SayreMacro9e ch9

SAYRE // MORRIS
Ninth Edition
CHAPTER 9
The Money Market and
Monetary Policy
Jason Dean, Wilfrid Laurier University
© 2018 McGraw-Hill Ryerson Limited 9- 1

CHAPTER 9

Monetary Policy
Learning Objectives:
1. Describe the determinants of money demand and
supply, and explain how equilibrium in the money
market is achieved
2. Explain how the Keynesian transmission process
works by targeting the money supply
3. Explain why monetarists believe that controlling the
money supply is vital

CHAPTER 9

Monetary Policy
4. Explain why many economists are critical of attempts to

target the money supply
5. Explain why most central banks around the world
believe targeting the interest rate is the most effective
monetary tool
6. Explain why anti-inflationary policy emphasizes
targeting the interest rate
7. List some of the recent criticisms of anti-inflationary
monetary policy

Supply of Money
• Interest Rate
– The annual rate at which payment is made for the use of

money (or borrowed funds)
– A percentage of the borrowed amount
– The price of money

Supply of Money
• The supply of money is determined by the Bank of Canada
MS
Rate of interest
The supply of money

is constant at any one
point in time
Quantity of money
The Bank of Canada
• Canada’s central bank
• Government owned institution
• Directors and governor are appointed by the federal cabinet
• Current governor Stephen Poloz
– Since June 2013

Functions of the Bank of Canada
• The issuer of currency
• The government’s bank and manager of foreign currency

reserves
• The bankers’ bank and lender of last resort
• The auditor and inspector of commercial banks
• The regulator of the money supply

Demand for Money
• Two types of demand for money:
– Transactions demand for money
– The desire to hold money as a medium of exchange, that is,
to effect transactions
– demand based on the levels of real GDP and prices
– Asset demand for money
– The desire to store money as a precaution, or when the
current return on investments is low
– Inversely related to interest rates

Transactions Demand for Money
MDT
r
Transactions demand is
unrelated to the rate of
interest
r1
r2
Q Quantity of Money

Asset Demand
r
There is an inverse
relationship between
r1 asset demand and the
rate of interest
r2
MDA
Q1 Q2 Q of Money

Money Demand
r MDT
Total demand for

money is the sum of
transactions demand
+ asset demand
MDA MD= MDT+ MDA
Q of Money

Demand for Money
• In summary, the demand for money is determined by:
– The level of transactions (real GDP)
– The average value of transactions (the price level)
– The rate of interest

Equilibrium
MS
At the equilibrium interest
rate, r1, there is no surplus or
shortage of money.
r1
r2
MD
Q1 Q of M
Equilibrium
MS
Surplus At the equilibrium interest
rate, r1, there is no surplus or
r3
shortage of money.
r1 At any other rate there is

either a shortage or surplus.
r2
Shortage MD
Q1 Q of M
Test Your Understanding
• Assume the asset demand for an economy shown below:
– If nominal GDP is $800 and transaction demand is 10% of
nominal GDP, draw the total demand

Transaction
Demand = 80
Total demand

Transaction Transaction demand

Demand = 80 = 10% x 800
= 80
Total demand =
asset demand
+ transaction
Total demand demand

• If the money supply is $150, draw in the money supply curve
Total demand

• If the money supply is $150, draw in the money supply curve
Money supply
The money supply

is fixed at $150
Total demand

• What is the equilibrium interest rate and quantity of money?
Money supply
Total demand

• What is the equilibrium interest rate and quantity of money?
Money supply
Equilibrium
interest rate is 8%
Equilibrium
quantity of money
is $150
Total demand

• If the interest rate is 10%, is there a shortage or surplus of
money, and by how much?
Money supply
Total demand

• If the interest rate is 10%, is there a shortage or surplus of
money, and by how much?
Money supply
There is a
surplus of $10
Total demand

An Increase in the Interest Rate
• Shifts in either the demand or supply of money can effect the market
interest rate.
How the Money Market Adjusts
• Money markets adjust to a surplus or shortage through bond
yields:
– People can hold wealth as either money or bonds
– Surplus of money: people buy bonds
– Shortage of money: people sell bonds

Bond Yields
• Bonds
– Loans for a set period of time
– Issued by corporations, banks, and various levels of

government
– Have a set face value
– Pay a fixed rate of interest (the coupon rate)
– Can be bought and sold in the market

