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CHAPTER 28 (12)
MONETARY POLICY AND THE DEBATE ABOUT
MACRO POLICY

LAUGHER CURVE
A caveman points to two of his hairy cousins carrying clubs over their shoulders and says:
"OK -- you hunt, you gather, and I'll fine tune the economy."
______________________________________________________________________________
CHAPTER OVERVIEW: What’s It All About?
The monetary policy of the U.S. is by law in the hands of the Federal Reserve System. It was
established in 1913 to act as the nation’s central bank. The Federal Reserve (the Fed) has a
number of important duties among which controlling money supply is its most important. The
Fed has three major tools for doing so: the reserve requirement, the discount rate, and the openmarket operations of the Federal Open Market Committee. Many capital-market and moneymarket analysts spend their careers trying to discern what the Fed is going to do next.
CHAPTER OBJECTIVES: Students Should Be Able To …
1. Summarize the structure and duties of the Fed. The Fed is a semiautonomous
organization composed of 12 regional banks. It is run by a Board of Governors appointed
by the President with the advice and consent of the Senate. The duties of the Fed include:
(1) conducting monetary policy, (2) supervising and regulating financial institutions, (3)
serving as a lender of last resort to financial institutions, (4) providing banking services to
the U.S. government, (5) issuing coin and currency, and (6) providing financial services
such as check clearing to commercial banks, savings and loan associations, savings
banks, and credit unions.
2. List the three tools of monetary policy and explain how they work. Changing the reserve
requirement (raising the reserve requirement increases interest rates; lowering it,
decreases them), changing the discount rate (raising the discount rate increases interest
rates; lowering it, decreases them), and open market operations (buying government
securities increases money supply thereby lowering interest rates; selling them does the
opposite).
3. Define the Federal funds rate and discuss how the Fed uses it as an intermediate target.
The Federal funds rate is the interest rate banks charge each other for Fed funds. The
Federal funds rate is an important intermediate target. At times of national emergencies,
such as floods or earthquakes -- when it is impossible for businesses or individuals to get
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to the bank to make loan payments -- the Fed will step in and buy or sell bonds to offset
such changes. These actions are called defensive actions. Offensive actions are those
meant to make monetary policy have expansionary or contractionary effects on the
economy.
4. State the Taylor Rule and explain its relevance to monetary policy. Set the Fed funds rate
at 2 percent plus current inflation if the economy is as desired output and desired
inflation. If the inflation rate is higher than desired, increase the Fed funds rate by .5
times the difference between desired and actual inflation. Similarly, if output is higher
than desired, increase the Fed funds rate by .5 times the percentage deviation.
5. Explain how monetary policy works in the AS/AD model. Contractionary policy works as
follows: M i I Y 
. Expansionary monetary policy works in the opposite

i

I

Y

direction. M
.
6. List five problems often encountered in conducting monetary policy. These are: (1)
knowing what policy to use, (2) understanding the policy you're using, (3) lags in
monetary policy, (4) political pressure, and (5) conflicting international goals.
WHAT’S NEW? Revisions to This Edition
Formerly Chapter 30 (Chapter 14 in Macroeconomics), this chapter has been revised to be clearer
and have more of a real-world focus. The Taylor rule has been clarified. A discussion of recent
Fed actions—its response to the 9/11 terrorist attacks and actions generally since early 2000—has
also been added. Finally, there is a new box, “Applying the Tools: Using the Multiplier in
Practice,” which explains how central banks no longer target the money supply, but instead
change the monetary base to target interest rates and bank credit.

New discussion of a typical FOMC meeting as well as a graph of the Fed funds rate and
discount rate since 1990.

