Unit 4

Equation of Exchange: MV=PQ

• M=money supply
• V= velocity of money: average # of times per year a certain dollar bill is spent
• P= price level
• Q= quantity
• MV= total amount spent by consumers
• PQ= NGDP

M1= money supply

• most liquid
• currency, coins, demand/ checkable deposits, traveler's checks

M2- less liquid, M1+savings

Demand for money: Total demand= Transaction+Asset

• Transaction demand- demand for money as medium of exchange, so like cash. As GDP/PL increase, transaction demand increase
• Asset demand- demand for money as a store of value, so like savings. Varies inversely with interest rate.

Money Market

• supply of money does not change unless the Federal Reserve changes it through monetary policy
• equilibrium NIR is intersection of supply and demand of money

International investors chase less expensive goods and high interest rates. High interest rates will assure that they get more money back for their financial investments.

Banks create money by:

• Fractional Reserves- the Fed sets reserve ratio (RRR) that requires the reserve requirement for each bank, but the bank can lend out its excess reserves allowing it to make loans not fully backed up by reserves. Banks create money through loans.
• Increase in money supply= initial cash deposit x multiplier (1/RRR)

Monetary Policies

• Open Market Operations
• buying securities- increase money supply by increasing bank excess reserves
• selling securities- decrease money supply by decreasing bank excess reserves
• raising reserve ratio- decrease money supply because bank allowed to loan out less reserves
• lowering reserve ratio- increase money supply because bank allowed to loan out more reserves
• lowering discount rate- increase money supply because commercial banks encouraged to obtain more reserves by borrowing from fed
• raising discount rate- decrease money supply because commercial banks discouraged from obtaining more reserves by borrowing from fed
• Easy Money policy- increase money supply
• Tight money policy- decrease money supply
• Fed funds rate- interest rates that member banks charge one another for overnight loans of reserves that are established by interaction of lenders and borrows

Nominal Interest Rate= Inflation Rate + Real Interest Rate