...2013 The Control of Money Supply & Demand of Money Today, we live in a world of scarcity where resources are limited and the choices one make has become so vital the economy. In the US, the government, the Federal Reserve, have control on the effect of supply and demand and money growth. As both supply and demand for money each depend on the interest rate, we specifically look at how inflation effects supply and demand on money. There are differences of money supply and demand for money; where it comes from and how it’s demanded. Given there are many variables that can effect money supply and the demand for money, we will focus on where it comes from and how inflation effects it. In the book, The General Theory of Employment, Interest, and Money by John Maynard Keynes, he explains liquidity factors in economic interest rates that balance supply and demand for money. There are two different types of interest rate that help explain, in monetary terms, how much borrowers pay for borrowed funds. Generally, during a period of inflation where prices increase, nominal interest can be misunderstood. As the nominal interest rate rises or falls, it can be misleading as to how much the borrower is truly borrowing and how much the lender is receiving. When the borrower repays the principle loan, they lender may not be able to purchase as much goods and services, then when originally loaned. This is because when the loan was initially issued the money was worth more than...
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...the discount rate controls the amount of money in the reserve it also affects interest rates on loans in the loanable funds market. A lower discount rate means more money supply which also means a lower interest rate. A high discount the rate equals a lower money supply and a higher interest rate. These all control the health of the economy. Interest rates are the prices that are charged or paid for the use of a financial asset (Colander, 2010). Financial assets are key variables in the financial sector and they can consist of either money or credit cards. However, money does not collect interest unless it is from the loanable funds market. In order for money to be considered in the loanable funds market it must be able to return into the loanable funds market for instance, an individual deposits $100 into the bank, the bank then loans $90 which is backed by the Federal Reserve out to anotherSince the discount rate controls the amount of money in the reserve it also affects interest rates on loans in the loanable funds market. A lower discount rate means more money supply which also means a lower interest rate. A high discount the rate equals a lower money supply and a higher interest rate. These all control the health of the economy. Interest rates are the prices that are charged or paid for the use of a financial asset (Colander, 2010). Financial assets are key variables in the financial sector and they can consist of either money or credit cards. However, money does not collect...
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...Should the Central Bank control the Money Supply or Interest Rate 7 Uses of Monetary Policy 9 Drawbacks of Monetary Policy 11 The Effectiveness of Monetary Policy 12 Monetary Policy of Pakistan 13 What is Monetary Policy Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. The Need for Monetary Policy The government must regulate the money supply in order to maintain economic stability. If the government doesn’t intervene, the banks can lead to destruction in the economy. During a recession, profit-oriented banks would be prone to reduce the money supply by increasing their excess reserves...
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...discount rate? The factors that influence the Fed adjusting the discount rate tie closely with whatever monetary policy is in place. Since the discount rate is the interest rate at which the Fed loans money to banks, an expansionary policy would lower the discount rate increasing money supply where as an increased discount would raise interest rates and contract the money supply. How does the discount rate affect the decisions of banks in setting their specific interest rates? The discount rate effects the decisions of banks in setting their specific rates by the discount rate acting as the indicator of ease at which the banks are able to borrow from the central bank. For instance, if the discount rate is lower, that means banks are able to borrow from the Fed more easily and since the banks are able to borrow more easily, their rates will be lower at which the lend to the average person. How does monetary policy aim to avoid inflation? The monetary policy that is used to avoid inflation is the contractionary monetary policy. This policy raises interest rates which decrease the amount of money being spent in the economy. When the amount of money being spent is decreased, the decreases consumer spending which eventually lowers the price of goods or at least slows down the rise in prices of goods. How does monetary policy control the money supply? Monetary policy controls the money supply by either raising or lowering interest rates. When interest rates are raised...