New diagram showing the Fed’s tools to help students understand how the Fed sets the
interest rate and targets its objectives.
DISCUSSION STARTERS: Get Your Class Rolling
1. If the Congress and/or the President ran the Fed, what kind of monetary policy would be most
politically popular – at least in the short run? What would happen to inflation over time?
Would a “political” business cycle be possible? Is a semi-autonomous Fed a good idea?
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2. Why do you think banks and savings and loan associations have been offering more variable
interest rate loans – loans where the interest rate charged borrowers fluctuates with current
market rates of interest?
3. How could the Fed regulate banks to reduce discriminatory loan eligibility requirements
based on geography?
TIPS FOR TEACHING LARGE SECTIONS
Short-Answer Quizzes
Certain chapters lend themselves to short-answer quizzes, often consisting of only one
question for which I give three or four points. Whenever they do, I give a short-answer quiz
rather than a multiple-choice quiz. The questions I ask on these quizzes are ones that I can grade
quickly. (I find that I can look at a graph, or short answer, and decide whether the student knows
what is going on in about 10 seconds.) I can grade up to six exams a minute, although I
sometimes take longer. (I can train good assistants to grade almost as fast.) The following are
examples of the questions I ask: Assume the reserve requirement is .2 and the cash to deposit
ratio is .3. If the Fed sells $100 worth of bonds, what will happen to the money supply. (I usually
give them about 2 minutes to answer this one because it is hard.) I grade these quizzes liberally,
and worry more about the curves being there and having the right slope than about the correct
labeling of the axes.
ON THE WEB: Integrating New Media into the Classroom
http://www.federalreserve.gov is the Web site of the Board of Governors of the Federal Reserve
System in Washington. There are links to testimony and speeches, monetary policy, banking
system, regulation and supervision, research and data, consumer information, community affairs,
reporting forms, and publications. Politics: balanced.
http://www.ny.frb.org/pihome/educator/fomcsim.html is the Web site of the Federal Reserve
Bank of New York. This particular site has a Federal Open Market Committee simulation
suitable for classroom use. The roles are as follows:
NUMBER OF STUDENTS
1
1
10
6
Remainder
ROLE
Federal Reserve Chairman
President of the Fed of New York
Economist-Advisors
Members of the Board of Governors
4 Reserve Bank presidents
Complete details are in Web site. Politics: none.
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http://www.ecb.int/home/home01.htm is the home page of the European Central Bank located in
Frankfurt am Main, Germany. Politics: none.
http:risk.icfi.ch is the Web site of the Risk Institute located in Zurich, Switzerland. IFCI is an
international risk management organization. There are key links to Key Concepts, Case Studies,
Risk Library, and Glossary. Politics: balanced.
http://epinet.org is the Web site for the Economic Policy Institute. There are links to: Living
Standards and Labor Markets; Government and the Economy; Trade and Globalization; Politics
and Public Opinion, and Sustainable Economics. Politics: conservative.
STUDENT STUMBLING BLOCKS: Common Areas of Difficulty
Federal Reserve Actions: An In-Class Review
Suppose the banking system’s cash reserves are $200,000, the demand-deposit liabilities
(customers’) are $1,000,000, and the reserve requirement ratio is 20 percent. Also assume banks
will loan out any excess reserves and the ratio of people’s cash to deposits is zero.
1. What are the banking system’s excess reserves?
ANS: Zero. Excess reserves = reserves – required reserves = $200,000 - $200,000 = 0, where
required reserves = ($1,000,000 X 0.20) = $200,000.
2. What is the money multiplier equal to?
ANS: 1/0.2 = 5.
3. What should the Fed do with open market operations if it wished to increase the money
supply by $50,000? Is this expansionary or contractionary monetary policy?
ANS: The Fed could buy $10,000 worth of U.S. government securities from banks. This will
increase banks’ cash reserves and therefore their excess reserves by that amount. Note that this
transaction will not affect banks’ required reserves. When these additional excess reserves are
loaned out, the money supply will expand by $50,000 via the money multiplier. Since the money
supply increases, the Fed would be undertaking an expansionary monetary policy.
4. Would the Fed be undertaking expansionary or contractionary monetary if it reduced the
reserve requirement to 10 percent? What effect would this have on the money supply?
ANS: Expansionary. Excess reserves would increase by $100,000 because required reserves
decrease by $100,000 and the money multiplier would become 10 (1/0.1). The money supply
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would increase by $1,000,000. Note that changing the required reserves of banks has a
potentially very powerful effect on the money supply because it changes excess reserves and the
money multiplier. That is why changing the reserve requirement is the tool least used by the Fed
to change the money supply.
5. Assume again that the reserve requirement is 20 percent. If the Fed wished to increase the
money supply by $70,000, and for every 1 percent change in the discount rate there is an increase
in bank borrowing from the Fed by $7,000, by how much should the Fed change the discount
rate?
ANS: The Fed should decrease the discount rate by 2 percent. To increase the money supply by
$70,000 when the money multiplier is 5 means that excess reserves need to by increased by
$14,000. This could be accomplished by reducing the discount rate by 2 percent.
TIES TO THE TOOLS: Bringing the Boxes into the Classroom
Applying the Tools: Central Banks in Other Countries
This featurette discusses the Bundesbank of Germany, the European Central Bank, the Bank of
England, and the Bank of Japan.
Beyond the Tools: History of the U.S. Banking System
The history of central banking in the U.S. is an on-again, off-again proposition. Supporters of the
idea argued that it would create stability and help prevent financial panics. Opponents feared the
concentration of economic power, its inability to prevent recessions, and the possibility that
industrial interest would take precedent over farming interests. During the financial panic of
1907, J. P. Morgan, among the most detested and feared men in America, almost single handedly
saved the banking system. Congress was so embarrassed it passed the Federal Reserve Act in
1913.
Applying the Tools: Three Letters
This relates to a joke about U.S. presidents. The outgoing president hands the new president
three letters labeled 1, 2, and 3. In the case of dire emergency he is to open the first letter. It
reads: “Blame it on Congress.” If that doesn’t work, open the second letter that reads: “Blame it
