Chapter 8 – Monetary Theory & Policy
ECONOMICS
THEORY AND PRACTICE
Seventh Edition
Patrick J. Welch
&
St. Louis University
Gerry F. Welch
St. Louis Community College
at Meramec
PowerPoint Presentation by:
Dr. Ray Everett
Pima Community College
Copyright © 2004 John Wiley & Sons, Inc. All rights reserved.
Monetary Theory & Policy
Contents
Money Supply & Economics
Money Creation
Interest Rates & Spending Levels
Federal Reserve & Monetary Policy
Monetary Theory & Policy
Chapter Objectives
• To explain the relationship between the economy’s money supply and
output, employment, and prices.
• To explain how money is created and destroyed through the loanmaking activities of financial depository institutions.
• To introduce the multiple expansion of money.
• To explain the role of the interest rate in encouraging or discouraging
borrowing from financial depository institutions.
• To show how interest rates are affected by changes in financial
depository institutions’ excess reserves.
• To define monetary policy and explain the major tools for carrying out
monetary policy by the Federal Reserve.
• To show the relationship between government borrowing to cover
deficit spending and monetary policy.
• To critically evaluate monetary policy.
Money Supply & Economic Activity
• Summary of Key Lessons
 Total, or aggregate, spending drives the economy’s levels
of production, employment, and income.
 Total spending is found by adding together the spending
of all four major macroeconomic sectors.
 Increases in total spending lead to increases in
production, employment, and income unless the
economy is at full employment.
 At (or near) full employment, increases in spending lead
to overall price increases or demand-pull inflation.
 Decreases in total spending result in a decline in
production, employment, and income, and may dampen
inflation.
 Money is created when financial depository institutions
make loans, and it is destroyed when loans are repaid.
8-1a
Money Supply & Economic Activity
• Equation of Exchange
 MV = PQ
• Illustrates how changes in the supply of money (M)
influence the level of prices (P) and/or the total output of
goods and services (Q).
• Velocity of money (V) is the number of times each dollar is
spent for new goods and services in a year, or how often
the money supply turns over each year.
• Changing the Money Supply
 Increase in money supply (M)
• If not at full employment/production, then (Q) increases
more than (P) increases.
• If at full employment/production, then (P) increases more
than (Q) increases.
 Decrease in money supply (M)
• Typically results in a decrease in (Q), but (P) usually does
not decrease.
8-1b
Money Creation
• Process of Money Creation
 Actual Reserves
• Financial depository institutions’ reserve account plus its
vault cash.
 Reserve Requirement
• Specific percentage of deposits that a financial depository
institution must keep as actual reserves.
 Required Reserves
• Amount of actual reserves that a financial depository
institution must keep to back its deposits.
 Excess Reserves
• Reserves of a financial depository institution over the
amount it is required to maintain in actual reserves.
– Actual reserves minus required reserves.
8-2a
Money Creation
• Process of Money Creation (cont.)
 Excess Reserves & Loan Making
• Depository institutions can make new loans up to the value
of their excess reserves.
8-2b
Money Creation
• Multiple Expansion of Money
 Multiplier Effect
• An initial change in excess reserves in the depository
institutions system causes a larger change in the money
supply.
TABLE 8-2
Multiple Expansion of Money (10 Percent Reserve Requirement)
8-2c
Money Creation
• Multiple Expansion of Money (cont.)
 Calculating the Money Multiplier
• Use the reciprocal of the reserve requirement.
– 10% reserve requirement = money multiplier of 10
– 20% reserve requirement = money multiplier of 5
 Calculating the Total Change in Money Supply
• Multiply the initial change in excess reserves by the money
multiplier, or
– $8,000,000 x 5 = $40,000,000
• Divide the initial change in excess reserves by the reserve
requirement.
– $8,000,000 / 0.20 = $40,000,000
8-2d
Interest Rates & Spending Levels
• Summary of Key Points
TABLE 8-3
Relationship between Loan Making, the Money Supply,
Spending, and the Level of Economic Activity
8-3a
Interest Rates & Spending Levels
• Interest Rate Overview
 Interest Rate
• Price paid to borrow money.
