Classwork Week 14

Monetary Policy
Notes1
The Demand for Money
A. The opportunity cost of holding money
1. The opportunity cost of holding money is measured by the forgone return that could be earned
by holding other financial assets.
B. The money demand curve
1. The money demand curve shows the relationship between the quantity of money demanded
and the interest rate.
2. The money demand curve is negatively sloped, indicating that a higher interest rate leads to a
higher opportunity cost of holding money and thus reduces the nominal quantity of money
demanded.
C. Shifts of the money demand curve
1. The most important factors causing the money demand curve to shift are:
a. changes in the aggregate price level.
b. changes in real GDP.
c. changes in banking technology.
d. changes in banking institutions.
D. The equilibrium interest rate
1. According to the liquidity preference model of the interest rate, the interest rate is determined
by the supply of and demand for money.
2. The money supply curve shows how the nominal quantity of money supplied varies with the
interest rate.
3. Equilibrium in the money market is determined where the money supply curve, which is vertical
at the quantity of money supplied as chosen by the Fed, intersects the money demand curve.
E. Two models of interest rates?
1. Both the loanable funds model and the liquidity preference model of the interest rate are
correct.
2. The loanable funds market is looking at longer term interest rates while the liquidity preference
model is looking at short term interest rates as set by the Federal Reserve.
2. The most important insight from the liquidity preference model of the interest rate is that it
shows us how monetary policy works.
4. The Fed Funds rates impacts all other interest rates in the economy, particularly other short-
term interest rates. Long run interest rates are influenced by the Fed. However, other factors
influence the long term interest rates as well (and are sometimes more important then the Fed).
Monetary policy and the interest rate
A. The target federal funds rate is the Federal Reserve’s desired federal funds rate.
B. The Open Market Desk of the Federal Reserve Bank of New York adjusts the money supply through the
purchase and sale of Treasury bills until the actual federal funds rate equals the target federal funds
rate.
C. If the actual federal funds rate is greater than the target federal funds rate, the Fed will increase the
money supply by making an open-market purchase of Treasury bills, which will increase the money
supply and push the money supply curve to the right, thereby lowering the interest rate.

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Notes adapted from Krugman and Wells Macroeconomics in Modules
 D. If the actual federal funds rate is lower than the target federal funds rate, the Fed will decrease the
money supply by making an open-market sale of Treasury bills, which will decrease the money supply
and push the money supply curve to the left, thereby raising the interest rate.
E. Long-term interest rates
1. Long-term interest rates do not always move with short-term interest rates.
2. Long-term interest rates reflect expectations concerning what is going to happen to short-term
rates in the future. If long-term rates are higher than short-term rates, the market expects
short-term rates to rise in the future.
3. Buying long-term bonds is more risky than short-term bonds because if you are forced to sell a
long-term bond early, you may not receive the price you were expecting.
Monetary Policy and Aggregate Demand
A. Expansionary and contractionary monetary policy
1. Expansionary monetary policy is monetary policy that increases aggregate demand.
2. Expansionary monetary policy reduces the interest rate, causing the aggregate demand curve to
shift to the right, and so is used to eliminate a recessionary gap.
3. Contractionary monetary policy is monetary policy that reduces aggregate demand.
4. Contractionary monetary policy increases the interest rate, causing the aggregate demand curve
to shift to the left, and so is used to eliminate an inflationary gap.
Money, Output, and Prices
A. Short-run and long-run effects of an increase in the money supply
1. In the short run, an increase in the money supply causes a rightward shift of the aggregate
demand curve. As a result, real GDP and the aggregate price level both rise.
2. In the long run, the short-run aggregate supply curve will shift to the left, due to the higher
wages demanded by laborers, ultimately causing real GDP to decrease. Thus, in the long run, an
increase in the money supply has no effect on real GDP but raises the aggregate price level.
B. Monetary neutrality
1. There is monetary neutrality when changes in the money supply have no real effects on the
economy.
2. Most economists believe that money is neutral in the long run.
C. Changes in the money supply and the interest rate in the long run
1. In the short run, an increase in the money supply leads to a fall in the interest rate. In the long
run, changes in the money supply do not affect the interest rate. In the long run, the price level
will rise and the money demand curve will shift to the right. A 10% increase in the money supply
is matched by a 10% increase in the price level.
 2. In the long run, the equilibrium interest rate in the economy matches the supply and demand
for loanable funds that arise at potential output in the market for loanable funds.

Practice Problems2
Practice Problem 1: Using the table and the graph below, answer each one of the questions.

Federal Quantity of Quantity of

Funds Rate Money Demanded Money Supplied
4% $2 trillion $6 trillion
3% $4 trillion $6 trillion
2% $6 trillion $6 trillion
1% $8 trillion $6 trillion

A. What is the equilibrium Fed Funds Rate?

Suppose that the money demand curve shifts rightward. The table presents a Federal Quantity of
revised demand schedule for money. Funds Rate Money
B. What is the new equilibrium Federal Funds Rate? Demanded
5% $5 trillion
4% $7 trillion
3% $9 trillion
C. Complete the statement: When the demand for money shifts right, there 2% $11 trillion
is a(n) in the equilibrium Federal Funds rate.

Practice Problem 2
A. Draw a graph showing how the short-run B. Draw a graph showing how the short-run
interest rate is determined using the interest rate is determined using the
liquidity preference model. loanable funds model.

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Some of the practice problems on this handout were adapted from the Knight Worksheets, Copyright Pearson ©2018
Practice Problem 3

A. Assume you are a member of the Federal Open Market Committee. The economic data indicate that a
recessionary gap is growing in the economy. What policy would you recommend regarding the target federal
funds rate?

B. How in practice can the Fed achieve the change in the target federal funds rate you recommended in part A?

C. Illustrate your response to part a with a graph of the money market showing the impact of the policy you
recommended to close the recessionary gap.

Practice Problem 4

A. Complete the statement. The sum of all notes, coins, and banks’ deposits held at the Federal Reserve is
referred to as the ____________________________

B. Complete the statement. The money multiplier is used to determine the change in the _____________ that
results from a one-dollar increase in the ____________________________

C. Suppose that the reserve requirement is 5%, and that depository institutions do not hold excess reserves.
What is value of the money multiplier?

D. Suppose that the reserve requirement is 5%, and that depository institutions do not hold excess reserves. If
the Fed decreases the monetary base by $10 billion, by how much does the money supply change?

Practice Problem 5
 A. What is the current equilibrium Fed Funds rate in the market?

B. Suppose that the money multiplier is 1.6. The Fed estimates that it needs to decrease the interest rate
to 1% to help expand the economy during a recessionary gap. How much should the Fed change its
monetary base?

Thought Question? What would happen if money rained down from the sky tomorrow? What would you do?

Practice Problem 6
A. What does the term monetary neutrality mean to an economist?

B. Does monetary neutrality occur in the short run? Explain your answer.

C. Does monetary neutrality occur in the long run? Explain your answer.

Federal Reserve Chairman Game (time permitting)

Link: Federal Reserve Chairman Game

Pre-Activity Questions
How should the Fed change interest rates to close a recessionary gap with high unemployment and low
inflation?
How should the Fed change interest rates to close an inflationary gap with low unemployment and high
inflation?

What do you think the Fed should do if there is both high unemployment and high inflation?

Post Activity Questions

How long did it take changes in the interest rate to have impacts on the economy?

What type of changes did you make to gradually move the economy in the “right” direction so that there were
not huge fluctuations?

Explain the most important lesson that you learned while playing the game.