on the Fed.” If that doesn’t work, open the third letter that reads: “Prepare three letters.”
Applying the Tools: Using the Multiplier in Practice
Usually central banks do not determine how much to change the monetary base to get a desired
change in the money supply by using a fixed multiplier. Instead, they adjust the monetary base to
target a desired amount of bank credit in the economy and short-term interest rate, and then
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adjust the monetary base to fit that. Thus, it is hard to use the money multiplier as an operational
variable, which is why much of monetary-policy discussion today focuses on the interest rate, not
the money supply.
Knowing the Tools: Inside an FOMC Meeting
This tool takes you through an FOMC committee meeting at the Fed of New York. The
information gathered for the meeting resides in three books: the Beige Book, the Green Book,
and the Blue Book. The Blue Book is the central policy document, and one of the three options it
presents will be selected by the Committee.
LECTURE OUTLINE: A Map of the Chapter
I. Introduction.
A. Monetary policy is that which influences the economy through changes in the money
supply and available credit.
1. Monetary policy is one of the two main traditional macroeconomic tools by which
government attempts to control the aggregate economy.
2. Government (the President and Congress) control fiscal policy.
3. The Federal Reserve (the Fed) controls monetary policy.
B. What is the effect of monetary policy on the AS/AD model? See Figure 28-1.
1. Expansionary monetary policy shifts the AD curve to the right.
2. Contractionary monetary policy shifts the AD curve to the left.
3. The general rule states that expansionary monetary policy increases nominal income. Its
effect on real income depends on how the price level responds.
%∆Real Income = %∆Nominal Income - %∆Price Level
II. Duties and structure of the Fed.
A. A central bank is a bankers' bank.
1. It conducts monetary policy.
2. If banks need to borrow money, they go to the central bank.
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3. If there is a run on a bank, the central bank lends money to the imperiled bank until the
danger has passed.
4. Its IOUs are cash, so by simply issuing an IOU it can create money.
5. In Great Britain, the Bank of England is part of the government.
6. In the U.S., the Fed is not part of the government.
B. Structure of the Fed is as follows:
1. The Fed is a semiautonomous organization composed of 12 regional banks. It is run by
a Board of Governors appointed by the President with the advice and consent of the
Senate (Chapter Objective 1a).
2. The Fed, although an agency of the federal government, has much more independence
than most agencies.
a. The considerable profits the Fed earns are turned over to the U.S. Treasury, not to the
"owners," the member banks.
b. Once appointed for a term of 14 years, governors cannot be removed from office,
which means they can pretty well do what they think is right.
3. The seven Fed governors are paid less than they could receive in the private sector.
Generally, the governors do not serve out their full terms but are recruited by private
businesses for substantially higher salaries.
4. The President appoints one of the seven members to chairman of the Board of
Governors for a four-year term, generally conceded to be the second most powerful
official in government.
5. Geographically, the Fed's districts reflect its political history, with nine of the twelve
banks situated in the East and Midwest. See Figure 28-2a.
C. Duties of the Fed (Chapter Objective 1b).
1. Conducting monetary policy (influencing the supply of money and credit in the
economy) is the most important job the Fed has to do.
2. Supervising and regulating financial institutions.
3. Serving as a lender of last resort to financial institutions.
4. Providing banking services to the U.S. government.
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5. Issuing coin and currency. The disastrous Susan B. Anthony minted dollar was initially
distributed through the banking system. It bombed. When the new Sacagawea minted
dollar was initially distributed not only through the Fed but also through Wal-Mart and
Sam’s Club, the banks and small retailers howled. It worked. The demand for the new
coin reached 200 million in the first month. It took the Susan B. Anthony four years to
reach that level.
6. Providing financial services such as check clearing to commercial banks, savings and
loan associations, savings banks, and credit unions.
D. The importance of monetary policy
1. Monetary policy is the Fed's most important job, and the most-used policy in
macroeconomics.
2. The Fed conducts it and controls it.
3. Actual decisions about monetary policy are made by the Federal Open Market
Committee (FOMC) -- the Fed's chief policymaking body.
a. The membership is made up of the seven members of the Board of Governors,
together with the president of the New York Fed and a rotating group of four of the
presidents of the other regional banks.
b. The actions of this group are closely watched -- indeed some observers have made a
career out of guessing with the Fed is likely to do in the future.
E. The conduct of monetary policy.
1. Bank reserves are IOUs of the Fed -- either vault cash or deposits are the Fed. The
monetary base is vault cash, currency in circulation, and deposits at the Fed.
2. By controlling the monetary base, the Fed can influence the amount of money in the
economy and the activities of commercial banks.
3. Other things being equal, as reserves decline, the interest rate will rise; and as reserves
increase, interest rates will fall. Thus, monetary policy is concerned with the cost of
money -- interest rates.
III. Tools of monetary policy (Chapter Objective 2).
A. Changing the reserve requirement.
1. By law, the Fed controls the minimum percentage of deposits banks keep in reserve by
controlling the reserve requirement of all U.S. banks.
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2. The minimum is called the reserve requirement -- the percentage the Federal Reserve
System sets as the minimum amount of reserves a bank must have.
3. Required reserves and excess reserves.
a. For most banks, the Fed's reserve requirement determines what they hold as reserves.
(1) Banks hold as little in reserves as possible since they earn no interest on them.
(2) In the late 1990s, required reserves for demand deposits were about 10 percent,
and zero for all other accounts, making the reserve requirement for all liabilities
a little under 2 percent.
b. In the late 1990s, excess reserves were about $1 billion.
4. The reserve requirement affects the money supply.
a. By changing the reserve requirement, the Fed can increase or decrease the money
supply.
(1) If the Fed increases the reserve requirement, it contracts the money supply.
(2) Since they have less money to lend out, the decreased money multiplier (the
multiple contraction of deposits occurring in response to a change in reserves)
