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CHAPTER 14
MONETARY POLICY
WHAT IS THIS CHAPTER ALL ABOUT?
This second chapter devoted to money and the banking system describes the structure of the
Federal Reserve System and looks at the impact of Fed policies on aggregate demand.
In addition to providing an understanding of the basic structure and operations of the Fed, the
purpose of this chapter is to encourage students to think about the following questions:
1.
How does the government control the amount of money in the
economy?
2.
How does the money supply affect macroeconomic outcomes?
NEW TO THIS EDITION



New headline on China's reserve requirement
New headline on interest rate cuts
Living Econ on “Why should I care about interest rates?”
LECTURE LAUNCHERS
Where should you start?
1.
Ask students who is the most powerful man in the U.S. or the world.
Some say the Chair of the Federal Reserve is. The Fed has tools it can use to affect the
economy. When the U.S. economy is affected, this also affects the world economy. This
conversation helps you lead into a discussion of the monetary tools.
2.
Ask the students what are the responsibilities of the Federal Reserve.
Regional functions are listed and explained on page 315. Don’t forget to include
monetary policy in the list.
3.
Discuss the independence of the Fed. Should it be independent?
Chapter 14 – Monetary Policy – Page 276
The Fed was created by an act of Congress in an attempt to remove political
considerations in monetary policy. As a result, the Fed can take actions that cancel out
fiscal policy decisions made by congress.
Note that the members of the Fed are appointed, not elected. Are they truly nonpolitical? Who should regulate the Fed?
4.
Ask students what would happen to the economy if the money supply was either
increased or decreased.
This question allows you to begin discussing monetary policy and the monetary tools
the fed has available.
5.
Ask students how they would react if banks offered lower interest loans.
Some students will say they would take out loans to buy cars, stereos, houses, or other
expensive items if they could get cheap loans. Use this discussion to talk about how
interest rates are determined and how aggregate demand relates to the interest rate.
6.
Illustrate that monetary policy is primarily designed to change AD.
This discussion helps illustrate that the effectiveness of monetary policy depends upon
the location of AD and the shape of AS as illustration in Figure 14.6.
COMMON STUDENT ERRORS
Many students make these common errors. This same list is included in the student study
guide. The first statement in each “common error” below is incorrect. Each incorrect statement
is followed by a corrected version and an explanation.
1.
2.
Bank reserves are required for the safety of depositor’s money. WRONG!
Bank reserves are for the control of the money supply. RIGHT!
Many people have the idea that bank reserves provide for the safety of depositors’
money. They don’t! The amount of demand deposits is several times larger than that
of reserves. Reserves are for control of the money supply. The FDIC provides for
safety of deposits by insuring them. Reserves are not principally for depositors’ safety.
Deposits of cash are necessary to start the process of lending and deposit creation.
WRONG!
To start the lending process, then banks must acquire reserves from outside of the
banking system. RIGHT!
Many find it difficult to understand that for deposit creation to occur, the banking
system needs only to acquire reserves from outside the system or be able to stretch
existing reserves further. It may acquire reserves by selling a security to the Fed or by
borrowing from the Fed. An individual bank, however, may acquire reserves from
another bank. Therefore, to the extent that it has increased its reserves, reserves of
Chapter 14 – Monetary Policy – Page 277
another bank have shrunk. Thus, the system has no more reserves after the transaction
than it had before and so the system’s lending capacity is unchanged.
3.
When the Fed sells government bonds in open-market operations, it is increasing the
money supply. WRONG!
When the Fed sells government bonds in open-market operations, it is decreasing the
money supply. RIGHT!
Think of it this way. If the Fed sold a bond to you, it would give you the bond in
exchange for money that you have. This in effect decreases the amount of money you
have to spend. Since the Fed does not put this money back in circulation, the nations
money supply is reduced.
4.
Monetary policy is easy to determine and to administer. WRONG!
Monetary policy is difficult to determine and to administer. RIGHT!
One could easily get the idea that monetary policy is easy to administer and that the
Fed always knows the rate at which the money supply should grow. This is not so.
