Economics

Villa, Monique Williams, Ronald Econ 1AH Beebe April 22nd, 2010 Chapter 12: The Supply & Demand for Money (Pages 267-284) Chapter twelve deals with the relationship between monetary policy and interest rates as it relates to the supply and demand for money. In this chapter, money is referred to as stock. As opposed to other “M2” assets, people prefer to hold certain quantities of money for particular periods of time for its high liquidity. Demand for money is based on people’s income, considering people with low income have too many expenses to withhold amounts of money while the wealthy can elect to hold assets in the highly liquid form of money as opposed to other assets. The stock of money people choose to hold varies proportionately to their level of income. This ratio of nominal domestic income to the stock of money is termed the income velocity of money. By making the choice to maintain any income velocity of money, people are choosing to forgo the opportunity cost of accumulating interest on alternative assets by employing the money in the domestic economic system. Therefore, we can assume that the income velocity varies directly with the opportunity cost of money. What does all of this mean in terms of demand and supply for money' This money sector curve illustrates the quantity of money that all firms and households want to hold under special conditions. The vertical axis represents nominal market interest rates. The quantity of money is the horizontal axis. The demand schedule of money is at a negative curve/slope which shows less quantities of money is demanded when interest rates are low; inversely, higher interest rates produce a higher demand of the quantities of money. The negative slope reflects the fact that, other things being equal, people want to hold less money and more non monetary assets as market interest rates rise. As market interest rates fall, people tend to reduce their holdings of non-monetary assets in order to gain the liquidity benefits of holding more money. The vertical money supply curve is under the control of the Federal Reserve. The shape of the money supply curve is reflective of how the Fed uses its tools of strict monetary control to keep the money stock constant. Once the Fed sets a target for the money stock, it utilizes open market operations to stabilize reserves to keep the money stock on target regardless of what happens to interest rates. The supply and demand curves intersect at a rate of 7 percent. At that rate, the amount of money supplied by the banking system equals the amount people want to hold. This equilibrium amount is determined by the amount of reserves the Fed supplies to the banking system. The actions that the Fed employ to orchestrate the money supply are known as policy instruments. But if the Fed has the ability to control the supply of money, what is the purpose of policy instruments' Policy instruments serve as tools for manipulating open market operations to meet policy targets over the long run. In addition to the long run, policy instruments are also used to guide day-to-day conduct in open market operations. This daily guide of the supply of money is known as the operating target. Market conditions are constantly changing in ways that push the money supply and demand curves around. Therefore, each day the Fed reviews market conditions and determines what open market purchases or sales are needed when market conditions threaten to push the interest rate above or below the target range. For example, if the nominal domestic income were to either rise or fall, the Fed would adjust the money supply so that the interest rate is adjusted to maintain the open market operations within the operating target range. There were a few grammatical and typographical errors in this chapter (as is common throughout Dolan’s text), as well as weaknesses overall. On Page 271 in the beginning of the third paragraph, the sentence reads, “The trade-off between the advantages of holding money (its liquidity) and the disadvantages of doing of holding money (the opportunity cost) is a matter of extent.” The underlined phrase should read, “the disadvantages of holding money”. On Page 271, the second and third sentences of the second paragraph are fragments and need to be combined, as they are not complete thoughts as written. In discussion problem #5, the instructions refer to Figure 12.2 part (b) when it should actually be Figure 12.1, which leads to confusion for students attempting to follow the directions as stated. The weaknesses of the chapter include the introduction to the subject matter as well as the length of the chapter in proportion to the other chapters in the textbook. The chapter begins with a speech from Alan Greenspan to the House of Representatives in 2003, regarding issues of monetary policy during that time; this introduction was never resolved in the text following and thus appears oddly placed. This chapter is also drastically shorter in length than the other chapters in the book (of which can be quite lengthy) and therefore seems oddly placed, as it could have been included in the previous chapters regarding money. Strengths of the chapter include the streamlined approach to the supply and demand curves when graphed (X-axis referring to the quantity of money, Y-axis referring to the interest rate). The graph starts out as a simple demand schedule and address variables such as equilibrium points with the money supply, increases in the money supply and finally increases in the nominal domestic income. Following the supply and demand of money and the supply and demand schedules, a final graph was included to illustrate the concept of an operating target. Accompanied by explanations as to what each graph means in the economy, the chapter is both well written and well illustrated. The length of the chapter can also be seen as a strength considering it does not overload the reader with difficult material. CHAPTER 12 ASSIGNMENT - #5 Rework the example given in Figure 12.4 for the case of a decrease in nominal domestic income from $600 billion to $400 billion. (Use part (b) of Figure 12.1 to draw the demand curve for a nominal domestic income of $400 billion.) A nominal domestic income of $600 billion puts the money demand curve at MD1. The equilibrium interest rate is 4 percent given this income and the money supply of $180 billion. If a decrease in nominal income to $400 billion shifts the demand curve to MD2 (to the left), there will be a deficient demand for money at the initial interest rate. People will try to decrease the quantity of money the hold, in part by increasing consumption.