Download Modern macroeconomics: monetary policy

Money that is available
(money supply)
affects Output
1. GDP = C + Ig + G + Xn
2. Increased spending increases output
3. Increased money supply increases
spending
M * V = P *Q
Money V
elocity
Price
Q Output
- the actual amount of money in circulation
- the number of time each $ is spent in a year
(considered to be stable)
- the level of prices
- the actual output of goods and services
M * V = P *Q
Money
Velocity
* =
Q =output
Price
• P Q
Total Sales (GDP)
• If V and P are constant, then an increase in
M will lead to a proportional increase in Q
GDP increases.
• but if V and Q are constant(at full
employment), then an increase in M will lead
to a proportional increase in P =Inflation.
1. Printing Money
2. Making Loans
a. Key Ingredients:
• Deposits – Household savings
• Required Reserves – money held at the
bank or at the FRS (around 10%)
• Excess Reserves – loan able funds
= Deposits – Required Reserves
A depository institution can
make loans up to the value of
its excess reserves
Fractional Reserve Banking
• The U.S. banking system is a fractional
reserve system where banks maintain only
a fraction of their assets as reserves to
meet the requirements of depositors.
• Under a fractional reserve system, an
increase in reserves will permit banks to
extend additional loans and thereby expand
the money supply (by creating additional
checking deposits).
Main Street Bank Situation:
Demand deposits
= $50,000
Reserve requirement
=
10 %
Actual reserves at bank = $10,000
Excess Reserves:
Demand deposits
= $50,000
Reserve requirement= 10 %
Actual reserves
= $10,000
- Required reserves = $5,000
= Excess reserves
= $5,000
Excess Reserves ($5,000) can be loaned
By making a loan, the bank has created
money.
The original deposits are still in Main Street
Bank, but now there is an additional $5,000
out floating around.
The Bank of the James which has a reserve ratio of
10 percent on its deposits, has calculated the
following numbers as of the end of business today:
total deposits = $13,500,000;
reserve account = $3,750,000; and
vault cash = $2,250,000.
Determine the following for this bank:
3,750,000 + 2,250,000 = 6,000,000
Actual reserves = __________________
13,500,000 x .10 = 1,350,000
Required reserves = _________________
6,000,000 -1,350,000 = 4,650,000
Excess reserves = __________________
How much in new loans can Madison Heights National
Bank make if its
deposits are $45,000,000,
vault cash is $5,500,000, and
reserve account balance is $7,750,000?
MHNB’s reserve requirement is 8%.
9,650,000
New loans = _____________________
5,500,000 + 7,750,000 = 13,250,000
45,000,000 x .08 = 3,600,000
13,250,000 -3,600,000 = 9,650,000
What is the amount that must be borrowed by the
Smith Mountain Lake Marine Bank to cover its
anticipated reserve shortfall if it has
a reserve requirement of 12 percent,
deposits of $27,500,000,
vault cash of $2,500,000,
a reserve account of $3,250,000, and it has just
made a new loan of $2,500,000 that has not yet
cleared?
-50,000
New borrowing = ___________________
2,500,000 + 3,250,000 = 5,750,000
27,500,000 x .12 = 3,300,000
5,750,000 -3,300,000 = 2,450,000
If the Excess Reserves are loaned
The borrowed money is spent and deposited
at another bank.
The second bank’s reserves are now up $5,000
- it must keep 10% or $500
- it can then loan out $4,500 ($5,000 – $500)
This process can be repeated at each step.
10% of the money is lost at each step
The more that is required to be held in
reserve, the less money can be created
The lower the reserve requirement, the greater
the amount of money that can be created
Creating Money from New Reserves
New cash
deposits:
Actual Reserves
Bank
Initial deposit (bank A)
Second stage (bank B)
Third stage (bank C)
Fourth stage (bank D)
Fifth stage (bank E)
Sixth stage (bank F)
Seventh stage (bank G)
All others (other banks)
Total
New
Required Reserves
Potential demand
deposits created by
extending new loans
$1,000.00
800.00
640.00
512.00
409.60
327.68
262.14
1,048.58
$200.00
160.00
128.00
102.40
81.92
65.54
52.43
209.71
$800.00
640.00
512.00
409.60
327.68
262.14
209.71
838.87
$5,000.00
$1,000.00
$4,000.00
• When banks are required to maintain 20% reserves
against demand deposits, the creation of $1,000 of new
reserves will potentially increase the supply of money by
$5,000.
From the table a deposit of $1000, with a
20% reserve requirement led to a $4000
expansion of the money supply
Is there a pattern here?
