Fundamentals of
Monetary Policy
Chen Wu, Ph.D.
Assistant Professor of Economics
Plymouth State University
The Uses of Money
• Barter is the direct (exchange ) of one good for
another, without the use of (money).
• The three functions of money (anything serving
these purposes is money):
• Medium of exchange–is accepted as (payment )
for goods and services and debts.
• Store of value–can be held for future
(purchases).
• Standard of value–serves as a (yardstick) for
measuring the prices of goods and services.
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Cash versus Money
• The concept of money includes more than dollar bills
and coins.
• (Checking) (accounts) can and do perform the same
market function as cash.
• Money is anything generally accepted as a medium of
(exchange).
• A transactions account is a bank account that permits
direct (payments) to a third party (e.g., with a check).
• The balance in your transactions account
substitutes for cash and, therefore, is a form of
(money).
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Basic Money Supply (M1)
• The basic money supply is typically referred to by the
abbreviation M1.
• M1 is (currency) held by the public, plus balances in
(transactions) accounts.
• Cash is only part of the money supply; most money
consists of balances in transactions accounts.
• Credit cards are another popular medium of exchange.
• Credit cards are (not) a form of money.
• They are simply a payment service, not a store of
value.
• The money supply (M1) includes:
• (Currency) in circulation
• (Transaction-account) balances
• Traveler’s (checks)
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Figure 13.1
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Near Money
•
•
•
•
Savings accounts
Certificates of deposit (CDs)
Money-market mutual funds
These represent additional measures of the money
supply (M2, M3, etc.).
• We will limit our discussion to M1, the basic
money supply.
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Cashless Society?
We’re keeping a smaller percentage of the
money supply as cash as we:
• Rely more on (credit) cards for purchases.
• Receive (direct) (deposit) for paychecks.
• Use more checks instead of cash.
• Rely more on (debit) (cards) for transactions.
• Complete many transactions via direct wire
transfer of money.
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Creation of Money: Deposit
Creation
• The Bureau of Engraving and Printing and the U.S.
Mint play only a minor role in creating money.
• Most of what we call money is bank balances, not cash.
• Deposit Creation:
• In making a loan, a bank effectively creates money,
because transactions-account balances are counted as
part of the money supply.
• Banks create (transactions-account) balances by making
(loans).
• Deposit creation–the creation of transactions deposits by
bank lending.
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Example of Deposit Creation
• A Monopoly Bank:
• Assume: one bank in a town, and no one regulates bank
behavior.
• You deposit $100 from your piggy bank into the monopoly
bank and receive a new (checking) (account).
• When you deposit cash or coins in a bank, you are changing the
composition of the money supply, not its size.
• An Initial Loan:
• The monopoly bank loans $100 to Campus Radio.
• It deposits $100 into Campus Radio’s (checking) account.
• (Money) has been created because the checking account is
considered to be money.
• Using the Loan:
• The money supply does not contract when Campus Radio
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spends the $100.
• The ownership of the deposit (changes).
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Fractional
Reserves
• Bank Reserves are assets held by a bank to fulfill its
(deposit) obligations.
• Bank reserves are only a fraction of total transactions
deposits.
• The Reserve Ratio is the ratio of a bank’s (reserves) to its
total transactions (deposits):
bank reserves
Reserve ratio =
total deposits
• The ability of a monopoly bank to hold fractional reserves
results from two facts:
• People use (checks) for most transactions.
13• There is no other bank.
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Required Reserves
• If a bank could create money at will, it would have a lot of
control over aggregate demand.
• In reality, no private bank has that much power.
• The power to create money resides in the banking system, not in
any single bank.
• The Federal Reserve System requires banks to maintain some
minimum reserve ratio.
• Required Reserves are the minimum amount of (reserves) a
bank is required to hold by government regulation.
• The minimum reserve requirement directly (limits) depositcreation possibilities.
• Required Reserves are equal to the required reserve ratio times
transactions deposits:
Required
required
total
=
X
reserves reserve ratio
deposits
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Excess Reserves
• Excess reserves are bank reserves in excess
of (required) reserves:
Excess Reserves =
(Total) Reserves – (Required) Reserves
• The ability of banks to make loans depends on
access to (excess ) reserves.
• So long as a bank has excess reserves, it
can make additional (loans).
• If a bank currently has $100 in reserves
and is required to hold $75, it can (lend out)
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the excess $25.
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The Money Multiplier
• A Multibank World:
• In reality there is more than one bank in town.
• The key issue is not how much excess reserves any specific
bank holds but how much excess reserves exist in the entire
banking system.
• (Excess) (reserves) are the source of bank lending authority.
• The cumulative amount of new loans is determined by the
money multiplier.
• The money multiplier is the number of deposit (loan)
dollars that the banking system can create from $1 of
excess reserves:
Money multiplier =
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required reserve ratio
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The Money Multiplier Process:
Example
• An initial deposit of $100 is made at University Bank.
• University Bank keeps $75 (75% of the $100 new
deposit) on reserve and loans out $25, which is
deposited in Bank Two.
