I. Preview / Review

A. The following figure and graphs illustrates what we have already done in chapters 9, 11, 12, 13, and 14, and what we will be doing in chapter 15

FED TOOLS ER MS Int. RatesI AD real GDP UE   Price Level IN OMO DR RR

B. Chapters 11 and 12

• a change in the money supply (MS) causes a change in interest rates (Int. Rates)
• a change in interest rates (Int. Rates) results in a change in Investment (I)
• a change in Investment (I) will change Aggregate Demand (AD)
• a change Aggregate Demand (AD) will change real GDP and therefore unemployment (real GDP UE)
• change Aggregate Demand (AD) will also change the price level, assuming we are in the intermediate range of the AS curve, and therefore it will also change inflation (Price Level IN). See the figure below and the graph.

FED TOOLS ER MS Int. RatesI AD OMO DR RR

real GDP UE   Price Level IN

C. Chapter 13

• we learned how a change in the money supply ( MS) creates a change in interest rates (Int. Rates).

• See figure above and the graph below.

FED TOOLS ER MS Int. RatesI AD

real GDP UE   Price Level IN

OMO
DR
RR

D. In chapter 9 of the textbook

1. Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc.

2. The expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get the expected rate of return. The text's example gives $100 expected profit on a $1000 investment, for a 10% expected rate of return. Thus, the business would not want to pay more than a 10% interest rate on investment. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk.

3. The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of investment.

a. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone.

b. If real interest rate exceeds the expected rate of return, the investment should not be made.

4. Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment.

a. As long as expected return exceeds the interest rate, the investment is expected to be profitable

b. Figure 9-5 shows the relationship when the investment rule is followed. Fewer projects are expected to provide high return, so less will be invested if interest rates are high.

Figure 9.5

5. graph

 

E. Put all the chapter graphs together: IF the MS increases:

FIRST: Chapter 13	THEN: Chapter 9	FINALLY: Chapters 11 and 12
If the MS increases: Chapter 13 MS shifts to the right interest rates decline	If the interest rates decline: the amount of investment increases there is a movement along the graph NOTE: the Investment demand graph does not shift	If investment increases: AD shifts to the right (increases) we have the chapter 12 multiplier effect real GDP increase and UE decreases the price level may increase causing more inflation

 

F. Chapter 14:

• How money is created to increase the money supply (MS)
• ER MS
•  

FED TOOLS ER MS Int. RatesI AD OMO DR RR

real GDP UE   Price Level IN

G. What is left to learn?

1. Chapter 15 - How the Fed controls the money supply: FED TOOLS

• open market operations (OMO)
• changing the discount rate (DR)
• changing the require reserve ratio (RR)

 

FED TOOLS ER MS Int. RatesI AD OMO DR RR

real GDP UE   Price Level IN

 2. HERE IT IS

If there is HIGH UNEMPLOYMENT in the economy, the appropriate monetary policy policy and its effect illustrated on our graphs would be:

FIRST: Chapters 14 and 15	SECOND: Chapter 13	THIRD: Chapter 9	FINALLY: Chapters 11 and 12
To increase the MS the fed must increase the ER of banks. Then banks could make more loans and create more money. To do this they would use an easy money policy.
Easy Money Policy: buy securities on the open market (OMO buy) lower the DR ( DR) decrease the required reserve ratio (RR)	If the MS increases: Chapter 13 MS shifts to the right interest rates decline	If the interest rates decline: the amount of investment increases there is a movement along the graph NOTE: the Investment demand graph does not shift	If investment increases: AD shifts to the right (increases) we have the chapter 12 multiplier effect real GDP increase and UE decreases the price level may increase causing more inflation

If there is HIGH INFLATION in the economy, the appropriate monetary policy policy and its effect illustrated on our graphs would be:

FIRST: Chapters 14 and 15	SECOND: Chapter 13	THIRD: Chapter 9	FINALLY: Chapters 11 and 12
To decrease the MS the Fed must decrease the ER of banks. Then banks could make FEWER loans and create more money. To do this they would use a tight money policy.
Tight Money Policy: sell securities on the open market (OMO buy) raise the DR ( DR) increase the required reserve ratio (RR)	If the MS decreases: Chapter 13 MS shifts to the left interest rates increase	If the interest rates increase: the amount of investment decreases there is a movement along the graph NOTE: the Investment demand graph does not shift	If investment increases: AD shifts to the left (increases) we have the chapter 12 multiplier effect real GDP decrease and IN decreases real GDP may decrease causing unemployment