Page 519 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 493

the price of the apples must decrease. However, if the supply of apples decreases,
all else the same, the price of apples must increase. By buying or selling government
securities from banks, the Fed can directly affect bank reserves and the federal
funds rate, or the price of those reserves.

A Closer Look at Open Market Operations. Exhibit 14.3 shows how
money and interest rates are affected by open market operations. The vertical axis
of the graph shows the federal funds rate. The horizontal axis shows the quantity of
money supplied or demanded by banks. The supply of money is directly under the
control of the central bank via open market operations and therefore is drawn as a
vertical line. This vertical line moves to the right as money supply is increased and
moves to the left as money supply is decreased. The demand for money is down-
ward sloping. The reason for this shape is that interest rate levels change banks’
demand for federal funds. At lower federal funds rates, banks will demand more
money, as these funds can be obtained at low cost to the bank. However, higher fed-
eral funds rates increase the cost of obtaining funds and will cause banks to
demand less money.
Now let’s see how Exhibit 14.3 can be used to better understand EXHIBIT 14.3
open market operations. Consider what would happen if there were
Monetary Policy and the Relationship
an increase in money supply from quantity S to S , which can be
1 2 Between Money Supply and Interest Rates
implemented by the Fed’s open market operation purchases of secu-
Central banks lower interest rates by increasing the
rities from banks. It is clear that a higher money supply reduces the
money supply.
federal funds rate from i to i . In this case the Fed is essentially
1
2
increasing the amount of cash reserves held by banks. The lowering
of interest rates is logical because now banks have more reserves to
lend, and interest rates represent the price of money. The lowering of
federal funds rates means a lower cost of funds for banks. Banks can i 1
pass these lower costs along to borrowers by offering loans at lower i 2 2
interest rates. So, lower federal funds rates lead to lower loan rates. Interest rate
And, lower loan rates tend to increase bank loans, as borrowers are 1
willing to seek credit at banks. D
Why would the Fed increase the money supply and lower money
S 1 S 2
market interest rates? It is important to recognize that the federal
funds rate is a benchmark interest rate that affects other interest
rates in the money and capital markets. As the federal funds rate M 1 M 2
moves up or down, the interest rates on bonds and bank loans like- Quantity of money
wise move up and down. In our example in Exhibit 14.3, the lower D = Money demand curve M = Quantity of money
federal funds rate could potentially stimulate business activity, as S = Money supply curve i = Interest rate
business firms would be attracted by the lower interest rates avail-
able at banks to borrow money needed to produce goods and services. Many indi-
viduals buying cars, houses, and other goods that require debt financing would be
beneficially affected by lower interest costs of borrowed funds also. Alternatively,
the Fed could sell government securities in open market operations, decrease the
money supply in banks, increase interest rates, and slow down business or eco-
nomic activity. It should be apparent that open market operations by central banks
can have powerful effects on business firms and individuals in particular and the
economy in general.

Why Money Matters. The well-known quantity theory provides insight into quantity theory The notion that money
how monetary policy affects the economy as a whole. In this theory, an equation of matters to the real economy as
expressed in the equation of exchange
exchange can be written that links the financial system on the left-hand side and
the economy on the right-hand side.

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