Central Bank and Control of Money Supply Ali Brosky, Melissa Johns, Sarah Tuckowski, and Victoria Wojton AP Econ - 5th Period

Central Bank and Money Supply: Overview Banks can create money, but there is also a need to control the money created, or the money supply. How is controlling the money supply achieved? -a central bank exists to control the money supply of a nation. -in the United States, the Federal Reserve serves as the central bank.

Central Bank and Money Supply: Overview Three objectives for the Federal Reserve. These objectives include: 1) Conduct monetary policy: usage of expansionary and contractionary policies to control inflation rates (increase/decrease supply of money) 2) Supervise and regulate financial firms: oversee all banks operating in the United States. 3) Provide financial services: able to give money to other banks.

Quantity Theory of Money: Overview There is a direct relationship between the amount of money in an economy and the price of goods and services sold. If the quantity of money in an economy doubles, price levels will also double.

Quantity Theory of Money: Fisher Equation MV = PT M = Money Supply V = Velocity of Circulation P = Average Price Level T = Volume of Transactions of Goods and Services

Interest Rates Keynesians: interest rates are affected by gov spending in order to fight inflation, decreasing the money supply will drive up interest rates and reduce consumption and investment Monetarists: natural rate of real interest - states that fluctuations in the nominal interest rate reflects changes in inflation only real interest rates must change to influence investments

Tools of Central Bank Policy The required reserve ratio (RRR) The discount rate Open-market operations

The Required Reserve Ratio (RRR) A specific percentage of checking account deposits that banks must keep in liquid, zero-interest reserves This amount is set by the Fed Money Multiplier = 1/RRR an increase of the RRR leads to a decrease in the money supply and vice versa

The Discount Rate Interest rate that the Fed charges to banks for borrowing money If the discount rate is increased, the cost of borrowing increases for banks and they will not borrow as much Banks will not make as many loans and money supply will decrease

Open-Market Operations The Fed's most powerful tool for adjusting bank reserves Buying and selling of government securities (bonds) in the open market When the Fed sells securities, money is given to the Fed in exchange Bank reserves decrease Money supply decreases When the Fed buys securities, it pays money out Deposits and bank reserves increase Money supply increases