Chapter 5

Policy Makers and the Money Policy Makers and the Money Supply Supply

© 2000 John Wiley & Sons, Inc.

2

Chapter Outcomes

Discuss the objectives of national economic policy and the conflicting nature of these objectives

Identify the major policy makers and briefly describe their primary responsibilities

Identify the policy instruments of the U.S. Treasury and briefly explain how the Treasury manages its activities

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Chapter Outcomes(Continued)

Describe U.S. Treasury tax policy and debt management responsibilities

Discuss how the expansion of the money supply takes place in the U.S. banking system

Briefly summarize the factors that affect bank reserves

4

Chapter Outcomes(Concluded)

Explain the meaning of the monetary base and money multiplier

Explain what is meant by the velocity of money and give reasons why it is important to control the money supply

5

National Economic Policy Objectives

Economic Growth High and Stable Levels of

Employment Price Stability International Financial Equilibrium

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National Economic Policy: Important Points

GROSS DOMESTIC PRODUCT: GDP is the output of goods and services in an economy

INFLATION: Increase in price of goods/services not offset by increase in quality

REAL GDP: When GDP exceeds rate of inflation, the result is higher living standards

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Major U.S. Policy Makers

FEDERAL RESERVE SYSTEM -Sets Monetary Policy

THE PRESIDENT -Helps set Fiscal Policy

CONGRESS -Helps set Fiscal Policy

U.S. TREASURY -Conducts Debt Management Policy

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Fiscal Policy: Definition and Fundraising Activities

FISCAL POLICY: Government influence on economic activity through taxation and expenditure plans

FUNDRAISING ACTIVITIES: A government raises funds to pay for its activities by: levying taxes, borrowing, or printing money for its own use

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Fiscal Policy: Stabilizing Factors

AUTOMATIC STABILIZERS: Continuing federal programs that stabilize economic activity

EXAMPLES: -Unemployment insurance -Welfare payments -Pay-as-you-go progressive income tax

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Changing the Money Supply

FRACTIONAL RESERVE SYSTEM: Allows Fed to alter the money supply

PRIMARY DEPOSIT: Deposit that adds new reserves to a bank

DERIVATIVE DEPOSIT: Occurs when reserves created from a primary deposit are made available to borrowers through bank loans

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Checkable Deposit Expansion

[Assume: reserve requirement is 20%]

Bank A receives a $10,000 primary

deposit and makes a loan of $8,000.

The “books” would show:

BANK A

Assets: Liabilities:

Reserves $10,000 Deposits $10,000

Loans $8,000

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Checkable Deposit Expansion [Continued]

[Assume: a check is drawn against Bank A and is deposited in Bank B (representing all other banks)]

BANK A

Assets: Liabilities:

Reserves $2,000 Deposits $10,000

Loans $8,000

BANK B

Assets: Liabilities:

Reserves $8,000 Deposits $8,000

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Checkable Deposit Expansion [Concluded]

[Assume: Bank B loans 80% of its reserves]

BANK B

Assets: Liabilities:

Reserves $8,000 Deposits $14,400

Loans $6,400

Now, if a $6,400 check is written on Bank B:

BANK B

Assets: Liabilities:

Reserves $1,600 Deposits $8,000

Loans $6,400

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Multiple Expansion of Checkable Deposits

BASIC EQUATION APPROACH:Change in Checkable Deposits =

(Increase in Excess Reserves)/(Reserve Ratio)

Assume Excess Reserves increase by $1,000 and the Reserve Ratio is 20%, then the Change in Checkable Deposits would be:

$1,000/.20 = $5,000

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Important Definitions of Reserves in the Banking System

BANK RESERVES: Reserve balances held at Federal Reserve Banks and vault cash held in the banking system

REQUIRED RESERVES: The minimum amount of total reserves that a depository institution must hold

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Important Definitions of Reserves in the Banking System

(Continued)

EXCESS RESERVES: The amount that total reserves are greater than required reserves

DEFICIT RESERVES: The amount that required reserves are greater than total reserves

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Transactions Affecting Bank Reserves

NONBANK PUBLIC: Change in the demand for currency held outside the banking system

FEDERAL RESERVE SYSTEM: Changes in open market operations, reserve ratio, and other transactions

UNITED STATES TREASURY: Change in Treasury cash holdings and spending

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Federal Reserve System Transactions Affecting

Bank Reserves Change in Reserve Ratio Open Market Operations Change in Bank Borrowings Change in Float Change in Foreign Deposits Held in

Reserve Banks Change in Other Federal Reserve

Accounts

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Monetary Base and Money Multiplier

EQUATION: MB x m = M1 MONETARY BASE (MB):

Banking system reserves plus currency held by the public

MONEY MULTIPLIER (m): In a simple monetary system, the ratio of 1 divided by the reserve ratio

MONEY SUPPLY (M1): Basic definition of the money supply

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Complex Money Multiplier (m)

EQUATION: m = (1 + k)/[r(1 + t + g) + k]

DEFINITIONS:

r = ratio of reserves to total reserves

k = ratio of currency held by nonbank public to checkable deposits

t = ratio of noncheckable deposits to checkable deposits

g = ratio of government deposits to checkable deposits

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Complex Money Multiplier (m) Example

Basic Information: r = 20%; k = 20%; t = 10%; & g = 5%. What is the money multiplier (m)?

m = (1 + k)/[r(1 + t + g) + k] m = (1 + .20)/[.20(1 + .10 + .05) + .20]

= (1.20)/[.20(1.15) + .20] = 1.20/.43 = 2.8

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Link Between Money Supply and Gross Domestic Product

Velocity of money (M1V) is the rate of circulation of money supply

Money supply (M1) is linked to gross domestic product (GDP) via velocity

Nominal GDP is real GDP (RGDP) + Inflation (I)

In terms of growth rates (g) we have: M1g + M1Vg = RGDPg + Ig