CHAPTER 14
THE MONEY MARKET AND MONETARY POLICY
MASTERY GOALS
The objectives of this chapter are to:
1. Explain how individuals’ wealth limits their demand for money.
2. Describe the tradeoff between holding money and holding bonds.
3. List the key variables that affect the demand for money and explain their effects.
4. Draw a money demand curve and explain what causes movements along it, and what
causes shi$s to a new money demand curve.
5. Draw a money supply curve and explain why it is ver&cal.
6. State the rela&onship between bond prices and the interest rate, and use this
rela&onship to explain how the money market reaches equilibrium.
7. Describe why the loanable funds market model, which determines the interest rate in
the long-run classical view, does not determine the interest rate in the short-run macro
view.
8. Describe how the Fed uses open market purchases to control the interest rate, and
explain how this affects equilibrium GDP.
9. Explain how the Fed can target just one interest rate but can yet influence several.
10. Explain unconven&onal monetary policy and how certain economic events can cause the
Fed to deviate from its conven&onal policies.
11. Explain how the Fed conduc&on monetary policy during the financial crisis of 2008.
12. (Appendix) Use the crowding-out effect to explain why interest rate changes diminish the
effec&veness of 4scal policy and other spending shocks.
THE CHAPTER IN A NUTSHELL
Money is one of the forms in which we can hold our wealth. Given a fixed total amount of
wealth, if we want to hold more wealth as money, we must hold less wealth in other forms. To
keep things simple, we can imagine that individuals choose how to divide wealth between two
assets: money and bonds. Money can be used as a means of payment but earns no interest,
while bonds earn interest but cannot be used as a means of payment. The price level, real
income, and the interest rate determine how much money an individual will decide to hold. The
demand for money by businesses follows the same principles as the demand for money by
individuals.
The economy-wide quan&ty of money demanded is the amount of total wealth in the economy
that all wealth holders, together, choose to hold as money, rather than as bonds. The money
demand curve shows the total quan&ty of money demanded in the economy at each interest
rate. A change in the interest rate moves us along the money demand curve, while a change in
real income or the price level will cause the money demand curve to shi$.
The economy’s money supply curve shows the total money supply at each interest rate. This line
is ver&cal because once the Fed sets the money supply, it remains constant un&l the Fed
changes it. Open market purchases of bonds inject reserves into the banking system and shi$
the money supply curve rightward. Open market sales have the opposite effect.
In the short run the equilibrium interest rate is determined in the money market. Equilibrium in
the money market occurs when the quan&ty of money people are actually holding is equal to
the quan&ty of money they want to hold. When the interest rate is above its equilibrium level,
people try to get rid of their excess supply of money by buying bonds. This raises bond prices
and lowers interest rates un&l people are sa&s4ed with their money holdings. A similar process
drives up the interest rate when it is below its equilibrium level.
Our view of the interest rate depends on the &me period we are considering. The market for
loanable funds determines the interest rate in the long-run (classical) model, while the money
market determines the interest rate in the short run.
When the Fed controls or manipulates the money supply in order to achieve any
macroeconomic goal it is engaging in monetary policy. When the Fed increases the money
supply, the equilibrium interest rate falls and spending on plant and equipment, new housing,
and consumer durables increases. This produces a mul&plier effect that increases equilibrium
GDP. Decreasing the money supply has the opposite effect.
Even though the Fed normally only targets one interest rate, the federal funds rate, this is
usually su?cient to influence other interest rates. Also, in October 2008 the Fed began paying
interest on reserves that banks hold in Federal Reserve accounts, something that many other
central banks had already been doing.
In addi&on to conven&onal monetary policy tools, the Fed may also employ other more
unconven&onal tools such as changing interest rate spreads. When the federal funds rate
reaches its zero bound, the Fed must intervene in other to lower other interest rates or reduce
the real federal funds rate. During financial crises, such as the one in 2008, restoring financial
stability can be the Fed’s most important policy tool.
A Using the Theory sec&on shows how the Fed reacted during the financial crises of 2008.
In the appendix, a more complete view of monetary policy is presented. Fiscal policy (like any
other spending changes) leads to an ini&al change in equilibrium. An increase in government
spending, for example, raises the interest rate and crowds out some private investment. It may
also crowd out consump&on spending. There is an important difference between crowding out
in the classical model and the effects in the short-run. In the classical, long-run model, there is
complete crowding out, while here the crowding out effect is not complete. This analysis
assumes that the Fed does not change the money supply in response to shi$s in the aggregate
expenditure line.
DEFINITIONS
In order presented in chapter.
Wealth constraint: At any point in &me, total wealth is fixed.