• Bank Two keeps 75% of the new deposit on reserve
($18.75) and loans out $6.25
• Bank Three keeps 75% of the new deposit on reserve
($4.69) and loans out $1.56.
• This process continues until all (excess) reserves have
disappeared.
13-
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Figure 13.2
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Limits to Deposit Creation
• The potential of the money multiplier to create (loans) is
summarized by the equation:
Potential
deposit
creation
=
money
multiplier
x
excess
reserves of
banking
system
• If the required reserve ratio = .75:
• The multiplier = (1.33)
• If the banking system has $25 in excess reserves:
• Potential deposit creation is ($25) x (1.33) = ($33.25)
• Excess Reserves as Lending Power:
• Each bank may lend an amount equal to its (excess) reserves and no
more.
• The entire banking system can increase the volume of loans by the
total amount of (excess) reserves in the banking system multiplied
13by the (money) (multiplier).
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The Macro Role of Banks
• Banks can create (money).
• Since virtually all market transactions involve the use of money, banks must have some
influence on macro outcomes.
• Financing Aggregate Demand
• Banks perform two essential functions:
•
•
Banks transfer money from savers to spenders by (lending) funds (reserves) held on deposit.
The banking system creates additional money by making (loans) in excess of
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Constraints on Money Creation
• There are four major constraints on banks’ lending ability:
• Bank Deposits
• Bank reserves will be lower if people prefer to hold
(cash) rather than make (deposits) in their transactions
accounts.
• Willing Borrowers and Lenders
• If consumers, businesses, and governments don’t want
to borrow, (fewer) deposits will be created.
• Banks may not be willing to satisfy credit demands,
choosing instead to hold (excess) reserves.
• Government Regulation
13• The Federal Reserve regulates bank (lending) practices.
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Recent Development in Money
• Digital Money
• The most common forms of money used in brick-and-mortar malls
cannot be used as a medium of exchange in electronic malls.
• Credit Cards
• Almost all Internet purchases are completed with a credit card.
• Dependence on credit cards limits the potential of e-commerce because
of:
• Security issues such as credit card number (theft).
• Use and sale of credit card databases by e-retailers for (undisclosed)
purposes.
• E-Payments
• Some companies offer a quasi-banking service by storing (purchasing)
(power) that consumers and e-retailers can access.
• Consumers must “deposit” e-cash with credit card advances.
• Speed of Spending
• Consumers still need cash and checking-account balances to pay for
their e-purchases.
• Virtual malls allow consumers to spend money balances (faster), 13thereby (boosting) aggregate demand.
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The Federal
Reserve System
• The Federal Reserve System (the Fed) is the central
banking system of the United States
• Created in 1913, it consists of two components:
• Headquarters in Washington, D.C.
• (12) District Banks
• Monetary Policy
• A central responsibility of the Federal Reserve is
monetary policy—the use of (money) and (credit)
controls to influence macroeconomic activity.
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Figure 14.1
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Figure 14.2
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The Board of Governors
• The key decision maker for (monetary) policy.
• Located in Washington, D.C
• Consists of (seven) members appointed by the
President and confirmed by the U.S. Senate.
• Board members are appointed for (14)-year terms
and cannot be reappointed.
• Terms are staggered every two years.
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Federal Reserve District Banks
• The 12 district banks perform many critical services,
including the following:
• Clearing (checks) between private banks
• Holding bank (reserves)
• Providing (currency)
• Providing (loans) (called discounting)
• The Fed Chairman
• The Chairman is the most visible member of the
Federal Reserve System.
• This person is selected by the President for a
(four)-year term and may be reappointed.
• (Janet Yellen) is the current Chairman of the 14Fed.
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Monetary Tools
• The Fed has the power to alter the money supply
through three tools (4 tools since 2009):
• Reserve requirements
• Discount rate
• Open market operations
• Changes in the interest rate paid on reserves
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Reserve Requirements
• By changing the reserve requirement, the Fed can directly
alter the (lending) capacity of the banking system.
• Required reserves are the minimum amount of reserves a
bank is required to hold by government regulation.
• The ability of the banking system to make additional loans
(create deposits) is determined by the amount of (excess)
reserves banks hold and the (money) (multiplier):
Available lending
capacity of the
banking system
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=
Money
Excess
x
multiplier
Reserves
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Reserve Requirements
• A decrease in required reserves directly (increases) excess
reserves.
• Excess reserves are bank reserves in excess of (required) reserves:
Excess
=
reserves
Total
reserves
Required
–
reserves
• A change in the reserve requirement causes:
• A change in (excess) reserves
• A change in the money (multiplier)
• A lower reserve requirement (increases) the value of the money
multiplier:
• Money Multiplier =
1
Reserve
Requirement
Ratio
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Table 14.1
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The Discount Rate
• The discount rate is the rate of interest charged by the Federal
Reserve Banks for lending reserves to (private) banks.
• Sometimes bank reserves run low and they must replenish their
reserves temporarily.