Many variables intervene to make monetary policy difficult to prescribe and
implement. Such variables include timing and the duration of a given policy,
unanticipated events on the fiscal side, and problems abroad. The Fed’s policymakers
analyze the data available and do the best they can to achieve a given objective, which
often involves compromises. The process is much more difficult than turning a printing
press on and off.
HEADLINES
This chapter has three Headlines boxes dealing with Fed actions:
"Central Bank in China Raises Reserve Requirement” (Reserve
Requirements)
In 2003, the central bank of China raised the deposit reserve ratio from 6 percent
to 7 percent. The stated reason was to alleviate “an excessive increase in current
monetary lending.”
“Fed Cuts Key Rate by Half a Point” (Discount Rates)
In 2002 the Federal Reserve cut short-term interest rates by half a percentage
point to help the economy over a “current soft spot.” The new rate, 1.25 percent,
was lowest in more than four decades.
“Fed increases dosage of anti-inflation medicine” (Monetary Restraint)
The Federal Reserve increases the interest rate to help fight inflation. When the
Fed fears that aggregate demand is growing too fast, it tries to cool the economy
down with higher interest rates.
Chapter 14 – Monetary Policy – Page 278
ANNOTATED CONTENTS IN DETAIL
I.
Monetary Policy (Figure 14.1)
Definition: Monetary Policy – The use of money and credit controls to influence
macroeconomic activity.
II.
The Federal Reserve System (Figure 14.2)
A.
Federal Reserve Banks - functions of
1.
Clears checks between private banks
2.
Holds bank reserves
3.
Provides currency
4.
Provides loans
B.
The Board of Governors (Figure 14.2)
1.
Key decision - maker for monetary policy.
2.
Seven members appointed by President of U.S. for 14-year terms.
C.
The Fed Chairman
1.
Most visible member of the Fed system.
2.
Selected by the President for a four-year term.
3.
Can be reappointed
Example:
President Reagan appointed Alan Greenspan. Greenspan
was reappointed by President George H. Bush, President
Clinton and again by President George W. Bush in 2004.
III. Monetary Tools
A.
Money Supply (M1)
Definition: Money Supply (M1) – Currency held by the public, plus
balances in transaction accounts.
B.
The basic tools of monetary policy are:
1.
Reserve requirements.
2.
Discount rates.
3.
Open-market operations.
C.
Reserve Requirements
1.
Required reserves
Definition: Required Reserves – The minimum amount of reserves
a bank is required to hold by government regulation; equal
to required reserve ratio times transaction deposits.
2.
By changing the reserve requirement, the Fed can directly alter the
lending capacity of the banking system.
3.
Formula
Available lending capacity of banking system  excess reserves  money multiplier
4.
Excess reserves
a.
Definition: Excess Reserves – Bank reserves in excess of
required reserves.
Chapter 14 – Monetary Policy – Page 279
b.
Formula:
Excess reserves  total reserves  required reserves
5.
6.
7.
A decrease in required reserves increases excess reserves (Table 14.1).
A lower reserve requirement directly increases value of money multiplier.
Money Multiplier
Definition: Money Multiplier – The number of deposit (loan)
dollars that the banking system can create from $1 of
excess reserves; equal to 1 ÷ required reserve ratio.
Formula:
1
required reserve ratio
8.
A change in the reserve requirement causes
a.
A change in excess reserves
b.
A change in the money multiplier
D.
Headline: "Central Bank in China Raises Reserve Requirement”
(Reserve Requirements)
In 2003, the central bank of China raised the deposit reserve ratio from 6 percent
to 7 percent. The stated reason was to alleviate “an excessive increase in current
monetary lending.”
E.
The Discount Rate (Figure 14.2)
1.
Discount rate
Definition: Discount Rate – The rate of interest charged by the
Federal Reserve banks for lending reserves to private bank.
2.
Since reserves earn no interest, banks have an incentive to maintain
excess reserves at the minimum possible level.
3.
Sometimes banks reserves run low and they must replenish their reserves
temporarily. Sources of last minute reserves are:
a.
Borrow from a reserve-rich bank.
b.
Sale of securities.
c.
Reserve credits from Federal Reserve System. (Discounting)
4.
Discounting
Definition: Discounting – Federal Reserve lending of reserves to
private banks.
Note: By raising or lowering the discount rate, the Fed changes the cost
of money for banks and the incentive to borrow reserves.
