Chapter 36 _ Interest Rates and Monetary Policy _ ECON 2020.pdf - \u201cSome newspaper commentators have stated that the chairperson of the Federal Reserve

Chapter 36 _ Interest Rates and Monetary Policy _ ECON 2020.pdf

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“Some newspaper commentators have stated that the chairperson of the Federal Reserve Board (currently Janet Yellen) is the second most powerful person in the United States, after the U.S. president. That is undoubtedly an exaggeration because the chair has only a single vote on the 7-person Federal Reserve Board and 12-person Federal Open Market Committee. But there can be no doubt about the chair’s influence as well as the overall importance of the Federal Reserve and the monetary policy that it conducts. Such policy consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy. The goal of monetary policy is to achieve and maintain price-level stability, full employment, and economic growth.” 36.1 [Interest Rates]: Discuss how the equilibrium interest rate is determined in the market for money. The Fed’s primary influence on the economy in normal economic times is through its ability to change the money supply (M1 and M2) and therefore affect interest rates. Interest rates can be thought of in several ways. Most basically, interest is the price paid for the use of money. It is also the price that borrowers need to pay lenders for transferring purchasing power to the future. And it can be thought of as the amount of money that must be paid for the use of $1 for 1 year. Although there are many different interest rates that vary by purpose, size, risk, maturity, and taxability, we will simply speak of the interest rate unless stated otherwise. Let’s see how the interest rate is determined. Because it is a “price,” we again turn to demand and supply analysis for the answer. The demand for money as a medium of exchange is called the transactions demand for money. The level of nominal GDP is the main determinant of the amount of money demanded for transactions. The larger the total money value of all goods and services exchanged in the economy, the larger the amount of money needed to negotiate those transactions. The transactions demand for money varies directly with nominal GDP. We specify nominal GDP because households and firms will want more money for transactions if prices rise or if real output increases. In both instances a larger dollar volume will be needed to accomplish the desired transactions. FIGURE 36.1 The demand for money, the supply of money, and the equilibrium interest rate. The total demand for money Dm is determined by horizontally adding the asset demand for money Da to the transactions demand Dt. The transactions demand is vertical because it is assumed to depend on nominal GDP rather than on the interest rate. The asset demand varies inversely with the interest rate because of the opportunity cost involved in holding currency and checkable deposits that pay no interest or very low interest. Combining the money supply (stock) Sm with the total money demand Dm portrays the market for money and determines the equilibrium interest rate ie.
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To the extent they want to hold money as an asset, there is an asset demand for money.
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