MONETARY POLICYThe Meat & Taters of….

Monetary Policy Policies employed by the Federal Reserve Bank to

influence the money supply & interest rates Federal Reserve Bank (“The Fed”/“The Banks’

Bank”): The USA’s centralized bank created in 1913 (Pres. Wilson) to help stabilize economy after several financial panics greatly impacted the American economy Consists of 12 regional banks & several smaller across the

country (we have a branch of The Fed. in Charlotte) FOMC (Federal Open Market Committee) established

Monetary Policy & the OMO (Open Market Operations) – DOES NOT print money, but controls/manipulates the MS (Money Supply)

Chairman of the Fed. appointed by the President (currently Ben Bernanke)

Money Supply: The amount of money currently in circulation Money is anything that is accepted as a medium of exchange

for goods/services Types of Money: 2 types:

Commodity $: Intrinsic value (gold, platinum, silver, etc) Token $: Gov’t. gives “OK” to use as currency – used today…paper money

AKA – Fiat Money

Interest Rate: Fee to borrow money The Fed. only INFLUENCES (nominal, not real)

It’s All About the Money, Money Money!!

Money Aggregates Functions of Money Measures liquidity: How

quickly it can be converted into cash So….when you hear of a store

liquidating its assets, they are selling everything to get cash (quickly)

M1: Money currently in circulation, checking accounts, & traveler’s cheques “Narrow $”

M2: M1 + savings accounts & money market accounts “Broad $”

M3: M2 + large time deposits & repurchase agreements

Medium of Exchange: Used to purchase goods/services I give the clerk $2 & get a bottle of

water in exchange

Unit of Account: Determines relevant value I know that my mortgage is worth ½

of my monthly salary, so….I also know that my other bills total ½ my mortgage payment & also equal ¼ my monthly salary

Store of Value: Money will always have some value The $20 I found in my winter jacket is

still $20 (regardless of inflation…) I love when this happens

Money Demand (Motive for …) Reasons money is

demanded Transaction Demand:

Pay bills & other out of pocket expenses IE: Movies, new shoes, gas,

groceries, etc.

Precautionary Demand: On hand for emergencies Should be about 20-25% of

your income (just saying!!) Emergencies like loss of job,

etc.

Speculative Demand: Save cash to prepare for a cash based investment opportunity

MS

MD

Q

Interest Rate

IR1

Q1

Money Supply: Vertical

curve b/c assumed

fixed

Money Deman

d

Money & Opportunity CostThe opportunity cost of holding money is interest rate

If interest rate increases, the opp. cost increases & QM decreases

If interest rate decreases, the opp. cost decreases & QM increases

MS1

MD

Q

IR1

Q1

MS1

MD

QQ1

IR1

MS2

MS2

IR2

Q2 Q2

IR2

Tools of the Fed Required Reserve Ration (RRR): The fraction of banks’

deposits it must keep liquid – excess reserves can be loaned out When excess reserved are loaned out, it creates a ripple effect

greater than the initial amount Money Multiplier = 1/RRR (See next slide for more details)

Changing the RRR is how The Fed can increase/decrease the Money Supply

Discount Rate (DR): % member banks can borrow money from The Fed if they (member banks) ever fall short. The Fed is the “lender of last resort” If the DR increases, the more expensive it is for the banks to

borrow money, so they borrow less = less consumer borrowing due to high rates & ultimately leads to a decrease in the MS (money supply)…and vice-versa

Open Market Operations (OMO): The most powerful tools of The Fed., buying/selling gov’t. securities (bonds, T-Bills) Sell on the OMO = decrease in the MS; Buy on the OMO =

increase in the MS

RRR & the Money Multiplier Using a Simple Money Multiplier….

◦ Simple b/c assuming borrowers don’t want to hold onto their cash or b/c no bank has excess reserves…

The initial deposit is $100 & the RRR is 10% (meaning $10 must be kept liquid & the other $90 can be loaned)◦ Money Multiplier = 1/RRR, then the multiplier = 10 (1/.01 – 10)

◦ Demand deposits = money multiplier x change in reserves (the initial deposit, which equals excess reserves)

◦ Demand deposits = 10 ($100) = $1,000

The initial deposit$100 & the RRR is 20% (meaning $20 must be kept liquid & the other $80 can be loaned out)◦ Money Multiplier – 1/RRR, then the multiplier = 1/.2 = 5

◦ $100x5 = $500 increase in demand deposits

The initial deposit of $100 & the RRR is 5%...◦ 5%RRR = Multiplier – 1/.05 = 20

◦ $100X20 = $2,000 increase in demand deposits

MONETARY POLICY IN A NUT SHELL…

Expansionary

Contractionary

Buy Bonds RRR Sell Bonds

Decrease DR Increase

Decrease OMO Increase

Have the Following Prepared for Monday

Explain the following views of Monetary Policy: Classical, Monetarist, & Keynesian;

Explain the Quantity Theory of Money; Show (create a chart, etc.) showing how Monetary &

Fiscal Policy work together during times of economic expansion & contraction;

Answer the multiple choice & FRQ on the next slides; and

Have any questions prepared & ready to ask

Multiple Choice Review1. An item used as money that also has

intrinsic value in some other use it:

a. Fiat Money

b. Token Money

c. Commodity Money

d. Legal Tender

e. Barter Money

2. If the RRR is 10%, the money multiplier is which of the following?

a. .1

b. 1

c. 9

d. 10

e. 5

3. Which of the following Fed actions would decrease the money supply?

a. An increase in the RRR

b. A decrease in federal spending

c. Buying gov’t securities

d. A decrease I the discount rate

e. An increase in taxes

4. When interest rates increase, bonds values will:

a. Decrease

b. Increase

c. Area unchanged because of the interest rate paid on bonds in fixed

d. Can either increase or decrease, depending on the type of bond

e. Are adjusted by the US Treasury

5. Suppose the money market is currently in equilibrium, but The Fed wants to reduce the interest rate. The Fed should pursue policies to:

a. Increase the money supply

b. Decrease the money supply

c. Increase the demand for money

d. Make the supply of money more inelastic

e. Decrease the demand for money

FRQs

1. The Fed’s RRR is 10%. Currently, the Main Bank - a member bank – has no excess reserves. Then Mr. Jones deposits $1,000 in his checking account at Main Bank.

If the bank deducts its RRR from the deposit, identify the amount of bank reserves available from the loan.

A) Calculate the money multiplier & show your work

B) What is the greatest amount by which the banking system can increase the money supply?

C) Identify the limits the bank system has on its ability to increase the money supply.

2. Let’s say the gov’t. decides to pursue expansionary fiscal policy that would threaten private investment

A). Using a graph of the loanable funds market, explain why this might happen

B). Explain what the central bank could do to support the fiscal policy and minimize the negative effect on private investment

C). Illustrate your answer to (B) on the graph you created for part (A)