Monetary policy

Monetary PolicyMonetary Policy

How is it Conducted and How Does How is it Conducted and How Does It Affect the Economy?It Affect the Economy?

How is it Conducted and How Does How is it Conducted and How Does It Affect the Economy?It Affect the Economy?

What is Money?

• Money is anything that serves as three functions:– Money as a medium of exchange– Money as a unit of account– Money as a store of value

What Counts as Money?

• M1: the most narrowly defined MS– Measures purchasing power– M1= currency + checkable deposits

• M2: adding near monies to M1– M2= M1 +near monies– Includes passbook savings accounts– Money market mutual funds– Small time deposits

Fractional Reserve Banking

• Def: Fractional reserve banking is a system in which banks keep only a percentage of their deposits.

Banker Bookkeeping

• A balance sheet is a statement of the assets and liabilities of a bank at a given point in time

• The balance sheet is known as the T-accounts– Liabilities- the right-hand side of the balance sheet

• The amounts the bank owes to other entities

– Assets- the left-hand side of the balance sheet- assets are amount the bank owns

• Any physical property or financial claim owned by the bank

Types of Reserves

• Excess Reserves: The amount of checkable deposits the bank holds over the required rate the Fed mandates

• Required Reserves: The amount of checkable deposits the Fed requires the bank to keep– $0 to 10.7 million – 0%– $10.7 million to $55.2 million- 3%– Greater than $55.2 million- 10%

What can the bank do with the Excess Reserves?

• Two Options:– Hold at the bank with no interest– Hold at the Fed with some interest

• Typically, banks are going to go with option two, because they earn interest off the excess reserves.

• What actions can they do with the excess reserves?– Make loans or– Purchase interest-bearing assets

• E.g.- Government bonds

Example of Creation of Money by Banks

The Federal Reserve System (The FED)

• Def: the Fed is the central banker for the nation and provides banking services to commercial banks, other financial institutions, and the federal government.

• They regulate, supervise, and they are responsible for policies concerning money.

The Fed’s Organizational Chart

• It is an independent agency of the federal government.

• It consists of 12 central banks and other financial institutions within each of the Federal Reserve districts.

• Board of Governors.

© 2010 South-Western, a part of Cengage Learning 11

The Twelve Federal Reserve Districts

What a Federal Reserve Bank DoesWhat a Federal Reserve Bank Does

• Controlling the Money Supply• Clearing Checks• Supervising and Regulating Banks• Maintaining and Circulating Currency• Protecting Consumers• Maintaining Federal Government Checking

Accounts & Gold

How the Fed Controls the MS?

• The establishment of reserve requirements for banks

• Buying and selling U.S. government securities and other financial assets in the open market

• The volume of loans extended to banks and other institutions

• The interest rate it pays banks on funds held as reserves

Recent Monetary Policy

• Increase in the monetary base from $828 billion at mid-year 2008 to $1.63 trillion in early 2009 to more than $2 trillion in 2010.

• Lower interest rates

How does Monetary Policy Influence the Economy?

• Expansionary monetary policy– Example

• Restrictive monetary policy– Example

Money and Inflation

• Inflation: It is an increase in the general (average) price level of goods & services in the economy.• “…more money chasing the available goods and

services.”http://www.youtube.com/watch?v=t_LWQQrpSc4&feature=related• What happens when it gets out of control?

Hyperinflation:http://www.youtube.com/watch?v=WI1i5yhwOz8

Monetary Policy As a Stabilization Tool

• A more expansionary monetary policy• Stimulate output and employment

• A more restrictive ( or contractionary) monetary policy• Reduce total demand and place downward

pressure on the general level of prices

Aggregate Demand for Goods and Services

• Quantity: the output of the entire economy– Real GDP

• Price: the price level in the entire economy– Price Index: CPI, GDP deflator

• Since demand in the goods and services market aggregates, then the purchases of all consumers, investors, government, and foreigners is called Aggregate Demand (AD

Aggregate Demand Curve• Aggregate Demand (AD) Curve: Shows the

various quantities of domestically produced goods and services consumers are willing to buy at different price levels in the economy.

• It shows the level of real GDP purchased by Households, government, and foreigners (net exports) at different possible price levels during a time period– Example of the Curve

• What does it mean to be downward sloping?– Is this is same as individual demand?

Example of AD Curve

Price Level

Final Goods & Services

AD

Why is it downward sloping

Three major reasons1. A lower price level will increase the

purchasing power of money ( Real Balances Effect)

2. The interest rate effect3. Domestic goods become cheaper than

foreign goods (the net exports effect)

Non-price Determinants of AD

• Changes in Consumption• Changes in Investment• Changes in Government Purchases• Net Exports

Aggregate Supply of Goods and Services

• Short-run versus long-run• Aggregate Supply (AS) curve: it is not a

reflection of changes in the relative prices of goods

Short-Run (SRAS) and Long-Run (LRAS)Aggregate Supply

• Short- Run: some prices are set by prior contracts and agreements

• Long-Run: A time period long enough that people are able to modify their behavior in response to price changes

SRAS

• What does the curve look like• Example of Graph and implications

EXAMPLE OF SRASEXAMPLE OF SRAS

Price Level

SRAS

Real GDP

• What does the curve look like• Example of Graph and implications

LRASLRAS

Equilibrium in the Goods and Services Equilibrium in the Goods and Services MarketMarket

AD

SRAS

LRAS

Real GDP

Price Level

• When L-R is met, then actual output (GDP) equals potential GDP

• Correspond with full employment of resources

L-R Equilibrium, Potential Output, and Full Employment

• Output is Greater than L-R Potential

• Output is Less than L-R Potential

What Happens When the Economy’s What Happens When the Economy’s Output Differs From Its L-R PotentialOutput Differs From Its L-R Potential

• This shift depends on if it is S-R or L-R.• L-R changes in AS is when it is possible to

achieve and sustain a larger rate of output.• S-R changes in one that is temporarily in its

altering of production capacity

Shifts in AS

• Changes in resource base• Changes in level of technology• Institutional arrangements that affect its

productivity and the efficient use of its resources

Changes in LRAS

• Changes in resource prices• Changes in the expected rate of inflation• Supply shocks

Changes in SRAS

The Housing Crisis of 2008