Bond Yields
• Bonds:
– The return (“yield”) on a bond depends on:
– the coupon rate
– the profit or loss on its sale
Rate of return = coupon interest +/- change in bond price x 100

price paid for bond
– Bond prices adjust to reflect return on other financial

instruments with similar risk
– The higher the price, the lower the return

Bond Yields
Rate of return = coupon interest +/- change in bond price x 100
price paid for bond
• E.g.: $5000 bond, 4% coupon rate, 1 year, bought for:
– The higher the purchase price, the lower the yield

– The lower the purchase price, the higher the yield
• Surplus of money
– People choose to buy bonds to reduce their liquidity and

earn income
– Bond prices rise, leading to a fall in bond yields and

interest rates
– Rates fall until there is no more surplus

• Shortage of money
– People sell bonds in order to increase their liquidity
– Bond prices fall, leading to an increase in bond yields and

interest rates
– Rates increase until there is no more shortage

• Increase in interest rate caused by:
– Rise in the demand for money
– Fall in the supply of money
• Decrease in interest rate caused by:
– Fall in the demand for money
– Rise in the supply of money

a) If money supply = $150, find the equilibrium interest rate.
Interest rate Transaction Total

Asset Demand
(%) Demand Demand
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
a) If money supply = $150, find the equilibrium interest rate.

Asset Demand
(%) Demand Demand
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 At 8% demand
70 equals supply of
80$150 150
7 75 80 155
6 80 80 160
b) If money supply = $140, find the equilibrium interest rate.

Asset Demand
(%) Demand Demand
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
b) If money supply = $140, find the equilibrium interest rate.

Asset Demand
(%) Demand Demand
12 50 80 130
11 55 80 135
10 At 10% demand
60 equals supply of
80 $140 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
c) If interest is 11% and MS = $150, what are the implications?

Asset Demand
(%) Demand Demand
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
c) If interest is 11% and MS = $150, what are the implications?

Asset Demand
(%) Demand Demand
12 50 80 130
11 At 11%
55 demand is $135. 80 135
10 With supply
60 of $150, there80is a 140
9 surplus
65 of 150 – 135 = $15
80 145
8 70 80 150
7 75 80 155
6 80 80 160
Monetary Policy
• Policy designed to change the money supply, credit
availability, and interest rates
• Responsibility of the Bank of Canada

Monetary Policy
• Expansionary Monetary Policy
– A policy that aims to increase the amount of money in the

economy and make credit cheaper and more easily
available
• Contractionary Monetary Policy
– A policy in which the amount of money in the economy is

decreased and credit becomes harder to obtain and more
expensive

Monetary Tools
• Open market operations
– Buying and selling securities by the Bank of Canada in the open
market
• Switching government deposits

– Transfer deposits from a commercial bank to the Bank of Canada to
decrease money supply
– Transfer deposits to a commercial bank to increase money supply
• Targeting the overnight rate
• Moral suasion

Quantitative Easing
• Central banks purchased long term government bonds after
the crash of 2008
– This increased demand for the bonds, pushing up their price
and making them less attractive
• Instead of buying more, the institutions that sold the bonds

lent some of the cash out, increasing the supply of loans and
lowering interest rates
• This induced more people to take out loans which, when
spent, stimulated the economy
a) In the following tables, show the effect if the Bank of
Canada buys $2 billion worth of securities directly from
commercial banks

All Commercial Banks Bank of Canada
ASSETS ASSETS
Reserves:
in vaults $ 70 T-bills and bonds $ 80
on deposit at B of C 10
Securities 120 Total assets $ 80
Loans 600
Total assets $ 800 LIABILITIES
Notes in circulation $ 65
LIABILITIES Deposits of banks 10
Deposits 800 Other liabilities 5
Total liabilities $ 800 Total liabilities $ 80
ASSETS ASSETS
Reserves:
in vaults $ 70 T-bills and bonds $ 80 +2
on deposit at B of C 10 +2
Securities 120 - 2 Total assets $ 80
Loans 600
LIABILITIES Deposits of banks 10 +2
ASSETS ASSETS
Reserves:
in vaults $ 70 T-bills and bonds $ 82
on deposit at B of C 12
Securities 118 Total assets $ 82
Loans 600
LIABILITIES Deposits of banks 12
Keynesian Transmission Process
• Keynesian monetary policy goals
– Steady growth in real GDP
– An exchange rate that ensures a viable balance of trade
– Stable prices
– Full employment

