Chapter 5 Policy Makers and the Money Supply © 2000 John Wiley & Sons, Inc.

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 and 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 and Stable Levels of Employment n Price Stability n International Financial Equilibrium

6 National Economic Policy: Important Points 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 Major U.S. Policy Makers 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

8 Fiscal Policy: Definition and Fundraising Activities n FISCAL POLICY: Government influence on economic activity through taxation and expenditure plans n FUNDRAISING ACTIVITIES: A government raises funds to pay for its activities by: levying taxes, borrowing, or printing money for its own use

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

10 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

11 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

12 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

13 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

14 Multiple Expansion of Checkable Deposits BASIC EQUATION APPROACH: Change in Checkable Deposits = (Increase in Excess Reserves)/(Reserve 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

15 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

16 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

17 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

18 Federal Reserve 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 Federal Reserve Accounts

19 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

20 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

21 Complex Money Multiplier (m) Example n Basic Information: r = 20%; k = 20%; t = 10%; & g = 5%. What is the money multiplier (m)? n m = (1 + k)/[r(1 + t + g) + k] n m = (1 +.20)/[.20( ) +.20] = (1.20)/[.20(1.15) +.20] = 1.20/.43 = 2.8

22 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