further contracts the money supply.
(3) If the Fed decreases the reserve requirement, it expands the money supply.
(4) The money multiplier further expands the money supply.
b. The approximate real-world money multiplier in the economy is 1/(r +c) where r =
the percentage of deposits banks hold in reserve and c is the ratio of money people
hold in cash to the money they hold as deposits.
c. An example: assume banks keep 8 percent in reserve and the ratio of individuals'
cash holdings to their deposits is 20 percent. The approximate real-world money
multiplier is: 1/(.08 +.20) = 1/.28 = 3.57. So $1,000,000 in vault cash plus currency
will support a total $3,570,000 money supply.
d. In reality, the cash-to-deposit ratio (c) is about 0.4 percent. As mentioned above, the
average reserve requirement for demand deposits (r) is about 0.1 . So the realistic
approximate money multiplier for demand deposits (M1) is: 1/(0.1 + 0.4) = 1/.5 = 2
e. An example: A $1,000,000 increase of reserves plus currency will support a
$2,000,000 increase in demand deposits. For other deposits, the reserve requirement
is much lower, so the money multiplier is larger for those.
f. What to do if a bank has a shortage of reserves?
(1) Go to the Federal funds market where the bank can borrow reserves from another
bank that has excess reserves. This is called the Federal Funds market. The rate
of interest charged is the Federal Funds rate.
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(2) If the Federal funds market dries up, the bank may stop making new loans and
keep as reserves the proceeds of loans that are paid off.
(3) Sell Treasury bonds in order to get reserves. The bonds themselves cannot be
used as reserves (they are sometimes called secondary reserves), but the cash
that comes from their sales does.
B. Changing the discount rate.
1. This second tool of the Fed concerns an alternative to those listed above -- borrow
reserves directly from the Fed, the bankers' bank.
2. The discount rate is the rate of interest the Fed charges for those loans it makes to
banks.
a. An increase in the rate of interest makes it more expensive for banks to borrow from
the Fed.
b. A decrease in the rate of interest makes it less expensive for banks to borrow from
the Fed.
c. Therefore, by changing the discount rate, the Fed can expand or contract the money
supply.
3. In practice, the discount rate is generally lower than other rates banks would have to pay
to borrow reserves. So why not just go to the Fed and pay the discount rate?
a. The Fed discourages banks from using this option.
b. Therefore, most banks do this as a last resort.
c. Fed auditors may show up if this option is overused.
4. The Fed uses announced changes in the discount rate as a signal that the Fed wants the
money supply to either expand or contract.
C. Executing open market operations.
1. Changes in the discount rate and reserve requirements are not used in day-to-day
operations of the Fed. These tools are used for major changes.
2. For day-to-day operations the Fed uses a third tool, open market operations -- the
Fed's buying and selling of government securities (the only type of asset the Fed is
allowed by law to hold in any appreciable quantity).
a. To expand money supply, the Fed buys bonds.
b. To contract money supply, the Fed sells bonds.
3. Periodically, the FOMC decides what its open market operations will be and whether it
wants to expand or contract the money supply.
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4. Examples of open market operations.
a. An open market purchase.
(1) When the Fed buys bonds, it deposits the money in federal government accounts
at a bank.
(2) When the Fed pays the government for its bonds, bank cash reserves rise,
encouraging the banks to lend out the excess.
(3) Money supply rises.
(4) Thus, an open market purchase is an example of expansionary monetary policy
-- usually defined to be a monetary policy that tends to reduce interest rates and
raise income.
b. An open market sale.
(1) Here, the Fed sells bonds.
(2) In return for the bond, the Fed receives a check drawn against a bank.
(3) The bank's reserve assets are reduced and money supply falls.
c. Thus, an open market sale is an example of contractionary monetary policy -usually defined to be a monetary policy that tends to raise interest rates and lower
income.
d. What happens to bond prices and interest rates during this process?
(1) An open market purchase. See Figure 28-3a. When the Fed buys bonds in an
open market purchase, it raises the demand for bonds. Bond prices rise and
interest rates fall. This happens in an expansionary monetary policy.
(2) An open market sale. See Figure 28-3b. When the Fed sells bonds in an open
market sale, the supply of bonds moves to the right, thereby lowering the
demand for bonds. Bond prices fall and interest rates rise. This happens in a
contractionary monetary policy.
5. The Fed funds market.
a. How the Fed funds market works.
(1) Banks with surplus reserves can lend money to banks with a reserve shortage.
(2) It is lent overnight as Fed funds -- loans of their reserves banks make to each
other.
(3) Banks with surplus reserves will call a Federal funds dealer to learn the Federal
funds rate -- the interest rate banks charge each other for Fed funds (Chapter
Objective 3).
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(4) This is all done electronically. A fall in bond prices means a rise in interest rates.
When the price of bonds rises, the interest rate falls. Thus, the price of bonds
and the interest rate are inversely related.
(5) The Federal funds market -- the market in which banks lend and borrow
reserves -- is highly efficient.
b. Offensive and defensive actions.
(1) The Federal funds rate is an important intermediate target.
(2) At times of national emergencies, such as floods or earthquakes -- when it is
impossible for businesses or individuals to get to the bank to make loan
payments -- the Fed will step in and buy or sell bonds to offset such changes.
These actions are called defensive actions.
(3) Defensive actions are meant to maintain the current monetary policy.
(4) Offensive actions are those meant to make monetary policy have expansionary or
contractionary effects on the economy.
c. The Fed funds rate as an operating target.
(1) How does the Fed decide whether its buying and selling of bonds is having the
desired effect?
(2) The Fed looks at intermediate targets. In recent years, the Federal funds rate has
been the operating target of the Fed.
d. The complex nature of monetary policy
(1) While the Fed focuses on the Fed funds rate as its operating target, it has its eyes
on its ultimate targets: stable prices, acceptable employment, sustainable growth,
and moderate long-term interest rates as well.
(2) The linkage is as follows:
Fed Tools (open market operations, discount rate, reserve requirement)
Operating Target (Fed Funds)
Intermediate Target (consumer confidence, stock prices, interest-rate spreads)
Ultimate Target (stable prices, sustainable growth, acceptable employment)