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...income continues indefinitely. Therefore, in the Keynesian-cross model, increasing government spending by one dollar causes an increase in income that is greater than one dollar: it increases by ∆G/(1 – MPC). 2. The theory of liquidity preference explains how the supply and demand for real money balances determine the interest rate. A simple version of this theory assumes that there is a fixed supply of money, which the Fed chooses. The price level P is also fixed in this model, so that the supply of real balances is fixed. The demand for real money balances depends on the interest rate, which is the opportunity cost of holding money. At a high interest rate, people hold less money because the opportunity cost is high. By holding money, they forgo the interest on interest-bearing deposits. In contrast, at a low interest rate, people hold more money because the opportunity cost is low. Figure 10–1 graphs the supply and demand for real money balances. Based on this theory of liquidity preference, the interest rate adjusts to equilibrate the supply and demand for real money balances. Interest rate r Figure 10–1 Supply of real money balances r Demand for L (r) = real money balances M/P Real money balances 82 M/P Chapter 10 Aggregate Demand I 83 Why does an...
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...factors that would influence the Federal Reserve in adjusting the discount rate? * The amount of money that is in the reserve determines the discount rate. The quantity of loanable funds supplied must equal the quantity of loanable funds demanded. The discount rate is an implemented rate set by the Federal Reserve (Thornton, n.d.). The discount rate is the interest rate that the Federal Reserve lends to reserve depositories such as Wells Fargo or Chase Morgan. Each depository has a set of reserve requirements. These loans from the Federal Reserve enable them to meet these requirements. An increase in the discount rate means a decrease in the money supply and a decrease in the discount rate means an increase in the money supply. The discount rate is used to influence the economy. The discount rate is used to stimulate the economy. It helps to stop inflation or to increase spending, depending on the current health of the economy. * * * How does the discount rate affect the decisions of banks in setting their specific interest rates? * Since the discount rate controls the amount of money in the reserve it also affects interest rates on loans in the loanable funds market. A lower discount rate means more money supply which also means a lower interest rate. A high discount the rate equals a lower money supply and a higher interest rate. These all control the health of the economy. Interest rates are the prices that are charged or paid for the use of a financial asset...
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...CHAPTER 11 MONEY, INTEREST, AND INCOME Chapter Outline • The Goods Market and the IS Curve • Investment and the Interest Rate • The Slope of the IS Curve • The Role of the Multiplier • The Position of the IS Curve • A Summary of the IS Curve • The Money Market and the LM Curve • The Demand for Money • The Supply of Money, Money Market Equilibrium and the LM Curve • The Slope of the LM Curve • Shifts in the LM Curve • A Summary of the LM Curve • Equilibrium in the Goods and Money Markets • Changes in the Equilibrium Income and Interest Rate: A First Look at Policy • Deriving the Aggregate Demand Curve • Working With Data Changes from the Previous Edition One of the major problems with this chapter in the previous editions is that the material was presented in a manner that made it sound like it would be difficult, which is not true. Therefore, the long introduction has been shortened, the confusing diagram (former Figure 12-2) has been removed, and the extra part concerning outline of the chapter has been removed. The derivation of the IS curve section has been rewritten at the beginning. Box 11-1 and Box 11-2 and 11-3 are new The LM curve section has been rewritten to make it more clear, and the relevant diagrams are now side by side, which makes much more sense. The last section of the chapter is rewritten to show the comparative statics of shifts in IS and LM; this serves as a good introduction to Chapter 12. Learning...
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...established, they include stable prices, maximum employment and reasonable long term interest rates (Hetzel, 2008). Factors that would influence the Federal Reserve in adjusting the discount rate Factors that would influence the Federal Reserve in adjusting the discount rate include: Money supply: When money supply in the economy increases, the Federal Reserve increases the discount rate to encourage more savings Rate of borrowing: When the rate of borrowing is high the Federal Reserve increases the discount rate to discourage borrowing. Available reserves: When the available reserves decrease, the Federal Reserve decreases the discount rate to encourage more savings. Interest rates: This is where a decrease in interest rate would culminate into a decrease in the discount rate (Brezina, 2012). Does the discount rate affect the decisions of banks in setting their specific interest rates? The discount rate charged on the commercial banks by Fed for reserve lending is unavoidably less than the Federal funds rate. Therefore, the interest rate charged by commercial banks to other banks is usually higher to ensure profitability of banks. This is usually facilitated by the fact that commercial banks usually borrow from each other When Federal Reserve increases the interest rate charged on other banks, the commercial banks increase their prime rate, which affects the rates charged on mortgages,...