It just takes 3 easy steps
1. Find the reciprocal of the required
reserve
1/20% = 1/1/5= 5
2. Multiply the initial change by the
multiplier
$1000 * 5 = $5000
3. Subtract out the the initial change
$5000 - 1000 = $4000
1. Deposit of $10,000
1. ________
2. ________
2. Required reserve 10%
3. ________
3. Increase in the money supply?
How about if the reserve
requirement was 20%?
1. ________
2. ________
3. ________
1. Deposit of $16,000
1. ________
2. ________
2. Required reserve 25%
3. ________
3. Increase in the money supply?
1. ________
How about if the reserve
2. ________
requirement was 20%?
3. ________
1. ________
How about if the reserve
2. ________
requirement was 10%?
3. ________
1. Loan making changes the money supply
2. Increases in loans leads to increased
spending which increases the money
supply.
3. BUT, decreases in loan making, or even
paying back a loan decreases the money
supply.
1. More or less voluntary transaction
2. The interest rate is important
3. Supply in the money for loans
a. Households decide to save or spend
b. Banks decide how to use the savings
3. Demand for the loans
a. Households how much to borrow
b. Businesses compare interest rate to
expected profit
Determining
Interest
Rate
S
the
Interest Rate
.05
D
Q
Quantity
of loans
• Households and Banks supply the money based on interest rates
• There is a direct relationship between interest rate and amount of $
• Household and business demand for money is based on the interest
• There is an inverse relationship between interest and amount of $
Determining
Interest
Rate
S
the
Interest Rate
r = .05
i = .03
D
D
(bad expections)
Q
Quantity
of loans
• Expectation of poor economic conditions could shift the curve left
• This would decrease the equilibrium interest rate
Determining
Interest
Rate
S(reserves decreased)
S
the
Interest Rate
i = .07
r = .05
D
Q
Quantity
of loans
• A decrease in excess reserves decreases money for loans
• This would shift the supply curve to the left and increase interest
Increasing
Excess
Reserves
Increases
Ability
to Lend
Decreases
Interest rate
for
Borrowing
Increases
Borrowing
Increases
Level of
Spending
Increases
Output and
Employment
(or Prices)
Decreasing
Excess
Reserves
Decreases
Ability
to Lend
Increases
Interest rate
for
Borrowing
Decreases
Borrowing
Decreases
Level of
Spending
Decreases
Output and
Employment
(or Prices)
1. Monetary Policy Tools:
a. The Reserve Requirement
-reducing it encourages loans and
increases the money supply
-increasing it discourages loans
and decreases the money supply
b. The Discount Rate
3 rates
1. Discount Rate
2. Federal Funds Rate
3. Prime Rate
federal reserve to
member banks
bank to bank
banks to best
customers
b. The Discount Rate
Raising Discount Rate
discourages bank borrowing
decreases money supply
Lowering Discount Rate
encourages bank borrowing
increases money supply
c. Open Market Operations
Buying and Selling Securities (Bonds)
-selling bonds puts bonds out and
take money out of circulation
What effect will this have on the economy??
-buying bonds puts money back in
circulation and takes bonds in
What effect will this have on the economy??
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
a. The Government competes
for money
b. They offer a higher
interest rate
c. Businesses and Household can
afford fewer loans
Less investment
+ quick implementation
+ flexible changes in rates
+ less political
- reserve ratios and interest rates
might not be enough incentive
- high rates may lead to higher prices
- FRS might now be too independent
What would be the effect of each of the following on
Uptown Bank’s excess reserves and loan-making ability if
the bank had $600 million in deposits, a 5% reserve
requirement, and actual reserves of $40 million?
a. The Federal Reserve sells $5 million in
government securities to Uptown Bank.
b. The reserve requirement increases from 5% to 6%.
c. The discount rate is increased.
d. The reserve requirement is lowered from 5% to
4%, and the Federal Reserve buys $10 million in
government securities.
a. Increase loan-making ability
b. Decrease loan-making ability
c. Have no effect
1.
In the equation of exchange, an increase in M
always causes an increase in Q, and a
decrease in M always causes a decrease in P.
2.
If a bank has $100 million in actual reserves and
$80 million in required reserves, it may
make new loans of up to $20 million.
3.
The size of the money multiplier is inversely
related to the size of the reserve
requirement.
4.
With a reserve requirement of 25 percent, an
injection of $100 million of new excess
reserves into the economy could cause the
money supply to expand by $400 million.
5. An increase in excess reserves in the economy
would encourage spending.
6. Lowering the reserve requirement is a tight money
policy.
7. Buying securities by the Fed would decrease excess
reserves held by financial
depository institutions.
8. Crowding out occurs when government borrowing
forces up the interest rate and
discourages households and businesses from
borrowing.