Fundamentals of
Monetary Policy
Chen Wu, Ph.D.
Assistant Professor of Economics
Plymouth State University
The Uses of Money
• Barter is the direct (
) of one good for
another, without the use of (
).
• The three functions of money (anything serving
these purposes is money):
• Medium of exchange–is accepted as (
)
for goods and services and debts.
• Store of value–can be held for future
(
).
• Standard of value–serves as a (
) for
measuring the prices of goods and services.
13-2
LO-1
Cash versus Money
• The concept of money includes more than dollar bills
and coins.
• (
)(
) can and do perform the same
market function as cash.
• Money is anything generally accepted as a medium of
(
).
• A transactions account is a bank account that permits
direct (
) to a third party (e.g., with a check).
• The balance in your transactions account
substitutes for cash and, therefore, is a form of
(
).
13-3
LO-1
Basic Money Supply (M1)
• The basic money supply is typically referred to by the
abbreviation M1.
• M1 is (
) held by the public, plus balances in
(
) 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 ( ) a form of money.
• They are simply a payment service, not a store of
value.
• The money supply (M1) includes:
• (
) in circulation
• (
) balances
• Traveler’s (
)
13-4
LO-2
13-5
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.
13-6
LO-2
Cashless Society?
We’re keeping a smaller percentage of the
money supply as cash as we:
• Rely more on (
) cards for purchases.
• Receive (
)(
) for paychecks.
• Use more checks instead of cash.
• Rely more on (
)(
) for transactions.
• Complete many transactions via direct wire
transfer of money.
13-7
LO-2
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 (
) balances by making
(
).
• Deposit creation–the creation of transactions deposits by
bank lending.
13-8
LO-3
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 (
)(
).
• 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 (
) account.
• (
) has been created because the checking account is
considered to be money.
• Using the Loan:
• The money supply does not contract when Campus Radio
13-9
spends the $100.
• The ownership of the deposit (changes).
LO-3
Fractional
Reserves
• Bank Reserves are assets held by a bank to fulfill its
(
) obligations.
• Bank reserves are only a fraction of total transactions
deposits.
• The Reserve Ratio is the ratio of a bank’s (
) to its
total transactions (
):
Reserve ratio =
bank reserves
total deposits
• The ability of a monopoly bank to hold fractional reserves
results from two facts:
• People use (
) for most transactions.
13• There is no other bank.
10
LO-3
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 (
)a
bank is required to hold by government regulation.
• The minimum reserve requirement directly (
) depositcreation possibilities.
• Required Reserves are equal to the required reserve ratio times
transactions deposits:
Required
required
total
=
X
reserves reserve ratio
deposits
1311
LO-3
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 (
) reserves.
• So long as a bank has excess reserves, it
can make additional (
).
• If a bank currently has $100 in reserves
and is required to hold $75, it can (
o1u3t-)
12
the excess $25.
LO-3
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.
• (
)(
) 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 =
1
required reserve ratio
1313
LO-4
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 (
) reserves have
disappeared.
1314
LO-4
1315
Limits to Deposit Creation
• The potential of the money multiplier to create (
summarized by the equation:
Potential
deposit
creation
=
money
multiplier
x
) is
excess
reserves of
banking
system
• If the required reserve ratio = .75:
• The multiplier = (
)
• If the banking system has $25 in excess reserves:
• Potential deposit creation is ($ ) x (
• Excess Reserves as Lending Power:
) = ($
)
• Each bank may lend an amount equal to its (
) reserves and no
more.
• The entire banking system can increase the volume of loans by the
total amount of (
) reserves in the banking system multiplied
13by the (
)(
).
16
LO-4
The Macro Role of Banks
• Banks can create (
).
• 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 (
) funds (reserves)
The banking system creates additional money by making (
)
.
1317
LO-5
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
(
) rather than make (
) in their transactions
accounts.
• Willing Borrowers and Lenders
• If consumers, businesses, and governments don’t want
to borrow, (
) deposits will be created.
• Banks may not be willing to satisfy credit demands,
choosing instead to hold (
) reserves.
• Government Regulation
13• The Federal Reserve regulates bank (
) prac1t8ices.
LO-5
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 (
).
• Use and sale of credit card databases by e-retailers for (
purposes.
)
• E-Payments
• Some companies offer a quasi-banking service by storing (
(
) 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 (
), 13thereby (
) aggregate demand.
19
LO-5
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.
• ( ) District Banks
• Monetary Policy
• A central responsibility of the Federal Reserve is
monetary policy—the use of (
) and (
)
controls to influence macroeconomic activity.
1420
LO-1
1421
1422
The Board of Governors
• The key decision maker for (
) policy.