Keynesian Transmission Process
• Transmission process
– The Keynesian view of how changes in money affect

(transmit to) the real variables in the economy
– The interest rate provides the link between the money

market and the goods market

Contractionary Monetary Policy
MS2 MS1
A drop in MS leads
r2 to interest rates rising
r1
Interest rate (%)
MD
Q2 Q1 Quantity of money

A higher interest rate

r2 leads to a drop in
investment spending
r1
Interest rate (%)
ID
I2 I1 Quantity of investment

Aggregate expenditures
A drop in investment
leads to a drop in AE AE1
AE2
YFE YE Real GDP

Price level
The ↓ in AE shifts
AD to the left
P1
AD1
AD2
Y1 Y2 Real GDP

The Effects of
P Potential GDP
Contractionary
AS
monetary policy
reduces AD1 to AD2
The inflationary gap

(YE – YFE) is thereby
closed
AD1
YFE YE
The Effects of
P Potential GDP
Contractionary
AS
monetary policy
reduces AD1 to AD2
The inflationary gap

(YE – YFE) is thereby
closed
AD1
AD2
YFE YE
The Effects of
Expansionary Monetary Policy
P Potential GDP
AS
Expansionary
monetary policy
increases AD1 to AD2
The recessionary gap

(YFE - YE) is thereby
closed
AD1
YE YFE
The Effects of
Expansionary Monetary Policy
P Potential GDP
AS
Expansionary
monetary policy
increases AD1 to AD2
The recessionary gap

(YFE - YE) is thereby
closed
AD1 AD2
YE YFE
Criticisms of
Keynesian Monetary Policy
• The twin goals of full employment and stable prices are
incompatible
• May not be possible to achieve them together
• The best a central bank can do is achieve a delicate balance

between the two, without ever attaining either goal

Monetarist Policy
• Monetarism
– An economic school of thought that believes that cyclical

fluctuations of GDP and inflation are usually caused by
changes in the money supply
– Popularized by Milton Friedman

Velocity of Money
• The number of times per year that a unit of currency is spent
– buying final goods or services
• Sometimes also called the velocity of circulation

Monetarist Policy
• Equation of exchange
– A formula that states that the quantity of money times

the velocity of money is equal to nominal GDP (price level
times real GDP)
MV = PQ
M = money supply P = price level
V = velocity of money Q = real GDP

Monetarist Policy
MV = PQ
• Monetarists assume the velocity of money (V) is constant
– If the economy is at full-employment output, then GDP (Q)

cannot increase
– Rearranging, P = MV
Q
• An increase in money supply (M) will lead to a directly proportional

increase in price levels (P)

a) If M is $100, P is $2, and Q is 500, what is the velocity of money?
b) Given the same parameters as in a), if the velocity of money stays

constant and assuming the economy is at full employment, what
will be the level of P if M increases to $120 (i.e. 20%)?

MV=PQ
100 x V = 2 x 500
V = 10


MV=PQ
100 x V = 2 x 500
V = 10

MV=PQ but V and Q are constant
120 x 10 = P x 500
P = 2.4 (so P is also up 20%)
Keynesians vs. Monetarists
• Keynesians: the demand for money is elastic so a change in money
supply only has a small impact on the interest rate; investment demand is
inelastic so the interest change has little impact on investment

Keynesians vs. Monetarists
• Monetarists: The demand for money is inelastic so a change in the
money supply has a big effect on the interest rate; investment demand is
elastic so the change in the interest rate has a big impact on investment

Criticisms of Keynesian and
Monetarist Policy
• The Bank of Canada cannot control the creation of loans by
the commercial banks
• The slope of the money demand curve is uncertain
• The position of the money demand curve is uncertain

Targeting the Interest Rate
• Suppose the present equilibrium rate is 3%, with quantity of
money demanded at Q1
• Targeting a rate
of 4% will require
a reduction of
the money
supply to Q2
(due to the drop
in quantity
demanded)
• Overnight interest rate
– The interest rate that commercial banks charge one

another on overnight loans
• Target for the overnight rate
– The Bank of Canada’s key policy interest rate
– The midpoint of the Bank’s 50-basis-point operating band