5.
Headline: “Fed Cuts Key Rate by Half a Point” (Discount Rates)
In 2002 the Federal Reserve cut short-term interest rates by half a
percentage point to help the economy over a “current soft spot.” The new
rate, 1.25 percent, was lowest in more than four decades.
Chapter 14 – Monetary Policy – Page 280
F.
Open - Market Operations (Figure 14.4)
1.
Open-market operations are the principal mechanism for directly
altering the reserves of the banking system.
2.
Open market operations are designed to affect these decisions:
a.
Portfolio decisions - where should idle funds be held, in
cash or some other asset.
b.
Hold money or bonds - the Fed attempts to influence
whether individuals hold idle funds in transaction accounts
or government bonds.
Note: When the Fed buys bonds from the public, it increases the
flow of deposits (reserves) to the banking system. Bond
sales by the Fed reduce the flow.
3.
4.
IV.
Open-Market Activity
a.
Changes in bond prices will alter portfolio choices
b.
The Fed buys or sells bonds to alter the level of bank
reserves.
c.
Open-Market Operations
Definition: Open-Market Operations - Federal
Reserve purchases and sales of government
bonds for purpose of altering bank reserves.
d.
Buying Bonds – By buying bonds, the Fed increases bank
reserves.
e.
Selling Bonds – By selling bonds, the Fed decreases bank
reserves.
Powerful Levers - How the Fed controls the nation's money
supply.
a.
Reserve requirements
b.
Discount rates
c.
Open-market operations
Shifting Aggregate Demand (Table 14.2)
A.
Expansionary Policy
1.
Aggregate Demand
Definition: Aggregate Demand – The total quantity of output
demanded at alternative price levels in a given time period,
ceteris paribus.
2.
Monetary policy may be used to shift aggregate demand. (Figure 14.5)
Example:
B.
If the Fed lowers reserve requirements, drops the discount
rate or buys more bonds it increases bank lending capacity.
Banks make more loans so AD shifts to the right reflecting
increased purchasing power.
Restrictive Policy
1.
Monetary policy can be used to cool an overheating economy.
2.
Fed can reduce money supply. (Decrease AD)
a.
Raise reserve requirements
b.
Increase discount rate
Chapter 14 – Monetary Policy – Page 281
3.
V.
Price vs. Output Effects
A.
Aggregate Demand - increases in money supply shift AD to the right.
B.
Aggregate Supply
Definition: Aggregate Supply – The total quantity of output producers are
willing and able to supply at alternative price levels in a given time
period, ceteris paribus.
1.
2.
VI.
c.
Sell bonds
“Fed Increases Dosage of Anti-Inflation Medicine” (Monetary
Restraint)
The Federal Reserve increases the interest rate to help fight inflation.
When the Fed fears that aggregate demand is growing too fast, it tries to
cool the economy down with higher interest rates.
The effects of an aggregate demand shift on prices and output depends on
the shape of the aggregate supply curve (Figure 14.6).
a.
Horizontal AS - output increases without any inflation.
b.
Vertical AS - inflation occurs without changing output.
c.
Upward sloped AS - both prices and output are affected by
monetary policy.
With an upward-sloping AS curve, expansionary policy causes some
inflation and restrictive policy causes some unemployment.
Policy Perspectives
A.
Fixed Rules or Discretion?
1.
Should the Fed try to fine-tune the economy with constant adjustments of
the money supply?
2.
Or should the Fed instead simply keep the money supply growing at a
steady pace?
B.
Discretionary Policy
1.
The economy is constantly beset by expansionary and recessionary forces.
2.
Thus, there is a need for continual adjustments to money supply,
restraining or stimulating the economy as needed.
C.
Fixed Rules
1.
Monetary policy under fixed rules is less prone to error than is
discretionary policy.
2.
Fixed rules call for increasing the money supply by a constant amount
each year.
3.
The AS curve could be vertical or at least upward sloping. As a result, too
much expansionary monetary policy would lead to inflation.
D.
The Fed's Eclecticism
1.
Flexible rules
2.
Limited discretion
3.
Mix of money supply and interest-rate adjustments to do whatever is
necessary to promote price stability and economic growth.