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...DEFINITION OF 'INTEREST RATE' The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the "lease rate". When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher. 1. What does negative interest rate mean? It is actually possible for real interest rates to be negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%. A comparison of real and nominal interest rates can therefore be summed up in this equation: Nominal interest rate – Inflation = Real interest rate An interest rate paid by a lender to a borrower rather than the other way around. Negative interest rates may occur when the interest rate is below the inflation rate, or when the lender actually pays the borrower more. Negative interest rates occur during periods of high volatility. Denmark and Switzerland have negative rates, as well...
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...Securities Liquid Money – Cash Page 230 230 231 231 B. Liquidity Preference and the Demand for Money 232 C. Implications of the Interest Sensitivity of the Demand for Money Interest Rates and Demand for Goods and Services Classical and Monetarist View The Keynesian View of Interest Rates and Expenditure Implications of the Differences 234 234 235 235 235 D. Changes in Liquidity Preference 237 E. The Quantity Theory of Money and the Importance of Money Supply The Money Equation Diagrammatic Representation of the Quantity Theory of Money 238 238 238 F. Methods of Controlling the Supply of Money Interest Rate Control Control over Banking Ratios Direct Controls over Banks Control of Government Borrowing 240 240 240 240 241 G. Monetary Policy and the Control of Inflation 241 © ABE and RRC 230 Monetary Policy Objectives The aim of this unit, in conjunction with Study Unit 12, is to explain and evaluate the effectiveness of monetary policy in a closed and open economy and discuss the possible impact of monetary policy on business decision-making. When you have completed this study unit and Study Unit 12 you will be able to: demonstrate an understanding of the relationship between the banking system and the creation of money identify the components of the high-powered money stock and explain why these have a magnified impact on the money supply explain the quantity theory of money and its role in explaining...
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...going to discuss Discount Rates set by the Federal Reserve and how this affects the supply of money and decisions made by banks on borrowing. I will explain the Monetary Policy used by the Fed to control the supply of money and how these aim to avoid inflation. I will explain how the infusion of stimulus programs affects the supply of money. I will also describe the current indicators that show there is too little or too much money in the economy today and what steps are being taken to correct this. The current state of the economy and the demand for money are factors that influence the Federal Reserve to adjust the discount rate. Banks request additional money when their reserves get low. Changes in real estate become a factor when homeowners are unable to pay their mortgages and banks lose money. The Federal Reserve decreased interest rates for the real estate market, which made it less expensive for banks to borrow funds. “A change in the credit supply and demand influenced the Federal Reserve to increase the discount rate, discouraging banks from requesting money by making it more expensive for banks to borrow funds, (Colander, 2010)”. The Feds use the spread between the Discount Rate and the Federal Funds Rate to increase or decrease the supply of money. If the Discount Rate is lower than the Federal Funds Rate, banks will borrow from other bank which does not increase the supply of money. When the Federal Funds Rate is lower than the Discount Rate, banks will borrow from...