– Percentage of the amount borrowed.
• Can be used to control the money supply.
• Determining Interest Rates on Loans
 Interest rates for loans are
determined by the demand for and
supply of funds for loans.
 Decreases in excess reserves will
cause interest rates to rise and the
amount of loans made to fall.
 Increases in the excess reserves will
cause interest rates to fall and the
amount of loans made to rise.
8-3b
Interest Rates & Spending Levels
Determining Interest Rates on Loans (cont.)
FIGURE 8-2
Effect of Changes in Excess Reserves on the
Interest Rate and the Quantity of Loans
8-3c
Interest Rates & Spending Levels
Determining Interest Rates on Loans (cont.)
FIGURE 8-3
Relationship among Excess Reserves, the Interest Rate,
Loan Making, and the Level of Economic Activity
8-3d
Federal Reserve & Monetary Policy
• Monetary Policy Overview
 Monetary Policy
• Changing the money supply to influence the levels of
output, employment, and/or prices in the economy.
 Easy Money Policy
• Policy by the Federal Reserve to increase excess reserves
of depository institutions in an effort to increase spending
and reduce unemployment.
 Tight Money Policy
• Policy by the Federal Reserve to reduce excess reserves of
depository institutions in an effort to reduce spending and
inflationary pressure.
8-4a
Federal Reserve & Monetary Policy
• Monetary Policy Tools
 Federal Reserve has three major tools to change excess
reserves in the financial depository institutions system:
• Reserve Requirement
• Discount Rate
• Federal Funds Market
8-4b
Federal Reserve & Monetary Policy
• Monetary Policy Tools (cont.)
 Reserve Requirement
• Decreases in the reserve requirement would increase
excess reserves and would be appropriate to stimulate the
economy.
• Increases in the reserve requirement would decrease
excess reserves and would be appropriate to fight demandpull inflation.
8-4c
Federal Reserve & Monetary Policy
• Monetary Policy Tools (cont.)
 Discount Rate
• Interest rate that a Federal Reserve Bank charges a
financial depository institution for borrowing reserves.
8-4d
Federal Reserve & Monetary Policy
• Monetary Policy Tools (cont.)
 Open Market Overview
• Open Market Operations
– Buying and selling of securities, primarily U.S.
government securities, on the open market by the Federal
Reserve.
• Open Market Committee
– Committee that determines the general policy on Federal
Reserve open market operations.
8-4e
Federal Reserve & Monetary Policy
• Monetary Policy Tools (cont.)
 Tools & Policy Objectives
• Expanding the economy requires:
– Buying securities from banks and dealers on the open
market, and/or
– Lowering the reserve requirement, and/or
– Lowering the discount rate
• Fighting demand-pull inflation requires:
– Selling securities to banks and dealers on the open
market, and/or
– Increasing the reserve requirement, and/or
– Increasing the discount rate
8-4f
Federal Reserve & Monetary Policy
• Government Deficits & Monetary Policy
 Crowding Out
• Occurs when borrowing by the federal government
increases the interest rate and reduces borrowing by
households and businesses.
 Monetizing the Debt
• Increasing the money supply by the Federal Reserve to
accommodate federal government borrowing and reduce
upward pressure on the interest rate.
8-4g
Federal Reserve & Monetary Policy
• Government Deficits & Monetary Policy (cont.)
FIGURE 8-4
Effect of Government Borrowing and Monetizing the Debt
on the Interest Rate and Loan Making
8-4h
Federal Reserve & Monetary Policy
• Advantages & Disadvantages of Monetary Policy
 Advantages:
• Quickly implemented in comparison to fiscal policy
• Largely removed from politics
 Disadvantages:
• Loan-making link
– Someone must be willing to borrow and a bank must be
willing to lend. The Federal Reserve cannot force the
loan-making process.
• Inflation
– As the money supply is tightened, interest rates increase,
and businesses that borrow at this high rate may raise
prices on their products to compensate.
8-4i
Chapter 8 – Monetary Theory & Policy
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ECONOMICS
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Seventh Edition
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