Chapter 14 – Monetary Policy – Page 282
IN-CLASS DEBATE, EXTENDING THE DEBATE, AND
DEBATE PROJECTS
In-class Debate
Should the FED be independent?
As chapter 14 points out, the Federal Reserve System has a large measure of political
independence. The Board of Governors, appointed by the US president and confirmed by the US
Senate, serve 14 year terms. In addition, the Federal Open Market Committee includes
representatives of private banks in the Federal Reserve system.
Proposed: The public should directly elect some of the representatives who make monetary
policy (as the public elects representatives who make fiscal policy)
Identify two strong arguments in favor this proposal.
Identify two strong arguments against this proposal.
Teaching notes
Classroom discussion often encourages students to debate one another. Although lively, such
discussion usually involves no more than a minority of students. The cooperative controversy
ensures that every student is involved in the debate while using a relatively short period of class
time. Moreover, it can help students see the arguments on both sides of an issue, often a difficult
task for college students. Finally, the technique helps focus on an outcome such as identification
of the strongest argument on each side or a final position. These outcomes may be useful in a
follow-up student essay or paper.
Format: Organize students into groups of two. (Use instructor assignment or random
assignment so that friends don’t work together.) One half of the groups take the pro side; the
other half take the con side. Each pair lists the strongest three arguments for their position.
Then pairs combine into groups of four with one pair on each side of the debate. One pair reads
their reasons while the other side listens. Then reverse so that the other pair reads their reasons.
Group of four selects strongest argument on each side and, if appropriate, reaches consensus on
final position.
Extending the Debate
What are the best goals for the FED? Shout it lean toward restraint or toward
expansion?
Policy advisors differ in their advice to the US Federal Reserve Board. Should the Fed be more
concerned about inflation, or should it be more concerned about jobs and economic growth in
the short run?
Chapter 14 – Monetary Policy – Page 283
For a summary of these two sides go to:
The National Center for Policy Analysis for a description of the dangers of an expansionary
monetary policy (“restraint is better”). http://www.ncpa.org/pi/internat/pd050799f.html
The Financial Markets Center for a description of the costs of a restrictive monetary policy
(“expansion is better”). http://www.fmcenter.org/fmc_superpage.asp?ID=127
What are the weak points in the argument on each side?
Overall, which side makes the strongest case?
Teaching notes
Use information gathered by students out of class to conduct an in-class cooperative
controversy. Or, use the information for individually-written essays on the topic.
Format: Organize students into groups of two. (Use instructor assignment or random
assignment so that friends don’t work together.) One half of the groups take the pro side; the
other half takes the con side. Each pair lists the strongest three arguments for their position.
Then pairs combine into groups of four with one pair on each side of the debate. One pair reads
their reasons while the other side listens. Then reverse so that the other pair reads their reasons.
Group of four selects strongest argument on each side and, if appropriate, reaches consensus on
final position.
Debate Project
Monetary Policy: What works?
Monetary policy by the US Federal Reserve is important for the US economy. However,
economists disagree about several aspects of Federal Reserve decision-making powers including
the composition of the Federal Reserve committees, Federal Reserve goals, and the actual
impact Federal Reserve of policy on the economy.
 Should the Federal Reserve Board focus exclusively on the problem of inflation?
 What other goals are appropriate for Federal Reserve policy?
 What is the appropriate goal for the inflation rate?
 How should the Federal Reserve Board use its policy to achieve its goals?
 How effective is Federal Reserve monetary policy in achieving its goals?
 Is the composition of the decision-making bodies of the Federal Reserve appropriate for
a democracy?
For information from the Federal Reserve Board itself, go to the Board of Governors of the
Federal Reserve System at http://www.federalreserve.gov/
The Board of Governors site contains the Fed's Beige Book, Congressional testimony and
speeches of Federal Reserve Board members, Federal Open Market Committee (FOMC)
information, press releases, current interest rate information, and general information about the
Chapter 14 – Monetary Policy – Page 284
Federal Reserve system. A PDF-format version of The Federal Reserve System: Purposes and
Functions, a thorough overview of the Federal Reserve System, is available by chapter or as a
single document.
