module 28 The Money Market 273
Section 5 The Financial Sector
holding significant sums of money. ATMs are
only one example of how changes in
technology have altered the de-
mand for money. The ability of
stores to process credit card and
debit card transactions via the In-
ternet has widened their accept-
ance and similarly reduced the
demand for cash.
Changes in Institutions Changes in
institutions can increase or decrease the
demand for money. For example, until Regu-
lationQwas eliminated in 1980, U.S. banks weren’t allowed to offer interest on check-
ing accounts. So the interest you would forgo by holding funds in a checking account
instead of an interest -bearing asset made the opportunity cost of holding funds in
checking accounts very high. When banking regulations changed, allowing banks to
pay interest on checking account funds, the demand for money rose and shifted the
money demand curve to the right.
Money and Interest Rates
The Federal Open Market Committee decided today to lower its target for the federal funds rate 75
basis points to 2^1 ⁄ 4 percent.
Recent information indicates that the outlook for economic activity has weakened further. Growth
in consumer spending has slowed and labor markets have softened. Financial markets remain under
considerable stress, and the tightening of credit conditions and the deepening of the housing contraction
are likely to weigh on economic growth over the next few quarters.So read the beginning of a press release from the Federal Reserve issued on March 18,
- (A basis point is equal to 0.01 percentage point. So the statement implies that the
Fed lowered the target from 3% to 2.25%.) The federal funds rate is the rate at which banks
lend reserves to each other to meet the required reserve ratio. As the statement implies, at
each of its eight -times -a -year meetings, the Federal Open Market Committee sets a target
value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is
done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and
sells short -term U.S. government debt, known as Treasury bills, to achieve that target.
As we’ve already seen, other short -term interest rates, such as the rates on CDs, move
with the federal funds rate. So when the Fed reduced its target for the federal funds rate
from 3% to 2.25% in March 2008, many other short -term interest rates also fell by
about three -quarters of a percentage point.
How does the Fed go about achieving a target federal funds rate? And more to the
point, how is the Fed able to affect interest rates at all?
The Equilibrium Interest Rate
Recall that, for simplicity, we’ve assumed that there is only one interest rate paid on
nonmonetary financial assets, both in the short run and in the long run. To under-
stand how the interest rate is determined, consider Figure 28.3 on the next page, which
illustrates the liquidity preference model of the interest rate;this model says that
the interest rate is determined by the supply and demand for money in the market for
money. Figure 28.3 combines the money demand curve, MD,with the money supply
curve,MS,which shows how the quantity of money supplied by the Federal Reserve
varies with the interest rate.
The Federal Reserve can increase or decrease the money supply: it usually does this
throughopen-market operations,buying or selling Treasury bills, but it can also lend via
thediscount windowor change reserve requirements.Let’s assume for simplicity that the
istockphotoAccording to the liquidity preference
model of the interest rate,the interest
rate is determined by the supply and demand
for money.
Themoney supply curveshows how the
quantity of money supplied varies with the
interest rate.