• There are three sources of last-minute extra reserves:
• Federal Funds Market, where banks may borrow from a reserve-rich
bank
• Securities Sales
• Discounting – obtaining reserve credits from the Federal Reserve
System
• By raising or lowering the discount rate, the Fed changes the
(cost) of money for banks and the incentive to (borrow)
reserves.
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Open-Market Operations
• Open-market operations are the principal mechanism for
directly altering the reserves of the banking system.ed to
affect portfolio decisions and the decision to hold money
or bonds.
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Hold Money or Bonds?
• The Fed attempts to influence whether individuals hold idle
funds in (transaction) accounts (in banks) or government
(bonds).
• Open-Market Activity
• Open-market operations–Federal Reserve purchases and sales
of government (bonds) for the purpose of altering bank
(reserves) (and thus money supply):
• If the Fed buys bonds, it (increases) bank reserves (and money
supply).
• If the Fed sells bonds, it (reduces) bank reserves.
hanges in bond prices alter portfolio choices.
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Changes in the interest rate
paid on reserves
• In October 2008, Congress granted the Fed authority to pay
(interest) on reserves of banks
• If the Fed raises the interest rate on reserves and thereby reduces
the differential between the federal funds rate and the interest rate
on reserves, banks have (less) incentive to lend reserves in the
federal funds market
• Federal Funds Market (FFM) – A private overnight market (made up
mostly of banks) in which banks can borrow reserves from other
(banks) that want to lend them
• Federal Funds Rate - The interest rate that banks pay to borrow
reserves in the interbank (FFM)
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Powerful Levers
• To summarize, there are three levers of monetary policy:
• Reserve (requirements)
• (Discount) rates
• Open-market (operations)
• Changes in the interest rate paid on (reserves)
• The Fed has effective control of the nation’s money
supply.
• Shifting Aggregate (Demand)
• The ultimate goal of all macro policy is to stabilize the
economy at its (full-employment) potential.
14• Monetary policy may be used to shift AD
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Expansionary Policy
• Monetary policy can be used to move the economy to its
full-employment potential.
• The Fed can increase AD by (increasing) the money supply
by:
•
•
•
•
(Lowering) reserve requirements
(Dropping) the discount rate
(Buying) more bonds to increase bank lending capacity
(Lower) the interest rate paid on reserves
• As a result of the near financial meltdown and recession of
2008-09, the Fed took on a massive expansionary policy by
expanding its balance sheet, e.g. (purchasing) many
government securities and non-government assets) and
14(lowering) interest rates to historic levels.
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Restrictive Policy
• Monetary policy can also be used to (cool) an
overheating economy.
• The Fed can decrease AD by (decreasing) the
money supply by:
• (Raising) reserve requirements
• (Increasing) the discount rate
• (Selling) bonds in the open market
• (Increase) the interest rate paid on reserves
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Interest-Rate Targets
• Interest rates are a key link between changes in the money
supply and shifts of the (AD) curve.
• Price versus Output Effects
• The success of monetary policy depends on the conditions
of AD and AS.
• Increases in the money supply shift AD to the (right).
• The shape of the AS curve determines the effectiveness of
expansionary monetary policy.
• Horizontal AS–output (increases) without any (inflation).
• Vertical AS– (inflation) occurs without changing (output).
• Upward-sloped AS – both prices and output are affected
14by monetary policy.
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Figure 14.7
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Fixed Rules or Discretion?
• The shape of the AS curve spotlights a central
policy debate.
• Should the Fed try to fine-tune the economy with
constant adjustments of the money supply?
• Or should the Fed instead simply keep the money
supply growing at a steady pace?
• The near financial meltdown of 2008 has raised
the tone of this debate.
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Discretionary Policy
• The economy is constantly beset by positive and
negative (shocks).
• There is a need for continual (adjustments) to the
money supply.
• This view is supported by (Keynesian)
economists who believe the economy is relatively
unstable and needs help.
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Fixed Rules
• Critics of discretionary monetary policy raise objections
linked to the shape of the AS curve.
• The AS curve could be (vertical) or at least (upward-sloping).
• With an upward-sloping AS curve, too much expansionary
monetary policy leads to (inflation).
• Fixed rules for money-supply management are less prone
to error than discretionary policy.
• The Fed should increase the money supply by a constant
(fixed) rate each year.
• The growth rate of Ms should be consistent with the (economic)
growth rate.
• This idea was supported by economists such as Milton
Friedman.
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The Fed’s Eclecticism
• The Fed currently uses a pragmatic, eclectic approach of:
• (Flexible) rules
• (Limited) discretion
• The Fed mixes money-supply and interest-rate
adjustments to do whatever is necessary to promote price
(stability) and economic (growth).
• Inflation Targeting
• Ben Bernanke, the former Fed Chairman, has been a bit more
specific about the Fed’s policy.
• He believes the Fed should set an (upper) (limit) on inflation
(called inflation targeting), then manipulate (interest) (rates) and
14the (money) (supply) to achieve it.
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