In addition, the site contains a summary of Federal Reserve regulations. Particularly useful is
the publication, “Purposes and Functions of the Federal Reserve System” at
http://www.federalreserve.gov/pf/pf.htm
Federal Reserve Banks publish research papers. See “What Is the Right Inflation Rate?
by David E. Altig” at http://www.clevelandfed.org/research/Com2003/0915.pdf
and, “The Science (and Art) of Monetary Policy” by Carl E. Walsh at
http://www.frbsf.org/publications/economics/letter/2001/el2001-13.html
Criticism of the Federal Reserve Board comes from both conservatives and liberals sides.
For a liberal viewpoint see the Financial Markets Center at: http://www.fmcenter.org/ It calls
itself “an independent, nonprofit institute that provides research and education resources to
grassroots groups, unions, policymakers and journalists interested in the Federal Reserve
System and financial markets. Through its work, the Center seeks to promote democratic values,
accountable public institutions and improved living standards for ordinary citizens.”
For a conservative viewpoint, see the Shadow Open Market Committee at:
http://www.somc.rochester.edu/ It is a group that recommends “that the Federal Reserve:



Adopt a clear public statement of its primary objective, the control of inflation;
Announce a specific target for inflation, with a goal of 1 percent CPI inflation; and
Announce a policy process that it will follow consistent with this objective.
For discussion of the Federal Reserves decision-making structures see:
“Righting the Balance: The Reserve Banks and Policymaking” at
http://www.fmcenter.org/fmc_superpage.asp?ID=162
For description by the Federal Reserve of its disclosure, see
http://www.federalreserve.gov/boarddocs/press/general/2000/20000119/default.htm
ANSWERS TO QUESTIONS FOR DISCUSSION, WEB
ACTIVITIES AND PROBLEMS
QUESTIONS FOR DISCUSSION
1.
Why do banks want to maintain as little excess reserves as possible? Under what
circumstances might banks desire to hold excess reserves? (Hint: see Figure 14.3.)
Excess reserves represent unused lending power. The opportunity cost of excess
reserves can be high. Banks are in the business of making profits. They need to
put their reserves to work by loaning them out and earning interest. In some
Chapter 14 – Monetary Policy – Page 285
cases, banks may be hesitant to make loans and therefore might want to hold
excess reserves if they expect a relatively high withdrawal rate from the bank.
2.
Why do people hold bonds rather than larger savings-account or checking-account
balances? Under what circumstances might they change their portfolios, moving their
funds out of bonds and into bank accounts?
Bonds have the advantage of offering possible capital appreciation as well as
interest payments. Neither savings nor checking accounts do that. A significant
depreciation in the selling price of bonds - occasioned by an increase in interest
rates - might cause bondholders to sell them and move their funds into bank
accounts.
3.
If the Federal Reserve banks mailed everyone a brand-new $100 bill, what would happen
to prices, output, and income? Illustrate with aggregate demand and supply curves.
The initial impact would be to increase aggregate demand. This could increase
prices or output or both, depending on the shape of the aggregate supply curve.
The possibilities are illustrated in Figure 14.6.
4.
How does an increase in the money supply get into the hands of consumers? What do
they do with it?
An increase in the money supply occurs when banks make loans. If the loans
are to consumers, then consumers are direct recipients of the increase in the
money supply. If these loans are used to finance business investment, then
consumers are indirect recipients of the increase in the money supply as total
payrolls increase and the household sector’s income and spending increases.
5.
Is a reduction in interest rates likely to affect spending on pizza? What kinds of spending
are sensitive to interest rate fluctuations?
Since consumers usually pay cash for pizza, a change in interest rates would not
directly affect spending on pizza. For the most part, interest rate changes only
directly affect spending on items that are purchased with borrowed money such
as houses, cars,, etc.
6.
If banks and credit card companies charged zero interest, would people spend and invest
more? What would inhibit business or consumer borrowing?
When consumers borrow money for consumption, their main concern is the
amount of the monthly payment. At zero interest, they could increase
consumption without increasing their monthly payment. Businesses would, in a
similar fashion, be able to increase investment expenditures. As long as the rate
return on capital is greater than the interest rate, it is a viable investment,
ceteris paribus.
Even though there would not be any interest on these loans, the principle still
needs to be re-paid. Consumer and business spending would be inhibited by
two by their available income.