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...regular interest rates. While this sounds easy in theory, there are many steps leading to these regulations being both defined and implemented. What is money? How does it affect not only trade, but other aspects of the nation and its citizens' financial health? In order to begin, one must first understand just what money is, and what purpose it serves. Money, by definition, is “any circulating medium of exchange, including coins, paper money, and demand deposits.” (www.dictionary.com). Before money as an actual, tangible form of currency, people engaged in bartering, which is the exchange of one good or service for another. For example, a farmer may have chickens, and be in need of medical care. The farmer could trade medical care for a chicken that would lay eggs and provide abstinence for the physician. Eventually, coin and paper currency were developed, an individuals were able to sell products and services for currency. Currency became more valuable, as it was not limited its its use, nor did it expire or spoil. The central bank manages monetary policy in several ways. First, the Federal Reserve controls the money supply which effects both interest rates and the rate of inflation. This is accomplished by reducing the available money supply when inflation is high, and increasing the money supply when rates either skyrocket, or there is extremely limited growth in the economy. The Federal Reserve has two tools. One is that it can alter interest rates on the money the Reserve...
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...try to influence either the supply of money or the price of money, as given by the rate of interest. Instruments of Monetary Policy. The instruments are what the Bank can directly manipulate in an effort to achieve its goals. The main instruments used are: 1) the purchase and sale of financial assets (mainly government securities) in the open-market, so called “open market operations” which directly affect bank reserves: 2) The rate at which it will offer credit to the banking system (interest rate). How Does Monetary Policy Work? 1. Open Market Operations Open market operations refer to the borrowing and repayment of Government debt to the general public. This is undertaken by the state bank to influence the money supply. The state bank can borrow money from the public by selling them securities, bonds and treasury bills. These bills and bonds last for some period of time and therefore that money is out of the market for that time period. 2. Special Deposits The state bank can reduce the money supply by calling for special deposits. The state bank orders commercial banks to deposit money with it for a certain period of time. Calling in special deposits automatically reduces the amount of money that banks have available to lend to their customers. 3. Funding Funding is the name given to the action of the state bank when it buys liquid assets and sells less liquid assets in order to reduce the money supply. 4. Directives Directives...
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...1. | Banks can borrow money from what sources? I. other banks II. the Fed's discount window II. ATM machines | | A. | I only | B. | II only | C. | III only | D. | I and II only | | Correct | Points Earned: | 1/1 | Your Response: | D | 2. | For a given money multiplier, a decrease in the banking system's reserves will cause the money supply to: | | A. | increase. | B. | decrease. | C. | remain constant. | D. | become difficult to predict. | | Incorrect | Points Earned: | 0/1 | Your Response: | A | 3. | When the Fed wants to increase interest rates, it: | | A. | instructs banks across the nation that they must raise their rates. | B. | sells bonds in the open market. | C. | buys bonds in the open market. | D. | adjusts the fractional reserve ratio. | | Correct | Points Earned: | 1/1 | Your Response: | B | 4. | Which of the following are the least liquid assets? | | A. | currencies | B. | checkable deposits | C. | small-time deposits | D. | savings deposits | | Incorrect | Points Earned: | 0/1 | Your Response: | B | 5. | If the Fed buys bonds in the open market: I. investment spending will increase. II. short-term interest rates will increase. III. inflation will increase. | | A. | I and II only | B. | II and III only | C. | I and III only | D. | I, II, and III | | Incorrect | Points Earned: | 0/1 | Your Response: | B | 6. | A bank will become illiquid if:...
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...reading this you should be able to fully understand the future of the economy and more importantly explain what is happening to your customers so they know that they have someone who knows what they are doing behind them. I will be going over the forecast for 2006 with projected quarterly growth rates and what they mean, as well as the rate of inflation for 2006. Along with that we must consider the action the Federal Reserve will take along with how they achieve their goal. The Federal Reserve The Federal Reserve System, often called the Federal Reserve or simply put as The Fed, is the central banking system of the United States. Founded in 1913 by the Federal Reserve Act in response to major financial panics, The Fed has assumed more responsibilities and evolved into a regulatory super bank. Its major duties include but are not limited to; creating monetary policies, supervising and regulating banking institutions and maintaining the stability of the financial system. Today we treat The Fed as a financial guru for when the economic stability of our country seems unusual. The Money Supply The money stock, or more commonly known as the money supply, is the total amount of money available in an economy at a particular point in...
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