Modern macroeconomics: monetary policy

1
More Money!!
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
2
The Equation of Exchange
P
Q
M
V
Q
M
V
P
- 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
3
The Equation of Exchange
P
Q
M
V

• 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.

4
Creating Money

• Printing Money
• 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
5
Backing Up
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).

6
Loan Making
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
7
Loan Making
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.
8
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 Required reserves _________________ Actual
reserves __________________ Excess reserves
__________________
9
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?
MHNBs reserve requirement is 8. New loans
_____________________
10
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? New borrowing ___________________
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Creating Money
If the Excess Reserves are loaned
The borrowed money is spent and deposited at
another bank.
The second banks 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
12
Creating Money from New Reserves
New cash depositsActual Reserves
Potential demand deposits created byextending
new loans
NewRequired Reserves
Bank
Initial deposit (bank A)
1,000.00
200.00
800.00
Second stage (bank B)
160.00
800.00
640.00
Third stage (bank C)
128.00
640.00
512.00
Fourth stage (bank D)
102.40
512.00
409.60
Fifth stage (bank E)
81.92
409.60
327.68
Sixth stage (bank F)
65.54
327.68
262.14
Seventh stage (bank G)
52.43
262.14
209.71
All others (other banks)
1,048.58
209.71
838.87
Total
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.

13
The Money Multiplier
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?
Yes!!!
It just takes 3 easy steps
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The Steps

• Find the initial change in the excess reserves
• 1000 80 (100-20) 800

• Find the reciprocal of the required reserve
• 1/20 1/1/5 5

• Multiply them together
• 800 5 4000

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Problem 1

• Deposit of 10,000

• ________
• ________
• ________

• Required reserve 10

• Increase in the money supply?

• ________
• ________
• ________

How about if the reserve requirement was 20?
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Problem 2

• Deposit of 16,000

• ________
• ________
• ________

• Required reserve 25

• Increase in the money supply?

• ________
• ________
• ________

How about if the reserve requirement was 20?

• ________
• ________
• ________

How about if the reserve requirement was 10?
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The Effect of Loaning Money
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.
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Getting a Loan
1. More or less voluntary transaction
2. The interest rate is important

• Supply in the money for loans
• a. Households decide to save or spend
• b. Banks decide how to use the savings

• Demand for the loans
• a. Households how much to borrow
• b. Businesses compare interest rate to expected
  profit

19
InterestRate
Determining the Interest Rate
S
.05
D
Quantityof loans
Q

• 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

20
InterestRate
Determining the Interest Rate
S
.05
r
D

Quantityof loans
Q
Q

• Expectation of poor economic conditions could
  shift the curve left
• This would decrease the equilibrium interest rate

21
InterestRate
Determining the Interest Rate
S
.05
r
D

Quantityof loans
Q
Q

• A decrease in excess reserves decreases money for
  loans
• This would shift the supply curve to the left and
  increase interest

22
Excess Reserves
the Level of Economic Activity
and
the Interest Rate
Loan Making
Decreases Interest rate for Borrowing
Increases Ability to Lend
Increasing Excess Reserves
Increases Level of Spending
Increases Output and Employment (or Prices)
Increases Borrowing
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and
Increases Interest rate for Borrowing
Decreases Ability to Lend
Decreasing Excess Reserves
Decreases Level of Spending
Decreases Output and Employment (or Prices)
Decreases Borrowing
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The Federal Reserve and Monetary policy
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
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The Federal Reserve and Monetary policy
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
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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
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b. The Discount Rate
Raising Discount Rate discourages bank
borrowing decreases money supply
Lowering Discount Rate encourages bank
borrowing increases money supply
Current Favorite
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The Federal Reserve and Monetary policy
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??
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Easy Money Policy
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
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Tight Money Policy
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
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Deficits and Borrowing
a. The Government competes for money
b. They offer a higher interest rate
c. Businesses and Household can afford fewer
loans
Less investment
Crowding Out
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Monetary Policy
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