7.
Which aggregate supply curve in Figure 14.6 does the Fed chairman fear the most?
Why?
The Fed chairman would fear the vertical AS curve in panel ‘b’ the most. In an
economy with a vertical AS curve, an change in AD will only affect prices
without changing the rate of real GDP. In such cases, all changes in AD will
Chapter 14 – Monetary Policy – Page 286
either be inflationary or deflationary and will have no effect on the level of
output.
8.
Like all human institutions, the Fed makes occasional errors in altering the money
supply. Would a constant (fixed) rate of money-supply growth eliminate errors?
Although some policy analysts call for a constant rate of money-supply growth,
according to the Keynesian perspective this will not eliminate errors. We know
that the economy is going to have its ups and downs as it moves through the
business cycle. When the economy needs to be stimulated, then the money
supply growth rage should be increased; when it needs to be slowed down, the
money supply growth rate should be decreased. Having a constant rate of
money supply growth guarantees that it will not be the right rate all of the time.
9.
Congress sometimes demands more control of monetary policy. Is this a good idea?
Why is fiscal policy, but not monetary policy, entrusted to elected politicians?
Giving congress control of the money supply would be a bad idea. Monetary
policy is an art of fine-tuning the economy. Because of political pressures,
congress has a tendency to: a) take a long time to make decisions, and b) overreact to economic problems. In addition, having fiscal and monetary policy
controlled by different institutions is another example of “checks and balances”
that are prevalent in our political system. There is the fear of having too much
power rest with any one institution.
Fiscal policy is usually used to resolve major economic problems and to help
resolve specific social issues. This social engineering is better left to the
politicians where the electoral process helps determine what specific taxation
and spending programs are enacted.
10.
Would you advocate monetary restraint or stimulus for today’s economy? Who would
disagree with you?
The answer to this question obviously depends on the current state of the
economy. If the economy is expanding near full employment, monetary
restraint is needed to help prevent the economy from experiencing increased
inflation. If the economy is contracting away from full employment, then
monetary stimulus is needed to prevent the economy from going into a
recession. In each of these situations, those who believe in “fixed rules,” i.e., the
money supply should be increased by a constant (fixed) rate would disagree.
WEB ACTIVITIES
1.
Log on to www.federalreserve.gov and read the description of the role of the Federal
Reserve System. Summarize the role of the Federal Reserve System from this
information.
The Fed describes its four general areas of responsibility as:
 Conducting the nation’s monetary policy.
 Supervising and regulating banking institutions and protecting the credit rights of
consumers.
 Maintaining the stability of the financial system.
Chapter 14 – Monetary Policy – Page 287

2.
Providing certain financial services to the U.S. government, the public, financial
institutions, and foreign official institutions.
Log on to www.federalreserve.gov/pubs/frseries/frseri.htm and find a description of the
current structure of the Federal Reserve System. Summarize the structure of the Federal
Reserve System from this information.
The Fed was created on December 23, 1913 by an Act of Congress. The System consists
of a seven member Board of Governors with headquarters in Washington, D.C., and
twelve Reserve Banks located in major cities throughout the United States.
3.
Log on to www.federalreserve.gov/policy.htm then click on the Monetary Policy Report
to Congress. Click on the most recent report and access the section on Monetary Policy
and Economic Outlook. Read the report and summarize the Fed’s perception of the
economy and their monetary policy response.
The answer to this question will depend upon when you access the report.
4.
Log into www.federalreserve.gov/releases/h15/ and click on the most recent release
data. Find the general trend for the Federal funds interest rate. What have been the
likely actions of the Fed that have caused the interest rates to move in the directions
shown?
The answer to this question will depend upon when you access the report. The most
frequently used tool of the Fed is Open Market operations and changing the discount
rate.
PROBLEMS
1.
Suppose the following data apply:
Total Bank
Reserves
Total Bank
Deposits
Cash Held by
the Public
$5 billion
Stocks held by public
$140 billion
$100 billion
$5 trillion
$10 billion
Gross Domestic
Product
Interest rate
Bonds Held by
the Public
$220 billion
Required reserve ratio
0.04
a.
b.
c.
d.
How large is the money supply as measured by M1?
How much excess reserves are there?