Bank rate The rate the commercial

2.75% banks pay to the Bank of
Canada on loans
Target for the

overnight rate 2.5%
The rate that the Bank of

Bankers deposit rate Canada pays the commercial
2.25% banks on deposits

Anti-inflationary Monetary Policy
• Bank of Canada Goal
“To contribute to solid economic performance and rising living

standards for Canadians by keeping inflation low, stable, and
predictable”
– Preserve internal and external value of currency which

means:
– Keeping inflation rate low (between 1% - 3%)
– Keeping exchange rate stable

Criticisms of
Anti-inflationary Monetary Policy
• If overly concerned about controlling inflation, may lose sight
of other goals, such as economic growth and low
unemployment
• By using high interest rates to control inflation, the central

bank has helped increase the cost of servicing the national
debt

CHAPTER 9
Key Concepts to Remember:
1. The determinants of money demand, supply and

equilibrium in the money markets
2. How the Keynesian transmission process works
3. The monetarist view and the equation of exchange
4. Targeting the interest rate to control inflation
5. Criticisms of targeting the money supply, interest
rates and inflation

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SAYRE // MORRIS

© 2018 McGraw-Hill Ryerson Limited 9- 1

The Money Market and

© 2018 McGraw-Hill Ryerson Limited 9- 2

The Money Market and

4. Explain why many economists are critical of attempts to

© 2018 McGraw-Hill Ryerson Limited 9- 3

– The annual rate at which payment is made for the use of

– A percentage of the borrowed amount

– The price of money

© 2018 McGraw-Hill Ryerson Limited 9- 4

The supply of money

• Government owned institution

• Directors and governor are appointed by the federal cabinet

• Current governor Stephen Poloz

– Since June 2013

© 2018 McGraw-Hill Ryerson Limited 9- 6

• The government’s bank and manager of foreign currency

• The bankers’ bank and lender of last resort

• The auditor and inspector of commercial banks

• The regulator of the money supply

© 2018 McGraw-Hill Ryerson Limited 9- 7

© 2018 McGraw-Hill Ryerson Limited 9- 8

© 2018 McGraw-Hill Ryerson Limited 9- 9

© 2018 McGraw-Hill Ryerson Limited 9- 10

Total demand for

MDA MD= MDT+ MDA

© 2018 McGraw-Hill Ryerson Limited 9- 11

• In summary, the demand for money is determined by:

– The level of transactions (real GDP)

– The average value of transactions (the price level)

– The rate of interest

© 2018 McGraw-Hill Ryerson Limited 9- 12

r1 At any other rate there is

© 2018 McGraw-Hill Ryerson Limited 9- 15

© 2018 McGraw-Hill Ryerson Limited 9- 16

Transaction Transaction demand

© 2018 McGraw-Hill Ryerson Limited 9- 17

© 2018 McGraw-Hill Ryerson Limited 9- 18

The money supply

© 2018 McGraw-Hill Ryerson Limited 9- 19

© 2018 McGraw-Hill Ryerson Limited 9- 20

© 2018 McGraw-Hill Ryerson Limited 9- 21

© 2018 McGraw-Hill Ryerson Limited 9- 22

© 2018 McGraw-Hill Ryerson Limited 9- 23

• Money markets adjust to a surplus or shortage through bond

– People can hold wealth as either money or bonds

– Surplus of money: people buy bonds

– Shortage of money: people sell bonds

© 2018 McGraw-Hill Ryerson Limited 9- 25

– Loans for a set period of time

– Issued by corporations, banks, and various levels of

– Have a set face value

– Pay a fixed rate of interest (the coupon rate)

– Can be bought and sold in the market

© 2018 McGraw-Hill Ryerson Limited 9- 26

Rate of return = coupon interest +/- change in bond price x 100

– Bond prices adjust to reflect return on other financial

© 2018 McGraw-Hill Ryerson Limited 9- 27

• E.g.: $5000 bond, 4% coupon rate, 1 year, bought for:

– The higher the purchase price, the lower the yield

– People choose to buy bonds to reduce their liquidity and

– Bond prices rise, leading to a fall in bond yields and