Download Chapter 8: Monetary Theory and Policy Summary of Key Lessons

Chapter 8: Monetary Theory and Policy
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.
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.
• 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.
• Process of Money Creation (cont.)
 Excess Reserves & Loan Making
• Depository institutions can make new loans
up to the value of their excess reserves.
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.
• 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
Summary of Key Points
• 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.
Determining Interest Rates on Loans (cont.)
• 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.
• 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
• 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 demand-pull inflation.
• Monetary Policy Tools (cont.)
 Discount Rate
• Interest rate that a Federal Reserve Bank
charges a financial depository institution for
borrowing reserves.
 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.
• 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
• 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.
• 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 loanmaking 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.