What is the money multiplier?
What is the available lending capacity?
Chapter 14 – Monetary Policy – Page 288
6 percent
a.
b.
c.
d.
2.
The basic money supply (M1) is transaction account balances and cash.
Assuming that the total bank deposits are in transaction accounts, the
money supply is $110 billion.
If the required reserve ratio is 0.04, then banks are required to keep $4
billion in reserve ($100 billion X 0.04). Since banks have total reserves
of $5 billion, there is $1 billion in excess reserves.
The money multiplier is calculates as 1/(required reserve ratio). Thus,
the money multiplier is 1/0.04 = 25.
Since there are $1 billion in excess reserves and the money multiplier is
25, there is $25 billion in available lending capacity.
Assume that the following data describe the condition of the commercial banking
system:
Total Reserves:
Transactions deposits:
Cash held by public:
Reserve requirement:
a.
b.
c.
d.
e.
f.
$200 billion
$800 billion
$100 billion
0.20
How large is the money supply (M1)?
Are the banks fully utilizing their lending capacity? Explain.
What would happen to the money supply initially if the public deposited another
$50 billion in cash in transactions accounts? Explain.
What would the lending capacity of the banking system be after such a portfolio
switch?
How large would the money supply be if the banks fully utilized their lending
capacity?
What three steps could the Fed take to offset the potential growth in M1?
a.
The money supply (M1) is $900 billion ($100 cash plus $800
Transactions Deposits).
b.
In this situation banks are not fully utilizing their lending capacity. Only
$160 billion of reserves are required at the required reserve ratio of
0.20. This is calculated as $800 billion in deposits x 0.20. Thus, $40
billion is excess reserves, where ER=0 when fully utilizing lending
capacity.
c.
Assuming this $50 billion cash is not new money in the system, i.e., it is
part of the $100 billion in cash currently being held, then there will be no
change in M1.
d.
After the additional deposit of $50 billion in cash, excess reserves jump
by another $40 billion to $80 billion. Lending capacity increases to
5 x $80 billion = $400 billion.
e.
Assuming the lending capacity of $400 billion is fully used, the money
supply will rise to $1,250 billion. This consists of the current $800
billion in transactions deposits, $50 billion in cash remaining after the
Chapter 14 – Monetary Policy – Page 289
deposit was made, plus $400 billion in new money created through the
lending process.
f.
3.
To offset the potential growth in M1 illustrated in ‘e’, the Fed could
increase the reserve requirement, raise the discount rate, or sell bonds in
the open market.
Suppose the Federal Reserve decided to purchase $10 billion worth of government
securities in the open market.
a.
How will M1 be affected initially?
b.
How will the lending capacity of the banking system be affected if the reserve
requirement is 25 percent?
c.
How will banks induce investors to utilize this expanded lending capacity?
When the Fed purchases $10 billion of securities on the open market:
a.
b.
c.
4.
M1 will increase by $10 billion, assuming that the sellers of the securities
hold the proceeds as cash or deposit them in a transaction account, e.g.,
checking account..
Lending capacity will increase by $30 billion. (A money multiplier of 4 x
excess reserves of $7.5 billion.)
As the money supply increases, interest rates go down and investors will
want to borrow more funds.
Suppose the economy is initially in equilibrium at an output level of 100 and price level
of 100. The Fed then manages to shift aggregate demand rightward by 20.
a.
Illustrate the initial equilibrium (E1) and the shift of AD.
b.
Show what happens to output and prices if the aggregate supply curve is (1)
horizontal, (2) vertical, and (3) upward sloping.
When the economy is at an equilibrium output of 100 and a price level is 100,
the impact of a shift in AD rightward by 20 is illustrated below:
(a)
Initial equilibrium is E1.
(b)
Output and price changes vary according to the shape of the AS curve.
Chapter 14 – Monetary Policy – Page 290
1
1
Aggregate
supply
P1
P5
Aggregate supply
P4
AD1
0
0
0
E1
AD2
AD5
0
1
QF
0
AD4
0
E1
R ATE O F OU T PUT
RATE OF OUTPUT
1
A gg re ga te
su pply
P7
P6
A D7
AD6
0
0
0
E1
Q7
1
R AT E O F O U TP U T
5.
