The Meat & Taters of….
MONETARY POLICY
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
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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
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Money is anything that is accepted as a medium of exchange for
goods/services
Types of Money: 2 types:
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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
Money Aggregates

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)

M2: M1 + savings accounts &
money market accounts
 “Broad $”
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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
M1: Money currently in
circulation, checking accounts, &
traveler’s cheques
 “Narrow $”
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Functions of Money

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 
M3: M2 + large time deposits &
repurchase agreements
It’s All About the Money, Money Money!!
Money Demand (Motive for …)


Reasons money is demanded
Transaction Demand: Pay
bills & other out of pocket
expenses
Money Supply:
Vertical curve
b/c assumed
fixed
MS
Interest
Rate
 IE: Movies, new shoes, gas,
groceries, etc.

Precautionary Demand: On
hand for emergencies
Money
Demand
MD
IR1
 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
Q1
Q
Money & Opportunity Cost
The opportunity cost of holding money is interest rate

If interest rate increases, the opp.
cost increases & QM decreases
MS2

If interest rate decreases, the opp.
cost decreases & QM increases
MS1
MS1
MS2
MD
IR2
IR1
IR1
IR2
MD
Q2
Q1
Q
Q1
Q2
Q
Tools of the Fed

Required Reserve Ration (RRR): The fraction of banks’ deposits
it must keep liquid – excess reserves can be loaned out
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When excess reserved are loaned out, it creates a ripple effect
greater than the initial amount
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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…
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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
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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
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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
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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 Review
1.
2.
3.
An item used as money that also has intrinsic
value in some other use it:
4.
When interest rates increase, bonds values
will:
a.
Fiat Money
a. Decrease
b.
Token Money
b. Increase
c.
Commodity Money
d.
Legal Tender
c. Area unchanged because of the interest rate
paid on bonds in fixed
e.
Barter Money
d. Can either increase or decrease, depending on
the type of bond
If the RRR is 10%, the money multiplier is which
of the following?
e. Are adjusted by the US Treasury
a.
.1
b.
1
c.
9
Suppose the money market is currently in
equilibrium, but The Fed wants to reduce
the interest rate. The Fed should pursue
policies to:
d.
10
a. Increase the money supply
e.
5
b. Decrease the money supply
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
5.
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)