e. The Taylor rule: set the Fed funds rate at 2 percent plus current inflation if the
economy is as desired output and desired inflation. If the inflation rate is higher than
desired, increase the Fed funds rate by .5 times the difference between desired and
actual inflation. Similarly, if output is higher than desired, increase the Fed funds
rate by .5 times the percentage deviation.
D. Fed response to September 11.
1. The Fed acted both defensively and offensively.
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2. By acting defensively, it provided short-term liquidity.
3. By acting offensively, six days later the FOMC reduced the Fed funds rate .5 percentage
point to 3 percent, and then continued to cut the Fed funds rate by 1¼ percentage points
by the end of 2001.
IV. Monetary policy in the AS/AD model.
A. In the AS/AD model, monetary policy works primarily through its effect on interest rates.
See Figure 28-5.
1. The Fed decreases money supply (uses contractionary monetary policy).
a.
b.
c.
d.
Interest rates go up.
As interest rates go up, the quantity of investment goes down.
As investment goes down, aggregate demand goes down.
Through multiplier effects, aggregate equilibrium demand and income go down by a
multiple of decrease in investment.
e. The AD curve shifts to the left by a multiple of the shift in investment.
f. Thus (Chapter Objective 4):
M i I Y 
2. Expansionary monetary policy works in the opposite direction. Thus (Chapter
Objective 4):
Mi I Y 
B. Monetary policy in the circular flow. See Figure 28-6.
1. If monetary and fiscal policies are needed, it is because the financial sector is in some
ways clogged and is not correctly translating savings into investment.
2. Monetary policy works to unclog the financial sector.
C. The emphasis on the interest rate.
1. A rising interest rate indicates a tightening monetary policy.
2. A falling interest rate indicates a loosening of monetary policy.
3. A natural conclusion is that the Fed should target interest rates in setting monetary
policy.
D. Real and nominal interest rates.
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1. There is a problem in using interest rates as a measure of the tightness or looseness of
monetary policy. That problem is the real/nominal interest rate problem.
a. Nominal interest rates are those you actually see and pay.
b. Real interest rates are those adjusted for expected inflation.
2. The real interest rate cannot be observed since it depends on expected inflation, which
cannot be directly observed.
Nominal interest rate = Real interest rate + Expected inflation rate.
E. Real and nominal interest rates and monetary policy.
1. Making a distinction between nominal and real interest rates adds another uncertainty to
the effect on monetary policy.
a. If expansionary monetary policy leads to expectations of increased inflation,
expansionary monetary policy can increase nominal interest rates and leave real
interest rates unchanged.
b. Why? Because of expectations of increased inflation.
2. The possible effect of monetary policy on expectations of inflation has led most
economists to conclude that a monetary regime, not a monetary policy, is the best
approach to policy.
a. A monetary regime is a rule; it is a predetermined statement of the policy that will
be followed in various situations.
b. On the other hand, a monetary policy is a policy response to events. It is chosen
without a predetermined framework.
3. The monetary regime the Fed is currently following involves feedback rules that center
on the federal funds rate.
a. If inflation is above its target, the Fed raises the federal funds rate by selling bonds,
thereby increasing the money supply, in an attempt to slow inflation down.
b. If inflation is below its target, and if the economy is sliding into a recession, the Fed
lowers the federal funds rate by buying bonds, thereby decreasing the money supply.
V. Problems in the conduct of monetary policy (Chapter Objective 5).
A. Knowing what policy to use.
1. The potential level of income must be known.
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2. Otherwise you don't know whether to use expansionary or contractionary monetary
policy.
B. Understanding the policy you're using.
1. In order to use monetary policy effectively, you must know whether the monetary policy
you are using is expansionary or contractionary.
2. The money multiplier is influenced by both the amount of cash people hold as well as
the lending process at the bank. Neither of these are stable numbers.
3. Then there are interest rates. If interest rates rise, is it because of expected inflation or
is it that the real interest rate is going up?
C. Lags in monetary policy.
1. Monetary policy takes time to work. Just because the Fed drops interest rates, that does
not necessarily mean that people or businesses will go out and borrow money.
2. In the face of a contractionary monetary policy, banks have been creative in
circumventing cuts in the money supply.
D. Political pressure.
1. The Fed is not totally insulated from political pressure.
2. Presidents place great pressure on the Fed to loosen the purse strings, especially during
an election year.
E. Conflicting international goals.
1. Monetary policy is conducted in an international arena.
2. It must be coordinated with other nations.
NOTE: For another approach to explaining monetary policy, see Appendix A, "The Effect of
Monetary Policy Using T-Accounts."
CHAPTER SUPPLEMENTS: Other Classroom Aids to Use
 Classic Readings in Economics: "100 Percent Reserves," pp. 89-94. This selection, taken
