1. Policy Makers and the Money Supply
Chapter 5
Policy Makers and the Money Supply
© 2003 John Wiley and Sons

2. 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

3. Chapter Outcomes (Continued)
Describe U.S. Treasury tax policy and 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

4. 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

5. National Economic Policy Objectives
Economic Growth
High and Stable Levels of Employment
Price Stability
Balance in International Transactions

6. National Economic Policy: Important Points
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

7. Major U.S. Policy Makers FEDERAL RESERVE SYSTEM -Sets Monetary Policy
THE PRESIDENT Helps set Fiscal Policy
CONGRESS Helps set Fiscal Policy
U.S. TREASURY Conducts Debt Management Policy

8. Fiscal Policy: Definition and Fundraising Activities
FISCAL POLICY: Government influence on economic activity through taxation and expenditure plans
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
AUTOMATIC STABILIZERS: Continuing federal programs that stabilize economic activity
EXAMPLES: Unemployment insurance Welfare payments Pay-as-you-go progressive income tax

10. 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

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
Reserves $8, 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:
Reserves $1, Deposits $8,000
Loans $6,400

14. 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

15. 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

16. 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

17. 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

18. Federal Reserve 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 Federal Reserve Accounts

19. 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

20. 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

21. 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 = ( )/[.20( ) + .40] = (1.40)/[.20(1.25) + .40] = 1.40/.65 = 2.15

22. 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

23. 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%