Money demand curve: A curve indica&ng how much money will be demanded at each
nominal interest rate.
Money supply curve: A line showing the total quan&ty of money in the economy at each
interest rate.
Excess supply of money: The amount of money supplied exceeds the amount demanded
at a par&cular interest rate.
Excess demand for bonds: The amount of bonds demanded exceeds the amount
supplied at a par&cular interest rate.
Monetary policy: Control of manipula&on of interest rates by the Federal Reserve designed
to achieve a macroeconomic goal.
Federal Funds rate: The interest rate charged for loans of reserves among banks.
Spread: The difference between an interest rate and some other benchmark interest rate.
Zero lower bound: The lowest possible value (zero) for any nominal interest rate (such as
the federal funds rate).
TEACHING TIPS
1. This chapter develops the nega&ve rela&onship between bond prices and interest rates
using a one-year bond. But you may also want to use the simple consol formula when
discussing this rela&onship. A consol is a bond that pays the holder a fixed yearly coupon
(payment) forever. If the price of the bond is denoted as PB, and the coupon payment is
c, then the interest rate, i, is simply
B
c
i
P
This rela&onship can also be expressed as: PB = c/i. Since the coupon is fixed, any change
in the bond price will cause the interest rate to move inversely, and vice versa.
2. Stress that now that we’ve integrated the money market into the short-run macro
model, the familiar phenomenon of “crowding out” occurs. But, unlike in the classical
model, it is less than complete. Why? In the classical model, GDP is fixed at the full
employment level (due to the market-clearing assump&on). Since income cannot rise as
a result of an increase in government spending (G), the other components of income (C
and I) will necessarily have to fall. But in the short-run macro model, a rise in G results in
an increase in Y, so that the fall in C and I is smaller than the rise in G. The following
equa&ons are helpful:
GDP = C + I + G
Classical (long run) model: C + I = G, so GDP = 0
Short run model: C + I < G, so GDP > 0
3. Students frequently 4nd it hard to grasp the concept that an individual’s demand for
money is not limitless. Emphasize that, while one’s demand for wealth may indeed be
limitless, one’s demand for money is not. Use a figure similar to Figure 1 in the chapter
to help students understand this. Extend Figure 1 to the right, so that you can include
non-monetary assets such as stocks, bonds, real estate, etc. Explain that, for a fixed level
of wealth, holding more M1 money means that an individual must reallocate his or her
wealth holdings away from other assets.
4. When the money market is not in equilibrium, the public tries to buy or sell bonds.
Emphasize that the word tries is important. On any given day, the total number of bonds
—like the money stock—is some fixed amount. Therefore, it is impossible for the public
as a whole to acquire more bonds, or get rid of them. A single individual may be able to
acquire bonds or money by exchanging them with another individual. But the total
amount of bonds and money held by the public will remain unchanged.
When many people simultaneously try to buy bonds, they cause the price of bonds to
rise. The price of bonds stops rising only when the public, as a whole, is happy holding
the same bonds they were holding originally. When many people simultaneously try to
sell bonds, they cause the price of bonds to fall. The price of bonds stops falling only
when the public, as a whole, is happy holding the same bonds they were holding
originally. Individuals may buy and sell bonds, but the public, as a whole, can only try to.
DISCUSSION STARTERS
1. As discussed in this chapter, the Fed prac&ces open market opera&ons by buying and
selling government bonds, specifically Treasury securi&es. But the shrinking supply of
Treasury securi&es in the early 2000s (due to budget surpluses) forced the Fed to seek
alterna&ves. As stated in Jacob M. Schlesinger, “Fed Is Wary of Expanding Clout of Fannie
Mae and Freddie Mac,” The Wall Street Journal, p. A2, May 19, 2000, the Fed started
using private-sector bonds, specifically Fannie Mae and Freddie Mac mortgage-backed
securi&es, to conduct open market opera&ons. Have your students read this ar&cle to
explore the implica&ons of using private-sector bonds to conduct monetary policy.
2. Go to hNp://www.federalreserve.gov/monetarypolicy/fomc.htm and read the first
paragraph of the statement for each FOMC mee&ng for the last year or so, in order to
see how the Fed’s federal funds rate target has changed recently. Have your students
explain how the Fed will work to achieve a higher federal funds rate target (answer: the
Fed will decrease the money supply by selling government bonds in the open market)
and how it will achieve a lower federal funds rate target (answer: the Fed will increase
the money supply by buying government bonds in the open market).
3. Go to hNp://www.bloomberg.com/apps/news?pid=20601087&sid=aoB0PvgvvNCU to
see how Federal Reserve Chairman Ben Bernanke defended the Fed’s ac&ons during the
financial crisis of 2008.