from Irving Fisher's 1935 book, 100% Money, argues just the opposite of John Law -- that
banks should only be allowed to issue checks if they back them 100 percent with U.S.
currency or gold.
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 Classic Readings in Economics: "Rules Versus Authorities in Monetary Policy," pp. 95-99.
Henry C. Simons's 1936 article pleads for the establishment of a framework within which the
market economy can function effectively
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POP QUIZ
NAME: __________________________________
COURSE: ________________________________
1. According to the AS/AD model, which of the following describes the cause-effect
relationships through which a change in money supply affects the level of economic activity?
a. An increase in the money supply will reduce interest rates, increase investment spending,
and increase the level of economic activity.
b. An increase in the money supply will reduce interest rates, decrease investment spending,
and decrease the level of economic activity.
c. An increase in interest rates will increase the money supply, decrease investment spending,
and decrease the level of economic activity.
d. An increase in aggregate expenditures will decrease the money supply, increase inflation,
and decrease the level of economic activity.
2. To offset a recession the Fed should:
a. use contractionary monetary policy.
b. decrease required reserves, decrease the discount rate, and/or buy U.S. government
securities on the open market.
c. increase required reserves, decrease the discount rate, and/or buy U.S. government
securities on the open market.
d. decrease banks’ excess reserves to decrease the money supply.
3. All of the following statements of the Taylor Rule are correct except:
a. this is a policy suggestion that the Fed follow.
b. set the Fed funds rate at 2 percent minus current inflation less desired output and desired
inflation.
c. this is a valuable first approximation of what the Fed might do.
d. the Fed should blindly follow this rule.
4. Which of the following statement about the Fed is true?
a. The Fed is run by the executive branch of government.
b. The Fed is completely insulated from political pressures.
c. The Fed’s most important duty is to control the money supply.
d. The most important policy-making body of the Fed is the Federal Advisory Council.
5. Which of the following statement is false?
a. If expansionary monetary policy is undertaken, most economists believe this will increase
real income and increase the price level.
b. When the Fed buys bonds, this increases the supply of bonds, decreasing their price and
increasing interest rates.
c. If the Federal funds rate goes above the Fed’s target range, the Fed will buy bonds.
d. If the Fed funds rate goes above the Fed’s target range, then monetary policy is too tight.
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6. During an expansionary phase of the business cycle, fiscal and monetary policy can logically
be coordinated to:
a. run a deficit and increase the money supply.
b. run a surplus and increase the money supply.
c. reduce government spending, increase taxes, increase the discount rate, increase reserve
requirements, and/or sell U.S. government debt on the open market.
d. increase government spending, reduce taxes, decrease the discount rate, decrease reserve
requirements, and/or buy U.S. government debt on the open market.
7. Which of the following statement is false?
a. An increase in the discount rate signals that the Fed wants the money supply tightened.
b. When the economy is below full employment, expansionary monetary policy will help
boost output.
c. The Fed targets interest rates in setting monetary policy.
d. Banks earn more profits when they hold more reserves than are required by law.
8. Which of the following statements is true?
a. The money multiplier is a relatively stable value that changes very little and only
infrequently.
b. If expansionary monetary policy leads to an increase in expected inflation, then nominal
interest rates will definitely fall.
c. The real interest rate equals the nominal interest rate plus expected inflation.
d. If the real interest rate is 6 percent and the expected rate of inflation is 4 percent, then the
nominal rate of interest will be 10 percent.
9. Which of the following is true concerning the Fed’s tools to change the money supply?
a. An increase in the reserve requirement will increase banks’ excess reserves and increase
the money multiplier.
b. Changing reserve requirements is potentially the most powerful tool and is therefore the
tool that is most used.
c. Changing the discount rate is the most powerful tool because banks are not that fond of
borrowing from the Fed.
d. Open market operations refers to the Fed’s buying and selling of U.S. government
securities and is the Fed’s most used tool.
10. Suppose the required reserve ratio is 25 percent and there are no cash holdings. If the Fed
buys $2 billion of government securities from banks then:
a. this will decrease banks’ excess reserves by $2 billion.
b. the amount of checkable deposits in the banking system and therefore the money supply
could eventually increase by $8 billion.
c. the Fed is undertaking contractionary monetary policy.
d. the interest rate will likely rise.
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ANSWERS TO POP QUIZ
1. a 2. b 3. d 4. c 5. b 6. c 7. d 8. d 9. d 10. b
IN-CLASS EXERCISE: Learning Concepts through Practice
At the beginning of the chapter, we learned that the cash the Fed issues is their IOUs.
A. Ask the students to reach into their wallets and purses and pull out a dollar bill. Let’s take a
