The Money Market and Monetary Policy
Emma wants a $\$20{,}000$ car loan. Her bank's rate depends on how much money is available to lend and how many people want to hold cash. Who controls that supply, and how does a decision in Washington, D.C. end up changing the rate on Emma's loan? By the end of this page you will be able to trace that chain.
The money market graph
The money market shows how the nominal interest rate is determined. On the vertical axis is the nominal interest rate (the opportunity cost of holding money instead of interest-bearing assets). On the horizontal axis is the quantity of money.
Money demand ($MD$) slopes downward. When the interest rate is high, holding cash costs you more in lost interest, so people hold less. When it is low, they hold more.
Money supply ($MS$) is a vertical line. The Federal Reserve sets the quantity of money, and it does not depend on the interest rate.
The equilibrium rate is where $MD$ crosses $MS$.
What shifts money demand?
Money demand shifts when people need more or less cash at every interest rate:
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Higher price level: you need more dollars to buy the same things, so $MD$ shifts right.
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Higher real GDP: more transactions, so $MD$ shifts right.
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A lower price level or lower real GDP shifts $MD$ left.
A change in the interest rate itself is a movement along $MD$, not a shift.
In a graph of the money market, what is measured on the vertical axis and what on the horizontal axis? State the direction in which the money demand curve shifts when…
In a graph of the money market, what is measured on the vertical axis and what on the horizontal axis? State the direction in which the money demand curve shifts when the price level rises, and explain why.
Banks and the money multiplier
Banks do not keep all deposits in the vault. The reserve requirement (RR) is the fraction of deposits that banks must hold as reserves. Required reserves equal $RR \times \text{deposits}$. Anything above that is excess reserves, which banks can lend.
When a bank lends money, the borrower spends it, and it is deposited in another bank, which lends part of it, and so on. Each round creates new deposits, so the money supply grows.
$$\text{money multiplier} = \frac{1}{RR}$$ $$\text{maximum change in deposits} = \text{money multiplier} \times \text{initial deposit (new reserves)}$$The multiplier applies to new excess reserves, and new loans are the change in deposits minus the initial deposit: $\text{new loans} = \text{change in deposits} - \text{initial deposit}$.
This is the maximum because the simple model assumes banks lend all excess reserves and nobody holds cash outside banks. In the Fed example below, the Fed buys $\$10$ million in bonds from banks. That adds $\$10$ million of excess reserves, and the multiplier is applied to that amount.
What counts as money? Money serves as a medium of exchange, a unit of account, and a store of value. M1 is the most liquid money (currency and checkable deposits), and M2 adds savings accounts and similar near-money.
The reserve requirement is 10%. Compute the money multiplier. A customer deposits $\$1{,}000…
The reserve requirement is 10%. Compute the money multiplier. A customer deposits $\$1{,}000$ in a checking account; compute the maximum total increase in checking deposits that can result, assuming banks lend out all excess reserves and no cash is held outside banks.
A customer deposits $\$2{,}000…
A customer deposits $\$2{,}000$ in a bank, and the reserve requirement is 20%. Each bank lends out all of its excess reserves, and every loan is redeposited in a bank. (a) Compute the amount lent by the first four banks in turn. (b) Compute the maximum total increase in deposits from the original $\$2{,}000$. (c) Compute the total amount of new loans created.
A bank has deposits of $\$5{,}000$ million, reserves of $\$900$ million, and loans of $\$4{,}100…
A bank has deposits of $\$5{,}000$ million, reserves of $\$900$ million, and loans of $\$4{,}100$ million. The reserve requirement is 10%. (a) Compute required reserves, excess reserves, and the maximum new loans the bank could make. (b) Suppose the Fed buys $\$50$ million of securities from the public, and the sellers deposit the full amount in banks. Compute the maximum increase in total deposits if banks lend out all excess reserves. (c) Now suppose banks also hold excess reserves equal to 5% of deposits. Compute the new money multiplier and the maximum increase in deposits. (d) Explain what this shows about the Fed's control over the money supply.
Tools of the Federal Reserve
The Federal Reserve (the Fed) has three main tools:
| Tool | Expansionary | Contractionary |
|---|---|---|
| Open market operations (buying or selling Treasury securities) | Buy securities | Sell securities |
| Discount rate (rate the Fed charges banks for loans) | Lower it | Raise it |
| Reserve requirement | Lower it | Raise it |
Open market operations are the Fed's main tool. When the Fed buys bonds, it pays banks by crediting their reserves. Excess reserves rise, banks lend more, and the money supply grows by a multiple of the purchase. When it sells bonds, reserves fall and the money supply shrinks.
The Fed also pays interest on reserves. Raising it makes banks more willing to hold reserves instead of lending them, which is contractionary. Lowering it is expansionary. The FOMC announces a target for the federal funds rate, the rate banks charge each other for overnight loans, and uses these tools to hit it.
The Federal Reserve buys $\$10…
The Federal Reserve buys $\$10$ billion of government bonds in the open market. Describe the effect on bank reserves, the money supply, and the nominal interest rate. State whether this is expansionary or contractionary monetary policy.
The reserve requirement is 20%. The Federal Reserve buys $\$20…
The reserve requirement is 20%. The Federal Reserve buys $\$20$ million in bonds from banks, and banks lend out all excess reserves. (a) Compute the money multiplier. (b) Compute the maximum change in the money supply. (c) Explain why the actual change is likely to be smaller.
The Federal Reserve raises the reserve requirement from 10% to 20% and also raises the discount rate. (a) Compute the money multiplier before and after the change. (b)…
The Federal Reserve raises the reserve requirement from 10% to 20% and also raises the discount rate. (a) Compute the money multiplier before and after the change. (b) Compute the required reserves on $\$1{,}000$ of deposits before and after. (c) Describe the effect on lending, the money supply, the nominal interest rate, investment, and aggregate demand.
From the money market to AD
Now put it all together. Here is the chain for expansionary policy during a recession:
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The Fed buys bonds (or lowers the discount rate or reserve requirement).
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Bank reserves rise, so $MS$ shifts right.
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The nominal interest rate falls (and, with sticky prices, the real rate falls too).
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Borrowing is cheaper, so investment ($I$) and interest-sensitive consumption rise.
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$AD = C + I + G + (X - M)$ shifts right.
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In the short run, the price level and real GDP both rise, and unemployment falls.
Contractionary policy reverses every step: $MS$ shifts left, the interest rate rises, investment falls, $AD$ shifts left, and the price level and real GDP fall. The Fed uses it to fight inflation.
The same chain in the AD–AS model: AD shifts right from $AD_1$ to $AD_2$, so the price level and real GDP rise in the short run.
Long run: Once the economy returns to full employment, nominal wages and input prices adjust. In the long run, a change in the money supply changes the price level but not real GDP, which is set by $LRAS$.
The US economy is in a recession and inflation is low. The Federal Open Market Committee (FOMC) decides to lower its target for the federal funds rate. (a) Describe the…
The US economy is in a recession and inflation is low. The Federal Open Market Committee (FOMC) decides to lower its target for the federal funds rate. (a) Describe the open market operation the Fed would use. (b) Use a money market graph to explain the change in the money supply and in the nominal interest rate. (c) Trace the effects on investment, aggregate demand, the price level, and real GDP in the short run. (d) Explain how the Fed could also use the discount rate or interest on reserves to support the same goal. (e) Explain the long-run effect on the price level and real GDP, assuming the economy returns to full employment.
Summary
Back to Emma: the Fed's decision changes bank reserves, which changes the money supply and the interest rate, and that changes the rate on her car loan.