Chapter 5 Policy Makers and the Money Supply © 2011 John Wiley and Sons

2 Chapter Outcomes n Discuss the objectives of national economic policy and the conflicting nature of these objectives n Identify the major policy makers and briefly describe their primary responsibilities n Identify the policy instruments of the U.S. Treasury and briefly explain how the Treasury manages its activities

3 Chapter Outcomes (Continued) n Describe U.S. Treasury tax policy & debt management responsibilities n Discuss how the expansion of the money supply takes place in the U.S. banking system n Briefly summarize the factors that affect bank reserves

4 Chapter Outcomes (Concluded) n Explain the meaning of the monetary base and money multiplier n Explain what is meant by the velocity of money and give reasons why it is important to control the money supply

5 National Economic Policy Objectives n Economic Growth n High Employment n Price Stability n Balance in International Transactions

6 National Economic Policy: Important Terms n GROSS DOMESTIC PRODUCT: GDP is the output of goods and services in an economy n INFLATION: Increase in price of goods/services not offset by increase in quality n REAL GDP: When GDP exceeds rate of inflation, the result is higher living standards

7 Four Policy Maker Groups n FEDERAL RESERVE SYSTEM Sets Monetary Policy n THE PRESIDENT Helps set Fiscal Policy n CONGRESS Helps set Fiscal Policy n U.S. TREASURY Conducts Debt Management Policy

Policy Makers & Economic Objectives Figure 5.1 in text depicts the: n four policy maker groups (Federal Reserve System, the President, Congress, and U.S. Treasury), n three types of policies or decisions (monetary policy, fiscal policy, and debt management) they make, and n four economic objectives (economic growth, high employment, price stability, and balance in international transactions) they are trying to achieve 8

9 Policy Makers in the European Economic Union nMnMembers of the European Union (EU): signed the Maastricht Treaty in 1991 with the objective to converge economies, fix exchange rates, & introduce the euro nEnEuropean Monetary Union (EMU): initially twelve members of the EU adopted the euro as their common currency nEnEuropean 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: n the government influences economic activity through taxation and expenditure plans n the government raises funds to pay for its activities in three ways: Levies taxes Borrows Prints money for its own use 10

Example of Joint Monetary and Fiscal Policy Efforts n Government Deficits: when the government spends more than it’s tax income, it must compete with other borrowers in the financial system n 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 11

12 Fiscal Policy: Stabilizing Factors n AUTOMATIC STABILIZERS: Continuing federal programs that help stabilize economic activity EXAMPLES: -Unemployment insurance -Welfare payments -Pay-as-you-go progressive income tax

13 Fiscal Policy: Stabilizing Factors (continued) n TRANSFER PAYMENTS: Government payments for which no current services are given in return EXAMPLES: -Unemployment benefits -Welfare benefits

14 Effects of Tax Policy n Tax Policy: Setting the level and structure of taxes to affect the economy n Deficit Financing: How a government finances its needs when spending is greater than revenues n 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 Financial Crisis: n Assisted, sometimes in cooperation with the Fed, financially weak institutions merge with stronger institutions n 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 15

16 Debt Management n Debt Management: Various Treasury decisions connected with refunding debt issues n 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

17 Changing the Money Supply n Fractional Reserve System: Allows Fed to alter the money supply n Primary Deposit: Deposit that adds new reserves to a bank n Derivative Deposit: Occurs when reserves created from a primary deposit are made available to borrowers through bank loans

18 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

19 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

20 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

21 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

22 Important Definitions of Reserves in the Banking System n Bank Reserves: Reserve balances held at Federal Reserve Banks and vault cash held in the banking system n Required Reserves: The minimum amount of total reserves that a depository institution must hold

23 Important Definitions of Reserves in the Banking System (Continued) n Excess Reserves: The amount that total reserves are greater than required reserves n Deficit Reserves: The amount that required reserves are greater than total reserves

24 Transactions Affecting Bank Reserves n Nonbank Public: Change in the demand for currency held outside the banking system n Federal Reserve System: Changes in open market operations, reserve ratio, and other transactions n United States Treasury: Change in Treasury cash holdings and spending

25 Non Bank Public Transactions Affecting Bank Reserves n 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

26 Fed System Transactions Affecting Bank Reserves n Change in Reserve Ratio n Open-Market Operations n Change in Bank Borrowings n Change in Float n Change in Foreign Deposits Held in Reserve Banks n Change in Other Fed Accounts

27 U.S. Treasury Transactions Affecting Bank Reserves n Change in Treasury spending out of accounts held at Reserve Banks n Change in Treasury cash holdings

28 Monetary Base and Money Multiplier n Equation: MB x m = M1 n Monetary Base (MB): Banking system reserves plus currency held by the public n Money Multiplier (m): In a simple monetary system, the ratio of 1 divided by the reserve ratio n Money Supply (M1): Basic definition of the money supply

29 Complex Money Multiplier (m) n Equation: m = (1 + k)/[r(1 + t + g) + k] n 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

30 Complex Money Multiplier (m) Example n Basic Information: r = 20%; k = 40%; t = 15%; & g = 10%. What is the money multiplier (m)? n m = (1 + k)/[r(1 + t + g) + k] n m = (1 +.40)/[.20( ) +.40] = (1.40)/[.20(1.25) +.40] = 1.40/.65 = 2.15

31 Link Between Money Supply and Gross Domestic Product n Velocity of money (M1V) is the rate of circulation of money supply n Money supply (M1) is linked to gross domestic product (GDP) via velocity n Nominal GDP is real GDP (RGDP) + Inflation (I) n In terms of growth rates (g) we have: M1 g + M1V g = RGDP g + I g

32 Example of Link Between Money Supply and Real GDP nAnAssume inflation is expected to be 3% next year nMnM1 is expected to grow by 4% and M1 velocity is expected to increase by 1% next year nWnWhat is real GDP expected to increase by? nRnRGDP growth = 4% + 1% - 3% = 2%

33 Web Links n n