good look at cash, specifically a $1 bill.
1. At the top it says Federal Reserve Note. Ask the class what this means. What backs it?
Gold? No, although there used to be gold certificates. Silver? No, although there used to
be silver certificates. Nothing backs it. Nothing except for the “full faith and credit of the
United States government.” This is considerable, since people will still kill in order to get
it. So this is an IOU issued by the Fed. If you went to a Fed office and demanded they
give you one dollar for the one you have, they would give you a crisp, brand new paper
dollar bill just like the one you gave the teller. Tie this in with what we had earlier: if
people think it’s money, it’s money even if nothing backs it.
2. It says in the upper left that This note is legal tender for all debts, public and private. Are
coins legal tender? No, they are not. For example, if you are angry and wish to pay the
IRS with pennies, they do not have to accept them. But say you wish to pay the $1 million
you owe the IRS with one-dollar bills, do they have to accept them? Yes, they do.
3. To the right of Washington’s portrait is the seal of the U.S. Treasury, the toughest part of
the bill to counterfeit.
4. To the left of the portrait is the seal of the Federal Reserve Bank that issued it – say bank
number 10, the Fed of Kansas City, Missouri. In the middle of the seal is the letter J, the
tenth letter of the alphabet. Note that in the four corners of the bill, the number 10 appears.
Incidentally, Missouri has two Federal Reserve Banks, this one and the one in St. Louis.
Why? The Speaker of the House at the time, James B. Clark of Missouri, saw to it, that’s
why.
B. The back of the bill is fascinating.
1. First the color – green, hence the name “greenback.” It started in the Civil War when
counterfeiting was rampant. They colored the backs green in order to make them harder to
fake.
2. On the right of the bill is the obverse side of the Great Seal of the United States. Benjamin
Franklin was the head of the committee charged with its design. He favored the wild
turkey because: (1) it was eatable, (2) of the role it played at Plymouth Colony, (3) it was
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concentrated in what was the U.S. at the time, (4) it did not eat dead things, and (5) it was a
symbol of peace, not war. He was outvoted. The bald eagle, which eats carrion, a raptor
President Teddy Roosevelt once called “a dandified buzzard” (he favored the grizzly bear),
became the nation’s symbol. Over the eagle’s head is a cloud formation called a “glory”
made up of 13 little clouds symbolizing the original colonies. In the middle of the glory
are 13 stars. In its beak is a ribbon imprinted with the nation’s motto, E Pluribus Unum,
“out of many, one.” In its right claw, the eagle holds an olive branch, symbol of peace,
with 13 leaves and 13 olives on it. This came down to us from the ancient Greeks. Why
an olive? It has been called the “tree of civilization” since one would have to be crazy to
plant it in a time of war. It takes many years to produce good olives. Why give your
enemies free olives? In its left claw are 13 arrows, symbol of war. Note that the eagle is
looking toward peace. In other words, “we look toward peace, but we can also kick butt.”
3. The left of the bill shows the reverse side of the seal. Both Washington and Franklin were
masons so this is fraught with Masonic symbolism. As I am not a member, what follows is
in the public domain: undoubtedly, there are subtle images in the seal known only to
Masons. A truncated pyramid dominates. It is unfinished and lies in a desert. There are
156 stones on this face of the pyramid, one for each of the signers of the Declaration of
Independence. At the base, in Latin numbers, is 1776. Below is Novus Ordo Seclorum,
meaning “new order of the ages,” which refers to the date, 1776. At the top is Annuit
Coeptis, “He has favored our undertakings.” Who has favored us? At the top of the
pyramid suspended in air is the eye of God. The idea is that God gave us an empty
continent and He is hoping, along with the new government, that we will finish the
pyramid and turn the desert into a Garden of Eden. But just in case, He’s watching us.
C. Now, those of you who are rich, take out a new $20, $10, or $5 bill.
1. The seal of the Treasury is the same, but the seal of each member bank has disappeared to
be replaced by the seal of the Fed instead. The eagle looks a bit like a turkey (old Ben
would be delighted). In the upper left corner, just below the serial number, the number of a
member bank appears: L12 for the San Francisco Fed, for example.
2. After the New Deal, the Fed in Washington got its own white-marble temple on
Constitution Avenue and the fate of the district banks was sealed. Power moved to
Washington. This is a subtle acknowledgement that the Fed in Washington is all-powerful
while the member banks have fallen in significance. This reinforces the material in the
text.
D. I wonder how Andy Jackson (the $20 bill) would like his new blow-dried coiffure. He’d
probably love it, that vain rascal.
For detailed information on counterfeiting, see: Know Your Money, Department of the Treasury,
United States Secret Service.
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CASE STUDIES: Real-World Cases of Textbook Concepts
Case Study 28-1: The Fed’s Response to September 11
The Federal Reserve moved quickly to help keep the nation’s financial and payments systems
running smoothly after the September 11, 2001, terrorist attacks. Among the actions the Fed
took:

