Fractional Reserve Banking and the Monetary Policy

J.A.SACCOModule 28/31- The Money Market and the Equation of ExchangeGraphing Monetary PolicyThree types of Money DemandTransaction Demand- hold money as a medium of exchange. National income increase, the demand for money increasesPrecautionary Demand- unplanned emergenciesAsset Demand- Money as a store of value instead of other assets.

Graphing Monetary PolicyDemand for Money Curve Why downward sloping?At high interest rate MD is low because rather hold other assets -opportunity host of holding money is high (give up interest on other assets) At low interest rate, MD is high because rate of interest on holding other assets is low -opportunity cost of holding money is lowInt. rate / Q.D. of MoneyInt. rate /Q.D. Money

*Remember a change in the interest rate is only a movement up and down the Money demand curveGraphing Monetary PolicyDemand for Money Curve Shifts?Changes in price level PL increase/ MD increase PL decrease/MD decreaseChanges in Real GDP GDP increase/ MD increase GDP decrease/ MD decreaseChanges in technology- ATMs, credit cardsTech. increase/ MD decreaseTech. decrease/ MD increase*Remember a change in the money demand curve is a shift of the curve

Graphing Monetary PolicyMoney Supply CurveAlways vertical, stock concept

MS increase, IR decrease, expansionaryMD decrease, IR increase, contractionary

Key Point- Interest rate in the money market is determined by the price of bonds in the bond market

Expansionary Monetary PolicyFed. Buys BondsPrice of Bonds?Money Supply?Interest Rate?Investment/Consumption?GDP?Inflation?Unemployment?

Expansionary Monetary PolicyFed. Buys BondsPrice of Bonds?Money Supply?Interest Rate?Invest? Consump?GDP?Inflation?Unemployment?

Draw an AD/AS model starting with a recessionary gap and show the results of the monetary expansion.

Contractionary Monetary PolicyFed. Sells BondsPrice of Bonds?Money Supply?Interest Rate?Invest? Consump?GDP?Inflation?Unemployment?

Draw an AD/AS model starting with a expansionary gap and show the results of the monetary contraction.Contractionary Monetary PolicyFed Sells BondsPrice of Bonds?Money Supply?Interest rate?Invest/Consumption?GDP?Inflation?Unemployment?

The Equation of ExchangeMathematical expression of the quantity theory of money devised by Irving FisherAggregate amount spent by buyers =Total value of all goods and servicesMV=PQEquation to explain how exchange and the role of M and V in determining the level of output (P &Q)The Equation of ExchangeM = Stock of Money- M1 money supply. Currency, travelers checks, checkable deposits. V = Velocity of Money-Income (GDP) velocity of circulation. The average number of times a dollar is spent on final goods and services per time (usually a year).The Equation of ExchangeP = The average price of the final goods and services in GDP. The GDP Deflator.

Q = Real Output. The quantity of goods and services in GDP. Real GDP in dollars of the base year of the deflator.The Equation of ExchangeExample- M= $300 B and V= 5, therefore if Q = $750B then P = ?$2 per unitWhy is this equation important to the money supply?Provides insight into what would happen to output(Q) and prices (P) when money supply changes.The Equation of ExchangeAssume Velocity of Money (V) is constant.If the Supply of Money (M) increases, then either Price (P) or Output (Q) or both must increase. The effect of the change in M on P and Q will depend on the state of the economy.Crude Quantity Theory of Money and PricesIf the economy is operating well below full employment (recession), an increase in M will tend to raise Q (ouput) more than P (price) as unemployed resources are re-employed.If the economy is already at full employment or above, any increase in M will tend to raise P more than Q. The increase in M will be purely inflationary.Thus depending on the state of the economy will have a major impact on whether or not to increase the money supply.Crude Quantity Theory of Money and PricesSo if GDP (Q) can increase 3-5% a year.Then if Q does increase by 3-5% a year, any increase in M above 5% merely increases the price level (demand pull inflation )Increases of less than 3% in M means Q cannot increase by 3% so the price level will fall, recession.The key is to grow the money supply with the growth of output (real GDP) in order to maintain economic stability.