Illustrate the effects on bank reserve of an open-market sale (See Figure 14.4)
An open market sale of government securities by the Federal Reserve would have
exactly the opposite effect of the change illustrated in Figure 14.4:
Step 1, FMOC sells government bond to the public, who pays by check.
Step 2, Funds are withdrawn from buyer’s private bank.
Step 3, Private bank’s account at Regional Federal Reserve Bank is debited.
6. How did the money multiplier change when China increased its reserve requirement? (see
Headline p. 318)
When the reserve requirement increased from 6 percent to 7 percent, the money
multiplier decreased from 16.7% to 14.3%.
Chapter 14 – Monetary Policy – Page 291
1
PRINT MEDIA EXERCISE
Chapter 14
Monetary Policy
Name: ___________________
Section: __________________
Grade: ___________________
Find an article that represents a shift of demand or supply for money. Use the article you have
found to fulfill the following instructions and questions:
1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page or
print an article from an Internet news agency such as www.cnn.com, www.msnbc.com,
www.abc.com, www.nytimes.com, etc.
2. Below the article, write one of the following four shifts that you will illustrate with the article
you have chosen:
b. A shift of the money supply curve to the left.
c. A shift of the money supply curve to the right.
d. A shift of the money demand curve to the left.
e. A shift of the money demand curve to the right.
3. Use an arrow to indicate in the article the desired or actual (past, present, or future) changes
in the quantity of money.
4. Underline the single sentence (not more than a sentence) that describes the change in the
determinant of demand or supply that has caused the shift you chose in number 2 above.
The demand for money changes as people receive larger incomes, as the speed with which
they use money changes, and as the inflation rate changes. The supply of money is
determined by the actions of the Federal Reserve System, the willingness of the financial
system (banks) to make loans, and individual perceptions of the future course of the
economy.
5. Circle the single sentence (not more than a sentence) indicating the effect on interest rates
(or expectations about interest rates) that results from the shift in money demand or supply.
(Hint: Be sure the changes are consistent with the shift you chose in number 2 above.)
6. In the remaining space below your article, indicate the source (name of newspaper,
magazine or web site), title (newspaper headline, magazine article, or web article title), date,
and page for the article you have chosen. Use this format:
Source: _____________________ Date: ______________ Page: _____________
Title: ___________________________________________________________
If this information also appears in the article itself, circle each item.
7.
Neatness counts.
Chapter 14 – Monetary Policy – Page 292
Professor's Note
Learning Objective for Media Exercise
To show students what to look for in the media to find if the demand or supply of money is
changing and to have students learn how to apply the tools of supply and demand to the money
market.
Suggestions for Correcting Media Exercise
1. Check for consistency between the shift in money demand or supply chosen in number 2 and
the change in the quantity of money indicated by the arrow in the article (as instructed in
number 3).
2. Check for consistency between the shift you chose in number 2 and the direction that
interest rates take in the passage circled (as instructed in number 5).
3. The underlined passage should indicate an event that will clearly change money supply or
demand.
Likely Student Mistakes and Lecture Opportunities
1. The relationship of interest rates and inflation rates to the price of money is often difficult
for the students to conceptualize. There are likely to be mistakes in the submitted articles,
reflecting students’ confusion.
2. Students also confuse money, income, sales, and other dollar-denominated quantities. It
may be useful here to distinguish the concepts of stocks (like money) from flows that have
been dealt with in earlier chapters.
3. Some students may turn in articles about money targets published by the Fed, changes in
currency denominations, articles about increased incomes of firms, etc., which totally miss
the point of the assignment. This may be an indication that some students haven't a clue
about the use of money supply and demand curves. Evidence of correct work by other
students can sometimes jog such students in the right direction.
SUPPLEMENTARY SOURCES
Friedman, Milton: "The Case for Overhauling the Federal Reserve," Challenge, JulyAugust 1985, pp. 4-12.
On Greenspan and the Federal Reserve see: Martin, Justin, Greenspan: The Man Behind
the Money, Woodward, Bob, Greenspan’s Fed and the American Boom, and
Greider, William, Secrets of the Temple: How the Federal Reserve Runs the
Country.
Chapter 14 – Monetary Policy – Page 293