The New York Trading Desk injected an unusual amount of liquidity into the economy
through repurchase agreements called repos.

The Fed lent money directly to banks through the discount window. The $45 billion in
discount loans outstanding on Wednesday, September 12, dwarfed the $59 million
average of the previous ten Wednesdays.

The Fed, along with the Comptroller of the Currency, urged banks to work with
customers affected by the events. The Fed stood ready with additional funds to assist in
restructuring loans.

Because the grounding of aircraft prevented the timely clearing of checks, the Fed
extended almost $23 billion in check float on September 12 – about 30 times the average
float over each of the previous ten Wednesdays.

The Fed extended swap lines with foreign central banks. Such arrangements enable
central banks to temporarily exchange currencies to meet liquidity needs in foreign
currencies. For example, the Fed and the European Central Bank agreed on an
arrangement that allowed the ECB to draw up to $50 billion in dollar-denominated
deposits in exchange for an equivalent amount in euro. The dollar deposits were
available to European banks whose U.S. operations were affected by the events of
September 11.

The Federal Open Market Committee reduced the federal funds rate target by half a
percentage point, to 3 percent, on Monday, September 17, just before the New York
Stock Exchange reopened. The Fed’s action was seen as an effort to boost confidence in
the economy. In announcing the rate cut, the Fed noted that it would continue to supply
unusually large volumes of liquidity to financial markets “until more normal market
functioning is restored.”
Deposits at Federal Reserve Banks give us a picture of the liquidity pumped into the economy.
On September 12, deposits totaled nearly $103 billion, more than five times the average of the
previous ten Wednesdays.
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A MONETARY SNAPSHOT (DATA IN $BILLION)
Discount
Deposits at Federal
Wednesday Averages
Repos
Window Lending
Float
Reserve Banks
July 4 – Sept. 5, 2001
$27,298
$59
$720
$19,009
September 12, 2001
61,005
45,528
22,929
102,704
September 19, 2001
39,600
2,587
2,345
13,169
Source: C. J. Neely, “September 11, 2001,” Monetary Trends, Federal Reserve Bank of St. Louis,
November 2001.
Questions:
1. Which of the tools of monetary policy did the Fed use in the emergency?
2. Why did the grounding of aircraft cause the Fed to act?
3. The chapter lists the duties the Fed must perform. Which duties are mentioned in the article?
4. What forms did liquidity take?
5. Do you think the Fed acted correctly?
Case Study 28-2: The Taylor Rule
Generally, economists have long been divided into two camps – those who think policymakers
should view the world and react accordingly and those who prefer rules. John Taylor thought
that the rules the Fed enumerated -- in those few instances when they did -- were vague. For
example, Fed officials still say that they lean against the economic wind. When the winds die
down, they lower rates; when the winds pick up, they raise them. But according to Taylor,
“neither the amount of leaning, the definition of the wind, not the measurement of the wind are
specified.”
Enter the “Taylor rule.” Forget the money supply, the dollar, the bond and stock markets, and the
latest consumer-confidence poll. The Taylor rule states that if inflation is one percentage point
above the Fed’s goal, rates should rise by 1.5 percentage points. If, as in a recession, an
economy’s total output is one percentage point below its full capacity, rates should fall by half a
percentage point. That’s it.
The rule is not only intended to tell policymakers what they should do, it explains what they
actually do. Tracking the actual federal-funds rates from 1983 through 1999 and comparing it
with what the rates would have been had the Fed simply followed the Taylor rule, shows an
astonishing similarity. The same is true for Germany’s Bundesbank, an institution that insists on
using money supply as its guide.
Since Taylor has formulated his rule:
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
Financial-market analysts love it since it gives them a seemingly scientific means of
explaining and predicting interest rates in the U.S. and Europe.

Central bankers are mildly miffed. One European central banker sniffed: “A central bank
cannot be bound by a simple policy rule.”

In textbooks and in central banking, the Taylor rule has replaced the formulation of Milton
Friedman. He thought the Fed should set a target for growth in the money supply, announce
it, and maintain it.
The beauty of the Taylor rule is that it not only deals with short-term interest rates, it provides a
means of resisting not only inflation but recessions as well.
Source: David Wessel, “Could One Little Rule Explain All of Economics?” The Wall Street
Journal, February 2, 2000, p. B1.
Questions:
1. Why should central bankers be miffed at the Taylor rule?
2. Do you think politicians like the Taylor rule?
3. Some viewers maintain that using the rule means that the future will always be like the past.
Do you agree?
4. Why do financial analysts like the Taylor rule?
5. Do you think the Taylor rule has caught on?
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