Chapter 5

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

© 2011 John Wiley and Sons

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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 & 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

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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

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National Economic Policy Objectives

Economic Growth High Employment Price Stability Balance in International

Transactions

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National Economic Policy: Important Terms

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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Four Policy Maker Groups

FEDERAL RESERVE SYSTEM Sets Monetary Policy

THE PRESIDENT Helps set Fiscal Policy

CONGRESS Helps set Fiscal Policy

U.S. TREASURY Conducts Debt Management Policy

Policy Makers & Economic Objectives

Figure 5.1 in text depicts the: four policy maker groups (Federal Reserve

System, the President, Congress, and U.S. Treasury),

three types of policies or decisions (monetary policy, fiscal policy, and debt management) they make, and

four economic objectives (economic growth, high employment, price stability, and balance in international transactions) they are trying to achieve

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Policy Makers in the European Economic Union

Members of the European Union (EU): signed the Maastricht Treaty in 1991 with the objective to converge economies, fix exchange rates, & introduce the euro

European Monetary Union (EMU): initially twelve members of the EU adopted the euro as their common currency

European Central Bank (ECB):focuses on maintaining price stability while each member country is responsible for its own fiscal policy

Government Influence on Economy

Fiscal Policy: the government influences economic

activity through taxation and expenditure plans

the government raises funds to pay for its activities in three ways:

Levies taxes

Borrows

Prints money for its own use10

Example of Joint Monetary and Fiscal Policy Efforts

Government Deficits:

when the government spends more than it’s tax income, it must compete with other borrowers in the financial system

Monetizing the Debt:

to maintain economic stability during economic deficits, the Fed may increase the money supply to offset the demand for increased funds to finance the deficit

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Fiscal Policy: Stabilizing Factors

AUTOMATIC STABILIZERS: Continuing federal programs that help stabilize economic activity

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

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Fiscal Policy: Stabilizing Factors (continued)

TRANSFER PAYMENTS: Government payments for which no current services are given in return

EXAMPLES: -Unemployment benefits -Welfare benefits

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Effects of Tax Policy

Tax Policy:Setting the level and structure of taxes to affect the economy

Deficit Financing:How a government finances its needs when spending is greater than revenues

Crowding Out:Lack of funds for private borrowing caused by the sale of government obligations to cover large federal deficits

Recent Financial Crisis-Related Activities

Treasury’s Role in Helping U.S. Survive the 2007-09 Financial Crisis:

Assisted, sometimes in cooperation with the Fed, financially weak institutions merge with stronger institutions

Allocated funds (Economic Stabilization Act of 2008) to purchase troubled assets held by financial institutions—funds actually were used to increase equity capital of banks and other firms

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Debt Management

Debt Management:Various Treasury decisions connected with refunding debt issues

Debt management includes determining the:--types of refunding to carry out--types of securities to sell--interest rate patterns to use--decision making on callable issues

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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)/(Required Reserves 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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Non Bank Public Transactions Affecting Bank Reserves

Changes in the Demand for Currency:

Change is the nonbank public’s demand for currency to be held outside the banking system

--Cash leakage

--Currency withdrawal

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Fed 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 Fed Accounts

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U.S. Treasury Transactions Affecting Bank Reserves

Change in Treasury spending out of accounts held at Reserve Banks

Change in Treasury cash holdings

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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 = 40%; t = 15%; & g = 10%. What is the money multiplier (m)?

m = (1 + k)/[r(1 + t + g) + k] m = (1 + .40)/[.20(1 + .15 + .10) + .40]

= (1.40)/[.20(1.25) + .40] = 1.40/.65 = 2.15

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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

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Example of Link Between Money Supply and Real GDP

Assume inflation is expected to be 3% next year

M1 is expected to grow by 4% and M1 velocity is expected to increase by 1% next year

What is real GDP expected to increase by?

RGDP growth = 4% + 1% - 3% = 2%

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Web Links

www.treas.gov www.stlouisfed.org