• Located in Washington, D.C
• Consists of (
) members appointed by the
President and confirmed by the U.S. Senate.
• Board members are appointed for ( )-year terms
and cannot be reappointed.
•
1423
LO-1
Federal Reserve District Banks
• The 12 district banks perform many critical services,
including the following:
• Clearing (
) between private banks
• Holding bank (
)
• Providing (
)
• Providing (
) (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
(
)-year term and may be reappointed.
• (
) is the current Chairman of the 14Fed.
24
LO-1
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
1425
LO-2
Reserve Requirements
• By changing the reserve requirement, the Fed can directly
alter the (
) 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 (
)
reserves banks hold and the (
)(
):
Available lending
capacity of the
banking system
=
Money
Excess
multiplier x Reser1v4e- s
26
LO-2
Reserve Requirements
• A decrease in required reserves directly (
) excess
reserves.
• Excess reserves are bank reserves in excess of (
) reserves:
Excess
=
reserves
Total
reserves
Required
–
reserves
• A change in the reserve requirement causes:
• A change in (
) reserves
• A change in the money (
)
• A lower reserve requirement (
multiplier:
• Money Multiplier =
) the value of the money
1
Reserve
Requirement
Ratio
1427
LO-2
1428
The Discount Rate
• The discount rate is the rate of interest charged by the Federal
Reserve Banks for lending reserves to (
) 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
(
) of money for banks and the incentive to (
)
reserves.
1429
LO-2
Open-Market Operations
• Open-market operations are the principal mechanism for
directly altering the reserves of the banking system.
1430
LO-3
Hold Money or Bonds?
• The Fed attempts to influence whether individuals hold idle
funds in (
) accounts (in banks) or government
(
).
• Open-Market Activity
• Open-market operations–Federal Reserve purchases and sales
of government (
) for the purpose of altering bank
(
) (and thus money supply):
• If the Fed buys bonds, it (
) bank reserves (and money
supply).
• If the Fed sells bonds, it (
) bank reserves.
1431
LO-3
Changes in the interest rate
paid on reserves
• In October 2008, Congress granted the Fed authority to pay
(
) 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 (
) 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
(
) that want to lend them
• Federal Funds Rate - The interest rate that banks pay to borrow
reserves in the interbank (
)
32
Powerful Levers
• To summarize, there are three levers of monetary policy:
• Reserve (
)
• (
) rates
• Open-market (
)
• Changes in the interest rate paid on (
)
• 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 (
t) potential.
14• Monetary policy may be used to shift AD
33
LO-2
Expansionary Policy
• Monetary policy can be used to move the economy to its
full-employment potential.
• The Fed can increase AD by (
) the money supply
by:
•
•
•
•
(
(
(
(
) reserve requirements
) the discount rate
) more bonds to increase bank lending capacity
) 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. (
) many
government securities and non-government assets) and
14(
) interest rates to historic levels.
LO-4
Restrictive Policy
• Monetary policy can also be used to (
overheating economy.
• The Fed can decrease AD by (
money supply by:
• (
) reserve requirements
• (
) the discount rate
• (
) bonds in the open market
• (
) an
) the
) the interest rate paid on reserves
1435
LO-4
Interest-Rate Targets
• Interest rates are a key link between changes in the money
supply and shifts of the ( ) 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 (
).
• The shape of the AS curve determines the effectiveness of
expansionary monetary policy.
• Horizontal AS–output (
) without any (
).
• Vertical AS– (
) occurs without changing (
).
• Upward-sloped AS – both prices and output are affected
14by monetary policy.
36
LO-4
1437
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.
1438
LO-5
Discretionary Policy
• The economy is constantly beset by positive and
negative (
).
• There is a need for continual (
) to the
money supply.
• This view is supported by (
)
economists who believe the economy is relatively
unstable and needs help.
1439
LO-5
Fixed Rules
• Critics of discretionary monetary policy raise objections
linked to the shape of the AS curve.
• The AS curve could be (
) or at least (
).
• With an upward-sloping AS curve, too much expansionary
monetary policy leads to (
).
• Fixed rules for money-supply management are less prone
to error than discretionary policy.
• The Fed should increase the money supply by a constant
(
) rate each year.
• The growth rate of Ms should be consistent with the (
growth rate.
• This idea was supported by economists such as Milton
Friedman.
)
1440
LO-5
The Fed’s Eclecticism
• The Fed currently uses a pragmatic, eclectic approach of:
• (
) rules
• (
) discretion
• The Fed mixes money-supply and interest-rate
adjustments to do whatever is necessary to promote price
(
) and economic (
).
• 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 (
)(
) on inflation
(called inflation targeting), then manipulate (
)(
) a1n4dthe (
)(
) to achieve it.
41
LO-5