Unit 4:

Money and
Monetary Policy

1
The Money Market
(Supply and Demand for Money)

2
 The Demand for Money
At any given time, people demand a certain amount of
liquid assets (money) for everyday purchases
The Demand for money shows an inverse
relationship between nominal interest rates
and the quantity of money demanded
1. What happens to the quantity demanded of
money when interest rates increase?
Quantity demanded falls because individuals
would prefer to have interest earning assets instead
2. What happens to the quantity demanded when
interest rates decrease?
Quantity demanded increases. There is no incentive
to convert cash into interest earning assets
3
 The Demand for Money
Inverse relationship between interest rates and
the quantity of money demanded
Nominal
Interest Rate
(ir)
20%

5%

2%

DMoney
0
Quantity of Money
(billions of dollars) 4
 The Demand for Money
What happens if price level increase?
Money Demand Shifters
Nominal 1. Changes in price level
Interest Rate 2. Changes in income
(ir)
20%
3. Changes in taxation
that affects investment
5%

2% DMoney1
DMoney
0
Quantity of Money
(billions of dollars) 5
 The Supply for Money
The U.S. Money Supply is set by the Board of
Governors of the Federal Reserve System (FED)
Interest
Rate (ir) SMoney The FED is a nonpartisan
government office that sets and
adjusts the money supply to
20% adjust the economy
This is called Monetary
5% Policy.

2%
DMoney
200 Quantity of Money
6
(billions of dollars)
 Monetary Policy
When the FED adjusts the money supply to
achieve the macroeconomic goals

7
 Increasing the Money Supply
Interest
Rate (ir) SM SM1 If the FED increases the
money supply, this causes
10%
interest rates to fall.

5%

2% How does this

DM affect AD?
200 250 Quantity of Money
(billions of dollars)
Increase Decreases Increases Increases
money supply interest rate investment AD 8
 Decreasing the Money Supply
Interest
Rate (ir) SM1 SM If the FED decreases the
money supply, this causes
10%
the interest rate to rise

5%

2% How does this

DM affect AD?
150 200 Quantity of Money
(billions of dollars)
Decrease Increase Decrease Decrease
money supply interest rate investment AD 9
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Video: The FED Today

11
2007B Practice FRQ

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2007B Practice FRQ

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2007B Practice FRQ

14
 Fractional Reserve Banking
When banks hold only a small portion of deposits
to cover potential withdrawals and then loans the
rest of the money out.
If we all went to the bank to withdrawal money at
the same time what would happen?

15
 Bank Balance Sheet
Demand Deposits- Money deposited in a
commercial bank in a checking account
Required Reserves- The percent that banks must
hold by law
Excess Reserves- The amount that the bank can
loan out (any $ beyond required reserves)
Assets- Anything that is owned or owed that has
value
(Ex: cash, real estate, loans owed)
Liabilities- An obligation that must be paid
(Ex: loans to be paid)
Are demand deposits in a bank a liability
or an asset? 16
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