Functions of Money

Monetary Policy

• Monetary Policy tools:
• The Fed can use the following tools to influence the money supply.
• 1. Open Market Operation: The Fed can affect the money supply by buying or selling U.S. government securities, using open market operations. When the Fed purchases a government security from the public, it does so with money that did not exist in the system. Thus, bank reserves will rise, increasing the money supply.
• 2. The Required-Reserve Ratio (r): The Fed can influence money supply by changing this ratio. This ratio specified the amount banks must hold as reserves on all deposits and limits the amount that banks may lend out. If the Fed increases the reserve ratio, the deposit and money multiplier will be smaller, thereby further limiting the amount by which banks may expand the money supply.
• 3. Discount Rate: Banks will borrow funds when needed. When the banks borrow from the Fed, they pay an interest rate called the Discount rate. When the discount rate is raised, banks will have less incentive to borrow, thus lowering the money supply in the system.
• When the economy is in inflationary gap, the Fed will adopt contractionary monetary policy to decrease the money supply in the market by selling securities, raising the reserve rate, and/or increasing the discount rate. These actions will lower the AD and close the GDP gap.
• When the economy is in recessionary gap, the Fed will adopt expansionary monetary policy to increase money supply in the market by buying securities, lowering the required reserve rate, and/or decreasing the discount/federal funds rate. These actions will increase the AD and close the GDP gap.
• However, these policy tools may not be effective due to issues like time lags, liquidity trap, or interest-insensitive investments.

Money Market

• The demand for money has two components: transactional demand and asset demand.
• Transactional demand (Dt) is money kept for purchases and will vary directly with GDP.
• Asset demand (Da) is money kept as a store of value for later use. . Asset demand varies inversely with the interest rate, since that is the price of holding idle money.
• Total demand for money will equal quantities of money demanded for assets plus that for transactions. The demand curve for money illustrates the inverse relationship between the quantity demanded of money and the interest rate.

• The supply of money is a vertical line, suggesting the quantity of money is fixed at a level largely determined by the Fed.
• Equilibrium in the money market exists when the quantity demanded of money equals the quantity supplied. In the above graph, it shows an equilibrium of the money market at interest rate of 6%, and quantity of money at 600 billions. The vertical curve indicates the money supply decided by the Federal Reserve.
• At any interest rate above the equilibrium rate, there is an excess supply of money. At any interest rate below the equilibrium rate, there is an excess demand of money.

• Fed can influence the market interest rate by adjusting the money supply. If the money supply increases (moving the vertical curve in the above graph towards the right), the interception point will demonstrate a lower interest rate in the market. If the money supply decreases (moving the vertical curve in the above graph towards the left), the interception point will demonstrate a higher interest rate. Therefore, market's interest rate is closely related to the monetary policy of the Fed.