Monetary Policy
Lecture 14


Supply and Demand for Money


  1. People hold money

    1. Transaction demand – people need money to buy goods and serves

    2. Precautionary demand – people hold money for uncertainty

      1. Medical emergency

      2. Bail a relative out of jail

    3. Store of value – people save money

  2. Demand for money

    1. As interest rate increases, people hold less money

    2. Deposit money into banks to earn interest

    3. A higher GDP requires more money

Demand for Money

  1. Supply of money

    1. Central bank supplies money

    2. Interest rate is independent of the money supply

Supply of Money

  1. Market equilibrium – interaction of supply and demand

Supply and Demand for Money

  1. Review – interest rates and bond prices are inversely related

    • Present value formula

Equation 1

  • Example – bought a $10,000 T-bill for $9,500. In one year, my return is

Equation 2

  • What if the bond market price is $9,000?

    Equation 3

Expansionary Monetary Policy


  1. Central bank increases the money supply

  2. Central bank buys assets

    1. The Fed usually buys U.S. gov. securities

    2. The Fed “electronically” increases the bank deposits as it buys assets

    3. “Fed” check

Expansionary monetary police decreases interest rates


Expansionary monetary policy creates inflations and boosts GDP

    1. Interest rates decrease

    2. Expands GDP and creates inflation

    3. Note: U.S. dollar depreciates relative to other currencies

      • More U.S. dollars in circulation relative to other currencies

    4. Expansionary monetary policy boost the economy

      • The lower interest rates

        1. Increases business investment

        2. Households buy more cars and houses

        3. Weaker U.S. dollar boosts the export industries

  1. Contractionary monetary policy

    • The complete opposite of expansionary monetary policy