Monetary policy

Supply and the Demand for Central

Bank Money
The demand for central bank money is equal to
the demand for currency by people plus the
demand for reserves by banks.
The supply of central bank money is under the
direct control of the central bank.
The equilibrium interest rate is such that the
demand and the supply for central bank money
are equal.

 The equilibrium interest rate is such that the

supply of central bank money is equal to the
demand for central bank money.

 A higher interest rate implies a lower demand for

central bank money for two reasons:
(1) The demand for currency by people goes down;
(2) the demand for checkable deposits by people also goes
down.

This leads to lower demand for reserves by

banks.
The supply of money is fixed and is represented
by a vertical line at H.
An increase in the supply of central bank money
leads to a shift in the vertical supply line to the
right. This leads to a lower interest rate.
An increase in central bank money leads to a
decrease in the interest rate.

The Goods Market

Equilibrium in the goods market: Production, Y,
be equal to the demand for goods, Z.
Z Y

Y C (Y T ) I (Y , i ) G
An increase in output leads, through its effects on
both consumption and investment, to an increase
in the demand for goods.
The above equation tells us how the interest rate
affects output.

 This relation between demand and output, for a

given interest rate, is represented by the upwardsloping curve ZZ.

IS (investment/saving)
curve
The relation between the interest rate and output
is represented by a downward sloping curve.
This curve is called the IS (investment/saving)
curve.
The increase in the interest rate decreases
investment. The decrease in investment leads to
a decrease in output, which further decreases
consumption and investment, through the
multiplier effect.

Derivation of the IS Curve

Equilibrium in the goods

market implies that an
increase in the interest
rate leads to a decrease
in output.
The IS curve is therefore
downward sloping.

Shifts of the IS Curve

Every point on the IS curve is an income/real interest
rate pair (Y,i) such that the demand for goods is
equal to the supply of goods or, equivalently, desired
national saving is equal to desired investment.
The IS curve is for given the values of taxes, T, and
government spending, G. Changes in either T or G
will shift the IS curve.
Changes in factors that decrease the demand for
goods given the interest rate shift the IS curve to the
left. Changes in factors that increase the demand for
goods given the interest rate shift the IS curve to the
right.

Financial Markets and the LM

Relation
Interest rate is determined by the equality of the supply of
and the demand for money.
The demand for money in the economy as a whole is just
the sum of all the individual demands for money by the
people in the economy.
Therefore, it depends on the overall level of transactions
in the economy and on the interest rate.

M $Y L(i)
The variable M on the left side is the nominal money
stock. The right side gives the demand for money, which
is a function of nominal income, $Y, and of the nominal
interest rate, i.

 An increase in nominal income increases the

demand for money; an increase in the interest
rate decreases the demand for money as people
put more of their wealth into bonds. Money
demand is a decreasing function of the interest
rate.

 Rewrite the relation among real money (that is,

money in terms of goods), real income (that is,
income in terms of goods), and the interest rate.
Nominal income divided by the price level equals
real income, Y. Dividing both sides of the equation
by the price level P gives
M

Y L(i)

This equation known as the LM

preference/money supply )relation.

(liquidity

 Example to understand real demand for money.

Think not of your demand for money in general
but just of your demand for coins. Suppose you
like to have coins in your pocket to buy two cups
of coffee during the day. If a cup costs $1.20, you
will want to keep about $2.40 in coins: This is
your nominal demand for coins. This is your
demand for coins in terms of goodshere in
terms of cups of coffee.

Deriving the LM Curve

An increase in income leads, at a given interest
rate, to an increase in the demand for money.
Given the money supply, this increase in the
demand for money leads to an increase in the
equilibrium interest rate. The LM curve is
therefore upward sloping.

 When
income
increases,
money
demand
increases; but the money supply is given. Thus,
the interest rate must go up until the two
opposite effects on the demand for moneythe
increase in income that leads people to want to
hold more money and the increase in the interest
rate that leads people to want to hold less money
cancel each other. At that point, the demand for
money is equal to the unchanged money supply,
and financial markets are again in equilibrium.

 For a given level of output, an increase in the

money supply leads to a decrease in the interest
rate. In graphic terms: An increase in the money
supply shifts the LM curve down.

The IS and the LM Relations

Together

Equilibrium in the goods market implies that an increase in

the interest rate leads to a decrease in output. This is
represented by the IS curve.
Equilibrium in financial markets implies that an increase in
output leads to an increase in the interest rate. This is
represented by the LM curve.
Only at point A, which is on both curves, are both goods
and financial markets in equilibrium.

Links Between the Goods

Market and the Money Market
The IS relation follows from the condition that the
supply of goods must be equal to the demand for
goods. Goods market determines Y given i. It
tells us what happens to Y when interest rate
changes.
The LM relation follows from the condition that
the supply of money must be equal to the
demand for money. Financial markets determine i
given Y; so we want to know what happens to
Goods rate
Market
Market
interest
when Money
output changes.
Y=C+I+G Link1 Link2
Money demand=Money supply
(determines Y) (determines interest rate i)
I depends on i
depends on Y

Money demand

Monetary Policy
An increase in the money supply is called a
monetary expansion.

A decrease in the money supply is called a

monetary
contraction
or
monetary
tightening.

 A monetary expansion leads to higher output and

a lower interest rate. The increase in money leads
to a lower interest rate. The lower interest rate
leads to an increase in investment and, in turn, to
an increase in demand and output.

 A low interest rate stimulates spending, particularly

investment; a high interest rate reduces spending.
By changing the interest rate, the Fed can change
aggregate output (income).
What Is the Feds Policy InstrumentThe Money
Supply or the Interest Rate?
Central bank changes in the money supply which
affects the interest rate by engaging in open
market operations (buying and selling government
securities).
In practice, the Fed targets the interest rate rather
than the money supply.

 In practice, it is the interest rate that directly affects

economic activity, for example, by affecting firms
decisions about investing. Targeting the interest rate
thus gives the Fed more control over the key
variable that matters to the economy.
The interest rate value that the Fed chooses
depends on the state of the economy.
The Fed wants high output and low inflation.
The Fed is likely to decrease the interest rate during
times of low output and low inflation, and it is likely
to increase the interest rate during times of high
output and high inflation.

Monetary Policies for Recession and

Inflation

Effects of Fiscal and Monetary Policy