Chapter 5
Policy Makers and the Money
Supply
© 2000 John Wiley & Sons, Inc.
Chapter Outcomes



Discuss the objectives of national
economic policy and the conflicting
nature of these objectives
Identify the major policy makers and
briefly describe their primary
responsibilities
Identify the policy instruments of the
U.S. Treasury and briefly explain how
the Treasury manages its activities 2
Chapter Outcomes
(Continued)



Describe U.S. Treasury tax policy and
debt management responsibilities
Discuss how the expansion of the
money supply takes place in the U.S.
banking system
Briefly summarize the factors that
affect bank reserves
3
Chapter Outcomes
(Concluded)


Explain the meaning of the monetary
base and money multiplier
Explain what is meant by the velocity
of money and give reasons why it is
important to control the money
supply
4
National Economic Policy
Objectives




Economic Growth
High and Stable Levels of
Employment
Price Stability
International Financial Equilibrium
5
National Economic Policy:
Important Points



GROSS DOMESTIC PRODUCT:
GDP is the output of goods and
services in an economy
INFLATION:
Increase in price of goods/services
not offset by increase in quality
REAL GDP:
When GDP exceeds rate of inflation,
the result is higher living standards 6
Major U.S. Policy Makers


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FEDERAL RESERVE SYSTEM
-Sets Monetary Policy
THE PRESIDENT
-Helps set Fiscal Policy
CONGRESS
-Helps set Fiscal Policy
U.S. TREASURY
-Conducts Debt Management Policy
7
Fiscal Policy: Definition and
Fundraising Activities


FISCAL POLICY:
Government influence on economic
activity through taxation and
expenditure plans
FUNDRAISING ACTIVITIES:
A government raises funds to pay for
its activities by: levying taxes,
borrowing, or printing money for its
own use
8
Fiscal Policy: Stabilizing Factors


AUTOMATIC STABILIZERS:
Continuing federal programs that
stabilize economic activity
EXAMPLES:
-Unemployment insurance
-Welfare payments
-Pay-as-you-go progressive income
tax
9
Changing the Money Supply



FRACTIONAL RESERVE SYSTEM:
Allows Fed to alter the money supply
PRIMARY DEPOSIT:
Deposit that adds new reserves to a
bank
DERIVATIVE DEPOSIT:
Occurs when reserves created from a
primary deposit are made available
to borrowers through bank loans
10
Checkable Deposit Expansion
[Assume: reserve requirement is 20%]
Bank A receives a $10,000 primary
deposit and makes a loan of $8,000.
The “books” would show:
BANK A
Assets:
Liabilities:
Reserves $10,000 Deposits $10,000
Loans
$8,000
11
Checkable Deposit Expansion
[Continued]
[Assume: a check is drawn against Bank A
and is deposited in Bank B (representing
all other banks)]
BANK A
Assets:
Liabilities:
Reserves $2,000
Deposits $10,000
Loans
$8,000
BANK B
Assets:
Liabilities:
Reserves $8,000
Deposits $8,000
12
Checkable Deposit Expansion
[Concluded]
[Assume: Bank B loans 80% of its reserves]
BANK B
Assets:
Liabilities:
Reserves $8,000
Deposits $14,400
Loans
$6,400
Now, if a $6,400 check is written on Bank B:
BANK B
Assets:
Liabilities:
Reserves $1,600
Deposits $8,000
Loans
$6,400
13
Multiple Expansion of
Checkable Deposits
BASIC EQUATION APPROACH:
Change in Checkable Deposits =
(Increase in Excess Reserves)/(Reserve
Ratio)
Assume Excess Reserves increase by
$1,000 and the Reserve Ratio is 20%, then
the Change in Checkable Deposits would
be:
$1,000/.20 = $5,000
14
Important Definitions of Reserves
in the Banking System


BANK RESERVES:
Reserve balances held at Federal
Reserve Banks and vault cash held
in the banking system
REQUIRED RESERVES:
The minimum amount of total
reserves that a depository institution
must hold
15
Important Definitions of Reserves
in the Banking System
(Continued)


EXCESS RESERVES:
The amount that total reserves are
greater than required reserves
DEFICIT RESERVES:
The amount that required reserves
are greater than total reserves
16
Transactions Affecting
Bank Reserves



NONBANK PUBLIC:
Change in the demand for currency
held outside the banking system
FEDERAL RESERVE SYSTEM:
Changes in open market operations,
reserve ratio, and other transactions
UNITED STATES TREASURY: Change
in Treasury cash holdings and
spending
17
Federal Reserve System
Transactions Affecting
Bank Reserves






Change in Reserve Ratio
Open Market Operations
Change in Bank Borrowings
Change in Float
Change in Foreign Deposits Held in
Reserve Banks
Change in Other Federal Reserve
Accounts
18
Monetary Base and
Money Multiplier




EQUATION: MB x m = M1
MONETARY BASE (MB):
Banking system reserves plus
currency held by the public
MONEY MULTIPLIER (m):
In a simple monetary system, the
ratio of 1 divided by the reserve ratio
MONEY SUPPLY (M1):
Basic definition of the money supply
19
Complex Money Multiplier (m)
EQUATION:
m = (1 + k)/[r(1 + t + g) + k]
 DEFINITIONS:
r = ratio of reserves to total reserves
k = ratio of currency held by nonbank
public to checkable deposits
t = ratio of noncheckable deposits to
checkable deposits
g = ratio of government deposits to
checkable deposits

20
Complex Money Multiplier (m)
Example



Basic Information: r = 20%; k = 20%;
t = 10%; & g = 5%. What is the
money multiplier (m)?
m = (1 + k)/[r(1 + t + g) + k]
m = (1 + .20)/[.20(1 + .10 + .05) + .20]
= (1.20)/[.20(1.15) + .20]
= 1.20/.43 = 2.8
21
Link Between Money Supply and
Gross Domestic Product




Velocity of money (M1V) is the rate of
circulation of money supply
Money supply (M1) is linked to gross
domestic product (GDP) via velocity
Nominal GDP is real GDP (RGDP) +
Inflation (I)
In terms of growth rates (g) we have:
M1g + M1Vg = RGDPg + Ig
22