When interest rates are below equilibrium money

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Unformatted text preview: will lower bond prices causing interest rates to rise. Eventually we will reach market equilibrium. Ryan W. Herzog (GU) Money March 17, 2014 37 / 41 Money Market Equilibrium Controlling the Nominal Interest Rate Because the Federal Reserve controls the money supply they can also control the nominal interest rate (i ). An increase in the money supply will lower the interest rate and a decrease in the money supply will raise the interest rate. How to change the money supply (by changing reserves): Open market operations: buying bonds from banks (increase the money supply) or selling bonds to banks (decrease the money supply) will affect bank reserves. Required Reserve Ratio: by raising the reserve ratio banks will have to hold more reserves (and make less loans) causing the money supply to decrease. Discount Window: During times of distress banks can borrow directly from the Fed through the discount window. By raising/lowering the discount rate (the interest rate charged by the Fed) the Fed can increase or decrease bank reserves. Most common method is open market operations, easy to implement and direct. Ryan W. Herzog (GU) Money March 17, 2014 38 / 41 Money Market Equilibrium An Increase in the Money Supply (Figure 11.8) An open market purchase will increase bank reserves and the money supply. Interest rates will fall. Ryan W. Herzog (GU) Money March 17, 2014 39 / 41 Equation of Exchange The Equation of Exchange The equation of exchange is used to measure the relationship between money and prices The velocity of money is a measure of the speed at which money changes hands involving final goods and services. Velocity = or V= Ryan W. Herzog (GU) Nominal GDP Money Stock (7) P ×Y M (8) Money March 17, 2014 40 / 41 Equation of Exchange The Equation of Exchange In the United States M1 is approximately $1.8 trillion while real GDP is $14 trillion. This implies the velocity of money for M1 is 14/1.8 = 7.8. The velocity of money has been relatively stable. If real GDP Y is also constant than there is a one to one relationship between money and the price level. (9) M ×V =P ×Y Any increase in M will result in an equal increase in P. Ryan W. Herzog (GU) Money March 17, 2014 41 / 41...
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