Welker’s Wikinomics practice activity

2.5 Macroeconomic Policies

The Tools of Monetary Policy

Introduction: For each of the questions below, assume the following:

● The Fed’s target inflation rate is 2%
● America’s natural rate of unemployment is 5%

The economy is currently experiencing inflation of 3%. The nominal interest rate is currently 5%.
1. Calculate the real interest rate.

2. Explain why an inflation rate higher than the target rate poses a concern to
macroeconomic policymakers (refer to the inflationary spiral in your answer).

3. Define and explain how a change in the following could help reduce inflation to its target
rate of 2%:
a. The Discount Rate:

b. The Reserve Requirement:

 Welker’s Wikinomics practice activity

Introduction to theory - Open Market Operations: The third tool of monetary policy requires a
central bank to increase or decrease the supply of liquid money in the economy by buying or
selling non-liquid assets from within the banking system. “Open-market operations” refers to the
buying and selling of government bonds by a nation’s central bank to increase or decrease the
supply of liquid money.

As you learned in the fiscal policy unit, there is an inverse relationship between the price of
government bonds and their yields (the interest rates on government bonds).
● Therefore, when a central bank intervenes in the market for government bonds by
buying bonds, this decreases their supply and raises the price, decreasing the yields on
government bonds. This is known as an expansionary monetary policy.
● If the central bank sells government bonds on the open market, their supply increases,
decreasing their prices and increasing their yields. This is known as a contractionary
monetary policy.

The effect of a central bank’s intervention in the bond market can be seen in the diagrams on
the next two pages.
 Welker’s Wikinomics practice activity

EXPANSIONARY MONETARY POLICY

CB buys bonds on the open market...

Market for 1 year, $1,000 US

government bonds
P
S2
S1

Expansionary
monetary policy:
CB buys bonds =>
990 supply decreases=>
price rises=> yield
on government
970 bonds falls (from
3.09% to 1.01% in
this case) => Qd for
government bonds
decreases =>
supply of liquid
money increases

Q2 Q1 Q

which leads to an increase in the money supply

 Welker’s Wikinomics practice activity

Nominal Interest Rate US Money Market

Sm1 Sm2

Expansionary
monetary policy:
Lower yields on
government bonds =>
increase of supply of
money in the banking
system as banks and
households demand
less of the lower yield
government bonds =>
3.09% lower nominal interest
rates =>more
investment and more
consumption =>

1.01%
Dm

Qm1 Qm2
Quantity of Money
 Welker’s Wikinomics practice activity

CONTRACTIONARY MONETARY POLICY

CB sells bonds on the open market...
Market for 1 year, $1,000 US
government bonds
P

S1
S2

Contractionary
monetary policy:
CB sells bonds =>
supply increases =>
970 price falls => yield
on government
bonds increases
950 (from 3.09% to
5.26% in this case)
=> Qd for
government bonds
increases => supply
of liquid money

Q1 Q2 Q

which leads to a decrease in the supply of liquid money.

 Welker’s Wikinomics practice activity

Nominal Interest Rate US Money Market

Sm2 Sm1

Contractionary monetary
policy: Higher yields on
government bonds =>
decrease of supply of
money in the banking
5.26%
system as banks and
households demand more
of the higher yield bonds =>
higher nominal interest
rates =>less investment
and less consumption =>
3.09%
decrease in AD

Dm

Qm2 Qm1
Quantity of Money

Practice: Answer the questions below to demonstrate your understanding of open market
operations.

4. The United States is experiencing 3% inflation. Outline the appropriate open-market

operation the Federal Reserve should enact to bring inflation down to its target rate of
2%.

5. On the graphs below, show the effect of the Fed’s open-market operations in
a. The US Money Market
b. The broader US economy in an AD/AS diagram
 Welker’s Wikinomics practice activity

Explain the changes you showed in your diagrams:

● Money Market:

● AD/AS:

For the following questions, refer to the Phillips Curve diagram below.

IR

1 X
SRPC
8 SRPC
UR (%)

6. Outline the likely causes and consequences of the macroeconomic problems faced by
the US economy as conveyed by the Short-run Phillips Curve above.

7. Assume the Fed takes no action and the government does not engage in any fiscal
policies. Explain the process by which the economy will adjust to the macroeconomic
conditions conveyed by the Short-run Phillips Curve above.
 Welker’s Wikinomics practice activity

8. Using a correctly labelled graph, show the changes in AD and/or AS that will occur in the
long-run assuming no policy actions are taken.

9. Now assume that the Fed decides to engage in open market operations to help the
economy recover and return to the target inflation rate. Outline the appropriate open-
market operation the Federal Reserve should enact.

10. Explain the process by which the Fed’s open-market operation will help the economy
return to its target rate of inflation.
 Welker’s Wikinomics practice activity

11. Using correctly labelled graphs, show the effect of the Fed’s open-market operation on
the US Money Market and on the Short-run Phillips Curve

IR

1 X
SRPC
8 SRPC
UR
 Welker’s Wikinomics practice activity

12. Besides the open-market operation you described above, outline and explain how
changes to the other policy tools the Fed has at its disposal would help to bring inflation
back to its target rate.
a. The Discount Rate:

b. The Reserve Requirement:

The Money Multiplier (AP-only concept): The concept of the money multiplier allows us to
calculate the total increase in the money supply that will result from a Central Bank action such
as a purchase of government bonds. If the Central Bank wishes, for example, to increase the
amount of liquid money in circulation by amount X, it does not need to inject X dollars into the
economy through bond purchases, since a proportion of every dollar the central bank injects will
be lent out by a bank, deposited at another bank, and a proportion of it will be lend out again.

The proportion of commercial banks’ deposits that they are allowed legally to loan out is
determined by their excess reserves, the level of which are determined by the Reserve
Requirement. If, for instance, there is a Reserve Requirement of 20%, then a bank with $1
million in total deposits is required to keep $200,000 of its total deposits in reserve, and has
excess reserves of $800,000. The bank will try to loan out as much of its excess reserves as
possible in order to earn interest on these deposits.
 Welker’s Wikinomics practice activity

Continuing with the example above, if the central bank engages in an open-market purchase of
government bonds (expansionary monetary policy), and buys $100,000 worth of bonds off of
this bank, the bank’s excess reserves increase by $100,000 and the bank will loan out as much
of this as possible. Assume the bank loans out all $100,000. To determine how much this new
lending will increase the overall money supply, we must multiply the bank’s new loans by the
money multiplier.

1 1
The Money Multiplier (m)= = =5
Reserve Requirement 0.2

In this example, the central bank’s purchase of $100,000 of government bonds from our bank
will increase the total money supply by $100,000*5 = $500,000.

When a central bank engages in an open-market purchase of government bonds by X dollars,

1
the total increase in the money supply will equal X*m, where m =
RR

When an individual deposits X dollars into a commercial bank, the total change in the money
supply will be smaller than when the central bank purchases X dollars of government bonds,
since the individual’s dollars were already part of the money supply. When an individual
deposits X dollars, the total change in the money supply will be (X*m) - X.

Example: For a graduation present Suzie received a $1,000 check from her grandparents,
which she deposits in her bank account. The reserve requirement is 0.2. Calculate the total
change in the money supply that will result from Suzie’s deposit.
● Suzie’s $1,000 deposit increases her bank’s excess reserves by $800 and its required
reserves by $200.
● The bank will loan out the $800 of excess reserves, which can the by multiplied by m,
1
which is =5
0.2
● $800*5 = $4,000. The total money supply will increase by $4,000 as a result of Suzie
depositing her graduation check in the bank.
● The total change in the money supply was therefore ($1,000*5) - $1,000 = $4,000.

Practice: Answer the questions below to demonstrate your understanding of the money
multiplier.

13. The reserve requirement is currently set at 0.15.

a. Calculate the maximum effect that a $200 deposit by an individual into her bank
account can have on the total supply of money in the banking system.
 Welker’s Wikinomics practice activity

b. Calculate the maximum effect that a $200 purchase of government bonds will
have on the total supply of money in the banking system.

c. Explain why the two scenarios above will result in different increases in the total
money supply.

14. The central bank lowers the reserve requirement from 0.15 to 0.10.
a. What is the immediate effect of the lowered reserve requirement on the level
commercial banks’ excess reserves?

b. What is the impact of the lowered reserve requirement on the money multiplier?

c. Calculate the effect of the two scenarios described in #1 after the decrease in the
reserve requirement.
i. $200 deposit by an individual

ii. $200 bond purchase by the central bank.

Welker’s Wikinomics practice activity