The asset demand for money is downsloping because

Chapter Sixteen outline

1. The fundamental goal of monetary policy is to achieve and maintain price stability, full employment, and economic growth. The Federal Reserve can accomplish this goal by exercising control over the amount of excess reserves held by commercial banks, and thereby influencing the size of the money supply and the total level of spending in the economy.

2. Interest is the price paid for the use of money. The interest rate is determined by demand and supply in the market for money.

a. Business firms and households wish to hold and, therefore, demand money for two reasons:

(1) Because they use money as a medium of exchange, they have a transactions demand for money that is directly related to the nominal gross domestic product (GDP) of the economy

(2) Because they also use money as a store of value, they have an asset demand for money that is inversely related to the rate of interest

(3) Their total demand for money is the sum of the transactions demand and asset demand for money.

b. In the market for money, the demand for money and the supply of money determine the equilibrium interest rate. Graphically, the demand for money is a downsloping line and the supply of money is a vertical line, and their intersection determines the equilibrium interest rate.

c. Disequilibrium in this market is corrected by changes in bond prices and their inverse relationship with interest rates.

(1) If there is a decrease in the money supply, there will be a shortage of money, so bonds will be sold to obtain money. The increase in supply of bonds will drive down bond prices, causing interest rates to rise until the shortage of money is eliminated.

(2) If there is an increase in the money supply, there will be a surplus of money, so bonds will be bought. The increase demand for bonds will drive up bond prices, causing interest rates to fall until the surplus of money is eliminated.

3. By examining the consolidated balance sheet and the principal assets and liabilities of the Federal Reserve Banks, and understanding of the ways the Federal Reserve can control and influence the reserves of commercial banks and the money supply can be obtained.

a. The principal assets of the Federal Reserve Banks are U.S. government securities and loans to commercial banks.

b. The principal liabilities are Federal Reserve Notes (outstanding), the reserve deposits of commercial banks, and U.S. Treasury deposits.

4. The Federal Reserve Banks use four principal tools to control the reserves of banks and the size of the money supply.

a. The Federal Reserve can buy or sell government securities through its open-market operations to change the excess reserves of banks and thus the lending ability of the banking system.

(1) Buying government securities in the open market from either banks or the public increases the excess reserves of banks.

(2) Selling government securities in the open market to either banks or the public decreases the excess reserves of banks.

b. The Federal Reserve can raise or lower the reserve ratio.

(1) Raising the reserve ratio decreases the excess reserves of banks and the size of the monetary (checkable-deposit) multiplier

(2) Lowering the reserve ratio increase the excess reserves of banks and the size of the monetary multiplier

c. The Federal Reserve can raise or lower the discount rate. Raising the discount rate discourages banks from borrowing reserves from the Fed. Lowering the discount rate encourages banks to borrow from the Fed.

d. The Federal Reserve can auction off to banks the right to borrow reserves for a set period of time (usually 28 days) through its term auction facility. Banks submit bids for the amount of desired reserves and the interest rate they would pay for them. The equilibrium interest rate is the lowest rate that brings the quantity demanded and the quantity supplied of reserves into balance. The use of such auctions by the Federal Reserve increases the excess reserves of banks.

e. Of the four main monetary tools, open-market operations is the most important because it is the most flexible and direct.

5. The Federal funds rate, the interest rate that banks charge each other for overnight loans of excess reserves, is a focus of monetary policy. The Federal Reserve can influence the Federal funds rate by buying or selling government securities. When the Federal Reserve buys bonds, banks have more excess reserves to lend overnight so the Federal funds rate falls. When the Federal Reserve sells bonds, banks have fewer excess reserves to lend overnight so the Federal funds rate rises. A graph of the market for Federal funds has the interest rate on the vertical axis and the quantity of reserves on the horizontal axis. The demand for reserves is a downsloping demand curve. The supply of reserves is a horizontal line at the desired rate because the supply of reserves is set by the Federal Reserve.

a. An expansionary monetary policy can be implemented by actions of the Federal Reserve to buy government securities in open-market operations to lower the Federal funds rate. This policy expands the money supply, putting downward pressure on other interest rates, and helps to stimulate aggregate demand. The prime interest rate is the benchmark rate that banks use to decide on the interest rate for loans to businesses and individuals; it rises and falls with the Federal funds rate.

b. A restrictive monetary policy can be implemented by actions of the Federal Reserve to sell government securities in open-market operations that raise the Federal funds rate. This policy contracts the money supply, putting upward pressure on other interest rates, and helps to reduce aggregate demand to maintain a stable price level.

6. Monetary policy affects the equilibrium GDP in many ways.

a. The cause-effect chain goes from the money market to investment spending to equilibrium GDP

(1) In the market for money, the demand curve for money and the supply curve of money determine the real interest rate

(2) This rate of interest in turn determines investment spending

(3) Investment spending then affects aggregate demand and the equilibrium levels of real output and prices

b. If recession or slow economic growth is a major problem, the Federal Reserve can institute an expansionary monetary policy that increases the money supply, causing the interest rate to fall and investment spending to increase, thereby increasing aggregate demand and increasing real GDP by a multiple of the increase in investment

c. If inflation is the problem, the Federal Reserve can adopt a restrictive monetary policy that decreases the money supply, causing the interest rate to rise and investment spending to decrease, thereby reducing aggregate demand and controlling inflation

7. Monetary policy is considered more important and valuable for stabilizing the national economy because of its several advantages over fiscal policy: it is quicker and more flexible; and it is more protected from political pressure

a. Recent U.S. monetary policy has been expansionary and restrictive in response to concerns about recession and inflation

(1) In late 2000 to late 2002, the Federal Reserve reduced the Federal funds rate to counter an economic slowdown and recession during that period. The rate was cut again in 2007 in response to the mortgage debt crisis and a term auction facility was initiated in December 2007 to increase the reserves of commercial banks.

(2) To curtail inflation, the Federal funds rate was raised from 1999 to late 2000. The rate was also raised from mid-2004 through mid-2006 to contain expected inflation.

b. There are limitations and real-world complications with monetary policy in spite of its successes over the years.

(1) It is subject to a recognition lag between the time when the need for the policy is recognized and also an operations lag that occurs between the time the policy is implemented and it begins to influence economic activity.

(2) There is a cyclical asymmetry with monetary policy: A restrictive monetary policy works better than an expansionary monetary policy. A restrictive policy seems to work better because the Federal Reserve can easily withdraw and absorb excess reserves from banks and curtail economic activity. An expansionary policy may not work because even when the Federal Reserve makes more reserves available to banks, the economic conditions of recession or slow growth may make businesses hesitant to increase their borrowing and increase their investment spending.

8. The ”big picture” of macroeconomics shows that the equilibrium levels of output, employment, income, and prices are determined by the interaction of aggregate supply and aggregate demand.

a. There are four expenditure components of aggregate demand: consumption, investment, government spending, and net export spending.

b. There are three major components of aggregate supply; the prices of inputs or resources, factors affecting the productivity with which resources are used, and the legal and institutional environment.

c. Fiscal, monetary, or other government policies may have an effect on the components of aggregate demand or supply, which in turn will affect the level of output, employment, income, and prices.