MonetaryPolicyToolsand TargetsThe Fed has three monetary policy tools at its disposal:: Open market operations·Discount policy:Reserve requirementsIt uses these tools to try to influence the unemployment and inflationrates.It does this by directly influencing its monetary policy targets:Themoneysupply: The interest rate (primary monetary policy target of the Fed)Note:Duringtherecessionof2007-2009,theFeddevelopednewpolicy tools. For now, we are addressing how the Fed carries outmonetarypolicyduring“normal"times.@2015PearsonEducation,lnc
© 2015 Pearson Education, Inc. 11 Monetary Policy Tools and Targets The Fed has three monetary policy tools at its disposal: • Open market operations • Discount policy • Reserve requirements It uses these tools to try to influence the unemployment and inflation rates. It does this by directly influencing its monetary policy targets: • The money supply • The interest rate (primary monetary policy target of the Fed) Note: During the recession of 2007-2009, the Fed developed new policy tools. For now, we are addressing how the Fed carries out monetary policy during “normal” times
The Demand for MoneyThe Fed's two monetarypolicy targets are relatedInterestin an important way:rate,i: Higher interest ratesresult in a lower4%1.Adecreaseintheinterestquantity of moneyrate..3demanded.Why?Whenthe interest2....causesrate is high, alternativesanincreaseinto holding money begin tothe quantityMoneyofmoneydemand, MDlook attractive-like U.S.demanded.Treasury bills.0$900950Quantityofmoney,M. So the opportunity cost(billionsofdollars)of holding money isFigure 15.2The demand formoneyhigher when theinterest rate is high12@2015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 12 The Demand for Money The Fed’s two monetary policy targets are related in an important way: • Higher interest rates result in a lower quantity of money demanded. Why? When the interest rate is high, alternatives to holding money begin to look attractive—like U.S. Treasury bills. • So the opportunity cost of holding money is higher when the interest rate is high. Figure 15.2 The demand for money
Shifts in the Money Demand CurveWhat could cause the moneydemand curve to shift?. A change in the needInterestrate,iAn increase in realto hold money, toGDPoran increase inthe price level will shiftengage intransactionsthemoneydemandcurve to the right.For example, if moretransactions are taking place(higher real GDP) or moreAdecrease inrealmoney is needed for eachGDPoradecreaseintheprice level will shiftMD2transaction (higher priceMD1themoneydemandMD3curvetothe left.level), the demand for moneywill be higher.0Quantityofmoney,M(billionsofdollars)DecreasesinrealGDPortheFigure 15.3Shifts in the moneyprice level decrease moneydemand curvedemand132015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 13 Shifts in the Money Demand Curve What could cause the money demand curve to shift? • A change in the need to hold money, to engage in transactions. For example, if more transactions are taking place (higher real GDP) or more money is needed for each transaction (higher price level), the demand for money will be higher. Decreases in real GDP or the price level decrease money demand. Shifts in the money demand curve Figure 15.3
How Does the Fed Manage the Money Supply?We saw in the previous chapter that the Fed alters the money supplyby buying and selling U.S. Treasury securities.. To increase the money supply, the Fed buys those securities, thesellers deposit the sale proceeds in a checking account, and themoney gets loaned out-increasing the money supply.: Decreasing the money supply would require selling securities@2015PearsonEducation,Inc.14
© 2015 Pearson Education, Inc. 14 How Does the Fed Manage the Money Supply? We saw in the previous chapter that the Fed alters the money supply by buying and selling U.S. Treasury securities. • To increase the money supply, the Fed buys those securities, the sellers deposit the sale proceeds in a checking account, and the money gets loaned out—increasing the money supply. • Decreasing the money supply would require selling securities
Eguilibrium inthe Money MarketMoneyInterestFor simplicity,we assume therate,isupply,MS2MS1Fed can completely control themoney supply1.WhentheFed: Then the money supplyincreasesthemoney4%..thesupplyfromMS,tocurve is a verticalMS2.equilibriuminterestratefalls.line--it does not3depend on the interest rate.Equilibrium occurs in the moneymarket where the two curvesMDcross.WhentheFedincreasesthe0$900950Quantityofmoney,M(billionsofdollars)money supply,the short-terminterestratemustfall until itFigure15.4The effectonthe interestreaches a levelat whichratewhentheFedhouseholds and firms are willingincreasesthemoney supplyto hold the additional money15@2015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 15 Equilibrium in the Money Market For simplicity, we assume the Fed can completely control the money supply. • Then the money supply curve is a vertical line—it does not depend on the interest rate. Equilibrium occurs in the money market where the two curves cross. When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money. The effect on the interest rate when the Fed increases the money supply Figure 15.4