied remains the same, as shown by the vertical money supply curve. (C) If the Fed wants to maintain a constant interest rate when the demand for money increases, explain what policy the Fed needs to follow and why. It must increase the money supply to meet the increase in the demand for money. (D) Why might the Fed want to maintain a constant interest rate? To stabilize the amount of investment in the economy 562 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.
4 Macroeconomics LESSON 5 ACTIVITY 39 Answer Figure 39.2 Alternative Money Demand Curves MS MS 1 INTEREST RATE MD QUANTITY OF MONEY MD 1 3. Suppose there are two money demand curves MD and MD 1 and the Fed increases the money supply from MS to MS 1 as shown in Figure 39.2. (A) Compare what happens to the interest rate with each MD curve. The interest rate declines further with the more inelastic money demand curve (MD 1 ) than with the more elastic money demand curve (MD). (B) Explain the effect of the change in the money supply on consumption, investment, real output and prices. Would there be a difference in the effects under the two different money demand curves? If so, explain. With either demand curve, the increase in supply will cause interest rates to decline and investment and consumption and thus real output to increase. AD increases, so prices are likely to increase. For the interest-sensitive component of consumption and investment, there will be a greater increase (or decrease) with a greater decrease (or increase) in the interest rate. For example, a larger decrease in interest rates will usually lead to a greater increase in investment. The increase in investment will increase aggregate demand. Thus, the increase in the money supply will lead to an increase in AD, which will lead to an increase in real output and in the price level. (C) How would you describe, in economic terms, the difference between the two money demand curves? MD 1 is more interest inelastic than MD. (D) If the Federal Reserve is trying to get the economy out of a recession, which money demand curve would it want to represent the economy? Explain. The Fed would prefer the moreinelastic money demand curve because a given increase in the money supply will lead to a greater decrease in interest rates, which should stimulate the economy. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 563
4 Macroeconomics LESSON 5 ACTIVITY 40 Answer The Federal Reserve: Monetary Policy and Macroeconomics 1. What is monetary policy? Monetary policy is action by the Federal Reserve to increase or decrease the money supply to influence the economy. 2. From 1998 to 2002, what was the dominant focus of monetary policy and why? From 1998 to 2001, the focus of monetary policy was to slow the growth of the economy to prevent an increase in inflation. In 2001 and 2002, the focus was to stimulate the economy without stimulating inflation. 3. Explain why the money supply and short-term interest rates are inversely related. When the Fed buys Treasury securities from the public, bank reserves increase. To decrease excess reserves and make loans, banks lower the interest rate to entice consumers and businesses to borrow. 4. What are some reasons for lags and imperfections in data used by central banks? Financial institutions report at specified periods, and the reporting time is not necessarily when the central bank can use the data. For short periods of time, the central bank collects data from only a sample of banks, and this leads to a certain amount of error in the data. 5. Why do many economists believe that central banks have more control over the price level than over real output? Many economists believe that real output is determined by the level of capital stock and the productivity of workers. Thus, changes in the money supply affect prices more than real output. 6. What might cause velocity to change? Some factors that might cause velocity to change are changes in how money is transferred (institutional changes), changes in interest rates and changes in the price level. 564 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.
4 Macroeconomics LESSON 5 ACTIVITY 40 Answer 7. If velocity were extremely volatile, why would this complicate the job of making monetary policy? One of the roles of monetary policy is stabilization of the price level. Thus, based on the equation of exchange (MV = PQ), changes in the money supply will yield a given change in PQ if velocity (V) is constant. If velocity is volatile, changes in the money supply may be either too small or too large, leading to inflation. 8. What role does the money multiplier play in enabling the Fed to conduct monetary policy? The money multiplier times the change in excess reserves yields the change in the money supply. Thus, if the Fed wants to change the money supply by a given amount, the money multiplier indicates by how much the excess reserves need to be changed. 9. What is the fed funds rate? The interest rate that financial institutions charge other financial institutions for short-term borrowing 10. What happens to the fed funds rate if the Fed follows a contractionary (tight money) policy? The federal funds rate increases. 11. What happens to the fed funds rate if the Fed follows an expansionary (easy money) policy? The federal funds rate decreases. 12. Why do observers pay close attention to the federal funds rate? It is an early indicator of monetary policy and provides a forecast of the direction for other interest rates and for Fed policy. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 565