Chapter 8 – Monetary Theory & Policy ECONOMICS THEORY AND PRACTICE Seventh Edition Copyright © 2004 John Wiley & Sons, Inc. All rights reserved. Patrick J. Welch St. Louis University Gerry F. Welch St. Louis Community College at Meramec & PowerPoint Presentation by: Dr. Ray Everett Pima Community College

Monetary Theory & Policy Contents Money Supply & Economics Money Creation Interest Rates & Spending Levels Federal Reserve & Monetary Policy

Monetary Theory & Policy Chapter Objectives To explain the relationship between the economy’s money supply and output, employment, and prices. To explain how money is created and destroyed through the loan- making activities of financial depository institutions. To introduce the multiple expansion of money. To explain the role of the interest rate in encouraging or discouraging borrowing from financial depository institutions. To show how interest rates are affected by changes in financial depository institutions’ excess reserves. To define monetary policy and explain the major tools for carrying out monetary policy by the Federal Reserve. To show the relationship between government borrowing to cover deficit spending and monetary policy. To critically evaluate monetary policy.

Summary of Key Lessons  Total, or aggregate, spending drives the economy’s levels of production, employment, and income.  Total spending is found by adding together the spending of all four major macroeconomic sectors.  Increases in total spending lead to increases in production, employment, and income unless the economy is at full employment.  At (or near) full employment, increases in spending lead to overall price increases or demand-pull inflation.  Decreases in total spending result in a decline in production, employment, and income, and may dampen inflation.  Money is created when financial depository institutions make loans, and it is destroyed when loans are repaid. Money Supply & Economic Activity 8-1a

Equation of Exchange  MV = PQ Illustrates how changes in the supply of money (M) influence the level of prices (P) and/or the total output of goods and services (Q). Velocity of money (V) is the number of times each dollar is spent for new goods and services in a year, or how often the money supply turns over each year. Changing the Money Supply  Increase in money supply (M) If not at full employment/production, then (Q) increases more than (P) increases. If at full employment/production, then (P) increases more than (Q) increases.  Decrease in money supply (M) Typically results in a decrease in (Q), but (P) usually does not decrease. Money Supply & Economic Activity 8-1b

Process of Money Creation  Actual Reserves Financial depository institutions’ reserve account plus its vault cash.  Reserve Requirement Specific percentage of deposits that a financial depository institution must keep as actual reserves.  Required Reserves Amount of actual reserves that a financial depository institution must keep to back its deposits.  Excess Reserves Reserves of a financial depository institution over the amount it is required to maintain in actual reserves. –Actual reserves minus required reserves. Money Creation 8-2a

Process of Money Creation (cont.)  Excess Reserves & Loan Making Depository institutions can make new loans up to the value of their excess reserves. Money Creation 8-2b

Multiple Expansion of Money  Multiplier Effect An initial change in excess reserves in the depository institutions system causes a larger change in the money supply. Money Creation 8-2c TABLE 8-2 Multiple Expansion of Money (10 Percent Reserve Requirement)

Multiple Expansion of Money (cont.)  Calculating the Money Multiplier Use the reciprocal of the reserve requirement. –10% reserve requirement = money multiplier of 10 –20% reserve requirement = money multiplier of 5  Calculating the Total Change in Money Supply Multiply the initial change in excess reserves by the money multiplier, or –$8,000,000 x 5 = $40,000,000 Divide the initial change in excess reserves by the reserve requirement. –$8,000,000 / 0.20 = $40,000,000 Money Creation 8-2d

Summary of Key Points Interest Rates & Spending Levels 8-3a TABLE 8-3 Relationship between Loan Making, the Money Supply, Spending, and the Level of Economic Activity

Interest Rate Overview  Interest Rate Price paid to borrow money. –Percentage of the amount borrowed. Can be used to control the money supply. Interest Rates & Spending Levels 8-3b Determining Interest Rates on Loans  Interest rates for loans are determined by the demand for and supply of funds for loans.  Decreases in excess reserves will cause interest rates to rise and the amount of loans made to fall.  Increases in the excess reserves will cause interest rates to fall and the amount of loans made to rise.

Determining Interest Rates on Loans (cont.) Interest Rates & Spending Levels 8-3c FIGURE 8-2 Effect of Changes in Excess Reserves on the Interest Rate and the Quantity of Loans

Determining Interest Rates on Loans (cont.) Interest Rates & Spending Levels 8-3d FIGURE 8-3 Relationship among Excess Reserves, the Interest Rate, Loan Making, and the Level of Economic Activity

Monetary Policy Overview  Monetary Policy Changing the money supply to influence the levels of output, employment, and/or prices in the economy.  Easy Money Policy Policy by the Federal Reserve to increase excess reserves of depository institutions in an effort to increase spending and reduce unemployment.  Tight Money Policy Policy by the Federal Reserve to reduce excess reserves of depository institutions in an effort to reduce spending and inflationary pressure. Federal Reserve & Monetary Policy 8-4a

Monetary Policy Tools  Federal Reserve has three major tools to change excess reserves in the financial depository institutions system: Reserve Requirement Discount Rate Federal Funds Market Federal Reserve & Monetary Policy 8-4b

Monetary Policy Tools (cont.)  Reserve Requirement Decreases in the reserve requirement would increase excess reserves and would be appropriate to stimulate the economy. Increases in the reserve requirement would decrease excess reserves and would be appropriate to fight demand- pull inflation. Federal Reserve & Monetary Policy 8-4c

Monetary Policy Tools (cont.)  Discount Rate Interest rate that a Federal Reserve Bank charges a financial depository institution for borrowing reserves. Federal Reserve & Monetary Policy 8-4d

Monetary Policy Tools (cont.)  Open Market Overview Open Market Operations –Buying and selling of securities, primarily U.S. government securities, on the open market by the Federal Reserve. Open Market Committee –Committee that determines the general policy on Federal Reserve open market operations. Federal Reserve & Monetary Policy 8-4e

Monetary Policy Tools (cont.)  Tools & Policy Objectives Expanding the economy requires: –Buying securities from banks and dealers on the open market, and/or –Lowering the reserve requirement, and/or –Lowering the discount rate Fighting demand-pull inflation requires: –Selling securities to banks and dealers on the open market, and/or –Increasing the reserve requirement, and/or –Increasing the discount rate Federal Reserve & Monetary Policy 8-4f

Government Deficits & Monetary Policy  Crowding Out Occurs when borrowing by the federal government increases the interest rate and reduces borrowing by households and businesses.  Monetizing the Debt Increasing the money supply by the Federal Reserve to accommodate federal government borrowing and reduce upward pressure on the interest rate. Federal Reserve & Monetary Policy 8-4g

Government Deficits & Monetary Policy (cont.) Federal Reserve & Monetary Policy 8-4h FIGURE 8-4 Effect of Government Borrowing and Monetizing the Debt on the Interest Rate and Loan Making

Advantages & Disadvantages of Monetary Policy  Advantages: Quickly implemented in comparison to fiscal policy Largely removed from politics  Disadvantages: Loan-making link –Someone must be willing to borrow and a bank must be willing to lend. The Federal Reserve cannot force the loan-making process. Inflation –As the money supply is tightened, interest rates increase, and businesses that borrow at this high rate may raise prices on their products to compensate. Federal Reserve & Monetary Policy 8-4i

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