Glossary
Central Bank (The Fed)
A national financial institution that conducts monetary policy, regulates banks, and provides financial services to the government and commercial banks.
Example:
The Federal Reserve, as the U.S. Central Bank, decides whether to raise or lower interest rates to influence economic activity.
Demand for Money
The quantity of money individuals and firms want to hold at various nominal interest rates, primarily for transactions and as an asset.
Example:
When interest rates are very low, people might prefer to hold more cash in their checking accounts rather than investing it, illustrating a higher demand for money.
Discount Rate
The interest rate at which commercial banks can borrow money directly from the Federal Reserve.
Example:
A decrease in the discount rate makes it cheaper for banks to borrow from the Fed, encouraging more lending and increasing the money supply.
Easy Monetary Policy
A central bank policy that increases the money supply and lowers interest rates to stimulate economic growth.
Example:
During a recession, the Fed might implement an easy monetary policy by buying bonds to encourage borrowing and spending.
Federal Funds Rate
The target interest rate at which commercial banks lend their excess reserves to other banks overnight.
Example:
The Fed uses open market operations to influence the supply of reserves in the banking system, thereby targeting a specific federal funds rate.
Investment Demand
The relationship between the nominal interest rate and the quantity of new capital goods that firms are willing to purchase.
Example:
A decrease in interest rates typically leads to an increase in investment demand as borrowing becomes cheaper for businesses looking to expand.
Monetary Policy
Actions undertaken by a central bank to influence the availability and cost of money and credit to help promote national economic goals.
Example:
To combat inflation, the Federal Reserve might implement a tight monetary policy by raising interest rates.
Money Market Equilibrium
The point where the quantity of money demanded equals the quantity of money supplied, determining the equilibrium nominal interest rate.
Example:
If the Fed increases the money supply, the money market equilibrium shifts, leading to a lower nominal interest rate.
Money Supply
The total amount of currency and other liquid assets in an economy at a given time, controlled by the central bank.
Example:
When the Federal Reserve buys government bonds, it increases the nation's money supply, making more funds available in the banking system.
Nominal Interest Rate
The stated interest rate on a loan or investment, not adjusted for inflation.
Example:
If a savings account offers a 2% annual return, that 2% is the nominal interest rate you earn before considering purchasing power changes.
Open Market Operations
The buying and selling of government securities by the central bank in the open market to influence the money supply.
Example:
When the Fed buys Treasury bonds from banks through open market operations, it injects money into the banking system, increasing reserves and the money supply.
Opportunity Cost of Holding Money
The return foregone by holding money as cash or in a low-interest account instead of investing it in interest-bearing assets like bonds.
Example:
Choosing to keep 50 per year.
Price Level (as a money demand shifter)
The average of current prices across the entire spectrum of goods and services produced in an economy.
Example:
If the price level for everything from groceries to rent increases significantly, people will need to hold more money to make their usual purchases, shifting money demand right.
Real GDP (as a money demand shifter)
The total value of all goods and services produced in an economy, adjusted for inflation.
Example:
During a period of strong economic growth, a higher real GDP means more transactions are occurring, increasing the demand for money.
Reserve Requirement
The fraction of deposits that banks are legally required to hold in reserve and not lend out.
Example:
If the Fed lowers the reserve requirement, banks have more money to lend, which can increase the money supply.
Tight Monetary Policy
A central bank policy that decreases the money supply and raises interest rates to curb inflation.
Example:
If inflation is a concern, the Fed might pursue a tight monetary policy by selling government bonds, which reduces the money supply.
Transaction Costs (as a money demand shifter)
The expenses incurred when buying or selling goods, services, or financial assets, including time and effort.
Example:
The widespread availability of mobile payment apps has reduced transaction costs for many purchases, potentially decreasing the need to hold as much physical cash.