Econ 102 Discussion Section 9 (Chapter 15) Chapter 15: Monetary Policy Money Supply and Demand The money demand curve shows the relationship between the interest rate and the quantity of money demanded. Why is the money demand curve downward sloping? - Opportunity cost of holding money is the nominal interest rate - ↑ nominal interest rate => ↑ opportunity cost of money => ↓ demand for money Shifts of Money Demand Curve: o Changes in Aggregate Price Level: ↑ prices => ↑ money needed to but goods and services => ↑ money demand o Changes in Real GDP ↑ GDP => ↑ quantity of goods and services bought => ↑ money demand o Changes in Credit Market and Banking Technology New technology (credit cards/debit cards) allow buying of goods and services without money and access to interest-bearing accounts at lower cost => ↓ money demand The money supply curve shows the amount of currency supplied by the Fed. The Federal Reserve is able to increase or decrease the money supply in order to affect the interest rate and stabilize the economy. This is referred to as monetary policy. In the AD/AS model monetary policy works by shifting the AD curve. The effects of monetary policy can be either expansionary or contractionary: Expansionary Monetary Policy: Monetary policy that increases aggregate demand ↑ money supply => ↓ interest rate => ↑ I , ↑ C (via multiplier) , ↑ NX => ↑ aggregate demand (AD curve shifts right) Contractionary Monetary Policy: Monetary policy that decreases aggregate demand ↓ money supply => ↑ interest rate => ↓ I , ↓ C (via multiplier) , ↓ NX => ↓ aggregate demand (AD curve shifts right) Also, note that this applies to both the static and the dynamic AD/AS model How does the Fed Set Monetary Policy Targets? Most economists believe that the interest rate is the best monetary policy target, as opposed to the money supply (the Fed cannot target both simultaneously. Taylor Rule for Monetary Policy: A rule that sets the federal funds rate according to the sum of the inflation rate, the equilibrium federal funds rate, and two addition terms (such as the inflation gap and output gap). An example is below: Federal Funds Rate = Inflation Rate + Equilibrium Fed Funds Rate + 0.5×inflation gap + 0.5×output gap Inflation Targeting: When the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target Practice Questions 1. If a checking account pays no interest and a Treasury bill pays 1% interest, then the opportunity cost of holding money in checking is A) 0% B) 1% C) 2% D) there is never an opportunity cost of holding money in checking 2. An increase in government purchases causes GDP to increase, then the A) money supply decreases. B) money supply increases. C) money demand decreases. D) money demand increases. 3. If the equilibrium interest rate in the money market is 2%, then at an interest rate of 5% A) money demanded exceeds the money supplied, and people shift from holding money to interest bearing assets, causing the interest rate to fall. B) money supplied exceeds the money demanded, and people shift from holding money to interest bearing assets, causing the interest rate to fall. C) money demanded exceeds the money supplied and people shift from holding interest bearing assets to money, causing the interest rate to rise. D) money supplied exceeds the money demanded and people shift from holding interest bearing assets to money, causing the interest rate to rise. 4. An increase in the required reserve ratio will __________ the money supply, causing interest rates to __________. A) decrease; decrease B) decrease; increase C) increase; decrease D) increase; increase 5. When the Federal Reserve wants to increase the federal funds rate, it ________ A) buys treasury bills from banks, increasing bank reserves and increasing the money supply. B) buys treasury bills from banks, decreasing bank reserves and decreasing the money supply. C) sells treasury bills to banks, increasing bank reserves and increasing the money supply. D) sells treasury bills to banks, decreasing bank reserves and decreasing the money supply. 6. When there is a recessionary gap, the Federal Reserve can __________ interest rates to __________ GDP and __________ the price level. A) increase; increase; increase B) increase; decrease; increase C) decrease; increase; increase D) decrease; decrease; increase 7. Suppose expansionary fiscal policy causes inflation to rise above the Federal Reserve’s inflation target. Then the Federal Reserve will __________ interest rates in order to __________ inflation. A) decrease; decrease B) decrease; increase C) increase; decrease D) increase; increase 8. Suppose that the Federal Reserve follows a Taylor rule for monetary policy. When inflation increases, the Federal Reserve will want to __________ the interest rate. So it will __________ banks, causing the money supply to __________. A) decrease; sell Treasury bills to; increase B) decrease; buy treasury bills from; increase C) increase; sell Treasury bills to; decrease D) increase; buy Treasury bills from; decrease 9. Consider an economy that is in its long-run equilibrium right now. If the Federal Reserve increases the money supply, then in the long run GDP will be __________ now and the price level will be __________ now. A) the same as; the same as B) lower than; higher than C) higher than; the same as D) the same as; higher than 10. Suppose the Federal Reserve increases the money supply by buying Treasury bills from banks. Then A) in the short run interest rates decrease, and in the long run interest rates stay low B) in the short run interest rates increase, and in the long run interest rates decrease C) in the short run interest rates decrease, and in the long run interest rates return to where they started D) in the short run interest rate stay the same, and in the long run interest rates decrease 11. Suppose the economy is in long run equilibrium. If the Fed engages in expansionary monetary policy: A) In the long run GDP increases and the price level increases B) In the long run GDP increases and the price level does not change C) In the long run neither GDP nor the price level changes D) In the long run GDP does not change and the price level increases 12. Suppose there is an inflationary gap in the economy. To address this the Fed can: A) Engage in an open market sale B) Engage in an open market purchase C) Both a and b D) The Fed cannot close an inflationary gap using monetary policy 13. If the interest rate increases: A) There is an increase in the quantity of money supplied B) There is a decrease in the quantity of money supplied C) There is no change in the quantity of money supplied D) Not enough information 14. Consider an economy that is in long run equilibrium. If the long run aggregate supply curve grows at a faster rate than demand, what can the Fed do in order to return to macroeconomic equilibrium? A) Conduct an open market sale B) Increase the discount rate C) Increase the required reserve ratio D) None of the above Answers: 1. B) 2. D) 8. C) 9. D) 3. B) 4. B) 5. D) 6. C) 7. C) 10. C) 11. D) 12. A) 13. C) 14. D)