Notes
Money and financial assets
- Functions of money: medium of exchange, unit of account, and store of value.
- M1: currency, checkable deposits and savings deposits (since 2020). M2: M1 plus small time deposits and money market funds.
- Bonds pay fixed interest. Bond prices and interest rates move in opposite directions. Stocks are ownership shares.
- Liquidity is how easily an asset becomes cash.
Banks and money creation
- Banks keep required reserves and lend out excess reserves.
- Money multiplier $\displaystyle = \frac{1}{\text{reserve requirement}}$. A new deposit of $D$ can increase the money supply by up to (excess reserves) × multiplier through new loans.
- A bank's balance sheet (T-account): assets (reserves, loans, securities) = liabilities (deposits) + owner's equity.
The money market
- Money demand slopes down: higher interest rates raise the opportunity cost of holding money. It shifts with the price level and real GDP.
- Money supply is vertical, set by the central bank.
- Equilibrium sets the nominal interest rate.
Monetary policy (the Federal Reserve)
- Expansionary: lower interest rates to raise investment and consumption, shifting AD right. Contractionary: raise rates to fight inflation.
- Tools: the interest on reserve balances (IORB) rate and the administered rates (the Fed's main tools in an "ample reserves" system), open market operations (buying bonds increases money supply; selling decreases it), the discount rate, and the reserve requirement.
- The federal funds rate is the rate banks charge each other for overnight loans; the Fed sets a target for it.
The loanable funds market
- Supply comes from savers; demand comes from borrowers (businesses and government). The equilibrium sets the real interest rate.
- Crowding out: government borrowing (deficit spending) increases demand for loanable funds, raising the real interest rate and reducing private investment.
Practice
Prices are stated in money units.
Older bonds paying lower rates become less attractive.
$\displaystyle \frac{1}{0.10} = 10$.
Excess reserves are 900 dollars; $900 \times 10 = 9{,}000$.
Buying bonds adds money and lowers interest rates.
Higher interest rates reduce spending.
Government borrowing competes with businesses for funds.
People need more money to buy the same goods.
Free response
Write your answer first, then open the scoring guide.
Free-response question
The economy is experiencing high inflation.
(a) Identify ONE open market operation the Fed could use and explain how it would affect the money supply.
Show the answer and scoring guide
Sell government bonds. Buyers pay with money that leaves the banking system, reducing reserves and the money supply.
Check off the points you earned:
(b) Explain how this affects the nominal interest rate, using the money market.
Show the answer and scoring guide
The money supply curve shifts left, so the equilibrium nominal interest rate rises.
Check off the points you earned:
(c) Explain how the change in interest rates affects aggregate demand and the price level.
Show the answer and scoring guide
Higher interest rates reduce investment and interest-sensitive consumption, shifting AD left and lowering the price level (reducing inflation).
Check off the points you earned: