Monetary Policy and The Federal Reserve

Introduction
to Economics:
Social Issues
and Economic
Thinking
Wendy A .
Stock
CHAPTER 22
MONETARY POLICY AND PowerPoint
Prepared by
THE FEDERAL RESERVE Z. Pan
Copyright © 2013 John Wiley & Sons, Inc. / Photo Credit: Camera Press/Redux Pictures
AFTER STUDYING THIS CHAPTER, YOU
SHOULD BE ABLE TO:
➢Define the concept of ➢Summarize the roles

money of the Federal Reserve
➢Explain how the ➢Explain how monetary
fractional reserve policy takes place
banking system allows ➢Illustrate the impact
banks to create money of monetary policy on
➢Explain how the market the economy
for loans functions ➢Assess the tradeoffs
➢Describe the structure associated with
of the Federal Reserve monetary policy
System
Copyright © 2013 John Wiley & Sons, Inc. 2
THE EVOLUTION OF THE MONETARY SYSTEM
➢Barter Exchange is the trading of goods and

services directly for other goods or services,
without using money.
➢Medium of Exchange is an item that is
widely accepted as payment for goods and
services.

THE FUNCTIONS OF MONEY
The three primary functions of money: (1)

medium of exchange; (2) unit of account; (3)
store of value.
➢A Unit of Account is a standard measure of
the value of goods and services.
➢A Store of Value is something that can be
saved and used at a later time.

THE MONEY SUPPLY
➢The standard definition of money supply is

money in circulation called M1.
➢M1 includes: cash, demand deposits,
traveler ’s checks, and other checkable
deposits.

MONEY SUPPLY IN THE U.S.

THE BANKING SYSTEM
➢Balance Sheet is a statement of assets

(things owned) and liabilities (things owed).
➢Total Reserves are a bank’s deposits that it
has received but has not lent out.
➢Required Reserve Ratio (rrr) is the
percentage of deposits that a bank must
hold as reserves by law.
➢Required Reserves is the dollar amount that
a bank is required to hold as reserves.

THE BANKING SYSTEM
➢Fractional Reserve Banking is a system

under which banks are required to hold only
a fraction of their deposits as reserves.
➢Excess Reserves are the difference between
a bank’s total reserves and its required
reserves.
Total reserves = required reserves + excess

reserves

AN EXAMPLE OF BALANCE SHEET

THE MARKET FOR LOANS
➢The supply of loans (S) comes primarily from

savings accounts. As the interest rate
increases, the amount of money people
decide to save rises.
➢The demand for loans (D) comes from
individuals and businesses who want to
borrow money. When the interest rate on
loans falls, the demand for loans increases.

THE MARKET FOR LOANS

BANKS AND MONEY CREATION
Money creation can be illustrated by the

following simple example:
➢you make a deposit of $10mi. in Econobank
➢bank’s total reserves increase by $10mi.
➢assuming rrr = 10%, bank’s excess reserves
increase by $9mi.
➢bank makes a loan of $9mi.
➢bank has recreated $9mi. more money
➢starting another and more rounds …
Initial Status of the bank’s balance sheet:

After you made a $10mi. deposit:

After Econobank made a loan of $9mi. and

borrower deposited the loan in the same
bank:

➢M oney Multiplier (MM) tells the maximum

amount that the money supply can increase
for a given increase in deposits.
➢MM is equal to the reciprocal of the required
reserve ratio.
MM = 1/rrr
In our example MM = 1/0.1 = 10

➢The maximum amount of money creation

equals the initial increase in deposit times
the money multiplier.
Max Money Creation = Initial Increase in

Deposits x MM
In our example: $10 mi. x 10 = $100 mi.

MONEY MULTIPLIER IN REVERSE:
MONEY DESTRUCTION
After you made a withdrawal of $5mi.

BANK REGULATION
➢A Bank Run occurs when a large number of

customers withdraw their deposits from the
bank because they worry that their bank
might fail.
➢Federal Deposit Insurance Corporation
(FDIC), 1933
➢Federal Reserve System

THE STRUCTURE OF THE
FEDERAL RESERVE SYSTEM
➢Board of Governors
➢ Chair (Ben Bernanke), 4-year terms
➢ 7 members, 14-year term
➢12 Federal Reserve District Banks
➢The Federal Open Market Committee
(FOMC), 12 members

FEDERAL RESERVE AND MONETARY POLICY
➢Two primary missions of the Federal Reserve

are to promote price stability and to promote
employment and economic growth.
➢Monetary Policy is the use of regulations or
actions by the central bank to influence the
money supply.

MONETARY POLICY
Three tools for monetary policy:
➢ Open Market Operations

➢ Discount Rates
➢ Reserve Requirements

MONETARY POLICY
➢Open Market Operations are the purchases

and sales of federal government securities
by the Fed.
➢If the Fed ’s objective is to increase the
money supply, it will conduct open market
purchases of securities from banks and
investors.
➢If the objective is to decrease the money
supply, it will sell securities to banks and
investors.
MONETARY POLICY: OPEN MARKET
PURCHASE TO INCREASE MONEY SUPPLY
Initial Status of the bank’s balance sheet:
After Fed purchased $10mi. securities:

MONETARY POLICY
➢Discount Rate is the interest rate that the

Federal Reserve charges banks for loans.
➢Federal Funds Rate is the interest rate that
banks charge one another for loans to cover
required reserve shortfalls.
➢A higher discount rate discourages banks
from borrowing from the Fed and from each
other, thus less funds available for loans and
less money supply created.

MONETARY POLICY
➢A third tool of monetary policy is setting

reserve requirements.
➢Changing the required reserve ratio instantly
impacts banks’ excess and required
reserves.
➢Increasing required reserve ratio will reduce
the money supply.
➢Decreasing required serve ratio will increase
the money supply.

MONETARY POLICY AND THE ECONOMY
➢Expansionary Monetary Policy involves Fed

actions to increase the money supply.
➢Contractionary Monetary Policy involves Fed
actions to decrease the money supply.

IMPACTS OF EXPANSIONARY
MONETARY POLICY

IMPACTS OF CONTRACTIONARY
MONETARY POLICY

ADVANTAGES AND DISADVANTAGES OF
MONETARY POLICY
➢Advantages:
➢ Flexibility
➢ Nonpolitical
➢Disadvantages:
➢ Tradeoff between fighting inflation &
unemployment
➢ Market expectations

QUESTIONS/DISCUSSIONS
1. Describe the actions the Federal

Reserve could take to increase the
money supply.
2. Describe the functions of money. How
well does cash fit these functions?
How well does a checking account
that earns zero interest fi t these
functions? How well does an interest-
earning savings account fit these
functions?

KEY CONCEPTS
• Barter exchange • Excess reserves

• Medium of exchange • Money multiplier
• Primary functions of • Bank run
money • Monetary policy
• Unit of account • Open market operations
• Store of value • Discount rate
• M1 money supply • Federal funds rate
• Balance sheet • Expansionary monetary
• Total reserves policy
• Required reserve ratio • Contractionary monetary
• Required reserves policy
• Fractional reserve banking

Monetary Policy and The Federal Reserve

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Introduction

THE FEDERAL RESERVE Z. Pan

➢Define the concept of ➢Summarize the roles

➢Barter Exchange is the trading of goods and

Copyright © 2013 John Wiley & Sons, Inc. 3

The three primary functions of money: (1)

Copyright © 2013 John Wiley & Sons, Inc. 4

➢The standard definition of money supply is

Copyright © 2013 John Wiley & Sons, Inc. 5

Copyright © 2013 John Wiley & Sons, Inc. 6

➢Balance Sheet is a statement of assets

Copyright © 2013 John Wiley & Sons, Inc. 7

➢Fractional Reserve Banking is a system

Total reserves = required reserves + excess

Copyright © 2013 John Wiley & Sons, Inc. 8

Copyright © 2013 John Wiley & Sons, Inc. 9

➢The supply of loans (S) comes primarily from

Copyright © 2013 John Wiley & Sons, Inc. 10

Copyright © 2013 John Wiley & Sons, Inc. 11

Money creation can be illustrated by the

Initial Status of the bank’s balance sheet:

Copyright © 2013 John Wiley & Sons, Inc. 13

After you made a $10mi. deposit:

Copyright © 2013 John Wiley & Sons, Inc. 14

After Econobank made a loan of $9mi. and

Copyright © 2013 John Wiley & Sons, Inc. 15

➢M oney Multiplier (MM) tells the maximum

In our example MM = 1/0.1 = 10

Copyright © 2013 John Wiley & Sons, Inc. 16

➢The maximum amount of money creation

Max Money Creation = Initial Increase in

In our example: $10 mi. x 10 = $100 mi.

Copyright © 2013 John Wiley & Sons, Inc. 17

After you made a withdrawal of $5mi.

Copyright © 2013 John Wiley & Sons, Inc. 18

➢A Bank Run occurs when a large number of

Copyright © 2013 John Wiley & Sons, Inc. 19

Copyright © 2013 John Wiley & Sons, Inc. 20

➢Two primary missions of the Federal Reserve

Copyright © 2013 John Wiley & Sons, Inc. 21

Three tools for monetary policy:

➢ Open Market Operations

Copyright © 2013 John Wiley & Sons, Inc. 22

➢Open Market Operations are the purchases

After Fed purchased $10mi. securities:

Copyright © 2013 John Wiley & Sons, Inc. 24

➢Discount Rate is the interest rate that the

Copyright © 2013 John Wiley & Sons, Inc. 25

➢A third tool of monetary policy is setting

Copyright © 2013 John Wiley & Sons, Inc. 26

➢Expansionary Monetary Policy involves Fed

Copyright © 2013 John Wiley & Sons, Inc. 27

Copyright © 2013 John Wiley & Sons, Inc. 28

Copyright © 2013 John Wiley & Sons, Inc. 29

Copyright © 2013 John Wiley & Sons, Inc. 30

1. Describe the actions the Federal

Copyright © 2013 John Wiley & Sons, Inc. 31

• Barter exchange • Excess reserves

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