1. Monetary Policy
AP Macroeconomics

2. Relating Money to GDP Nominal GDP = Economist Irving Fisher postulated
The Money Supply
X Money’s Velocity

3. Equation of exchange MV = PQ M = money supply V = velocity of money
P = price level
Q = quantity of output (real output)
Where’s George?

4. The equation
P x Q represents the expenditure on goods in a year, which must equal the amount of money multiplied by the number of times/year the money is spent.
V is highly predictable and stable.
Changes in M result in changes in nominal GDP (P x Q)…
Monetarists believe output is relatively fixed. What does that mean about the Federal Reserve Bank creating money?

5. The Monetary Equation of Exchange
MV=PQ
M=$2 trillion
V = 7
PQ = $14 trillion
LRAS
SRAS PL P AD QF
GDPR

6. Factors that affect income velocity
Stable, but not constant
Shorter pay periods
Widespread use of credit cards
Faster means of making payments
We hold less money and turn it over more rapidly
Velocity doesn’t change in response to the money supply.
Activity 4-8

7. What is the Fed? Central bank of the United States Established in 1913
Purpose is to ensure a stable economy for the nation
What is the Fed?
The Federal Reserve is the central bank of the United States and its purpose is to help ensure a stable economy for the nation.
Established as a result of the Federal Reserve Act, signed in 1913.
Receives no congressionally appropriated funds. Its operations are financed primarily from the interest earned on the U.S. government securities it acquires in the course of its monetary policy actions.
Another major source of income is derived from the fees received for certain services provided to depository institutions.
After payment of certain expenses, all the net earnings of the Federal Reserve Banks are transferred to the U.S. Treasury. In 2004, for example, the Fed paid approximately $18.1 billion to the U.S. Treasury. 7

8. stlouisfed.org/education_resources/in-plain-english-video/
As you watch, write down the STRUCTURE of the Fed and the Fed’s ROLES & RESPONSIBILITIES
CHAPTER THE MONETARY SYSTEM

9. Money Supply
Basically, the Fed is charged with controlling the amount of money in circulation.
Fed policy can increase or decrease the money supply, which increases or decreases interest rates.
Decrease
Interest Rates
Decrease
Money Supply
Increase
Money Supply
Increase
Interest Rates
Leads to
Leads to

11. Key Tools of Monetary Policy
Reserve Requirements
Discount Rate
Fed Funds Rate
Open Market Operations
We’ll chat about all 4 types… No yelling!
The tools the Fed utilizes to influence the economy (or affect the amount of funds in the banking system) are:
Discount Rate:
Rate of interest charged to banks that need to borrow from the Fed to cover temporary deposit drains (short-term “discount window” loans).
Reserve Requirements:
Portions of deposits that banks must hold in reserve, either in their vaults or on deposit at a Reserve bank.
Federal Open Market Operations:
The most frequently used and most flexible tool is that of Open Market Operations, which involves the buying and selling of U.S. government securities. This tool is directed by the FOMC and carried out at the domestic trading desk at the Federal Reserve Bank of New York 11

12. Reserve Requirement
With a 10% reserve requirement, banks must hold 10% of deposits in reserves and they can loan out 90% of their deposits.
Raising the reserve requirement to 12% means banks have less money to loan out
Increasing Interest Rates → Reducing the Quantity Demand for Money → Contracting the Money Supply
Lowering the reserve requirement to 8% means banks have more money to loan out
Decreasing Interest Rates → Increasing the Quantity Demand for Money → Expanding the Money Supply
Contractionary
Expansionary

13. Discount Rate
The rate of interest the Fed charges financial institutions to borrow money from the Fed
Overnight loans to help banks meet their reserve requirements
The discount rate is a “base” rate for other interest rates
Interest
Rates
Consumer
Prime Rate
Discount Rate
Fed Funds Rate

14. Discount Rate
Lower discount rates decrease the cost of borrowing money – for banks and for consumers
Increases the quantity demand for money
Expands the money supply
Lowers interest rates
Higher discount rates increase the cost of borrowing money -- for banks and consumers
Decreases the quantity demand for money
Contracts the money supply
Raises interest rates
Expansionary
Contractionary

15. Fed Funds Rate
The rate of interest banks charge for loaning excess reserves to other banks
Overnight loans
Another “base” rate for interest rates
“Controlled” by the Fed, but not “set” by the Fed

17. Open Market Operations
Buying and selling of government securities (bonds) in the “open market”
All open market operations are based at the NY Fed
The Fed open market desk buys and sells with approximately 30 primary dealers

18. Open market operations
The Fed buys government securities
Increases the money supply
Lowers the interest rates
Increases the quantity demand for money
The Fed sells government securities
Decreases the money supply
Increases interest rates
Decreases the quantity demand for money
Expansionary
Contractionary

19. Summary of Monetary Policy
Reserve Requirement
Discount Rate
Open Market Operations
Expansionary
Decrease RR
Decrease DR
Buy Government Securities
Contractionary
Increase RR
Increase DR
Sell Government Securities
Expansionary
Contractionary
4.4.38

20. Conclusion Expansionary Monetary Policy Contract’ary Monetary Policy
FEATURES of
the process
CONDITIONS necessary for the process to take place
Ways the process
SUPPORTS progress
INHIBITS progress
PROCESS 1
Expansionary Monetary Policy
PROCESS 2
Contract’ary Monetary Policy
Conclusion

21. Conclusion Expansionary Monetary Policy Contract’ary Monetary Policy
FEATURES of
the process
CONDITIONS necessary for the process to take place
Ways the process
SUPPORTS progress
INHIBITS progress
PROCESS 1
Expansionary Monetary Policy
PROCESS 2
Contract’ary Monetary Policy
Conclusion
Increase money in circulation. Lower interest rates: decrease RR, target FFR, DR. Buy OMO.
Recession, low rGDP.
Must be demand-deficient in order for policy to work.
FOMC must act, and the policy has long outside lag.
Reduce money in circulation. Raise interest rates: increase RR, target FFR, DR. Sell OMO.
Inflationary period.
Must be too much demand in order for policy to work.

22. Conclusion Expansionary Monetary Policy Contract’ary Monetary Policy
FEATURES of
the process
CONDITIONS necessary for the process to take place
Ways the process
SUPPORTS progress
INHIBITS progress
PROCESS 1
Expansionary Monetary Policy
PROCESS 2
Contract’ary Monetary Policy
Conclusion
Increase money in circulation. Lower interest rates: decrease RR, target FFR, DR. Buy OMO.
Recession, low rGDP.
Must be demand-deficient in order for policy to work.
FOMC must act, and the policy has long outside lag.
Reduce money in circulation. Raise interest rates: increase RR, target FFR, DR. Sell OMO.
Inflationary period.
Must be too much demand in order for policy to work.
Tradeoff is economic contraction.
AD shifts to right. Money is injected into the economy and spent several times through circular flow.
Tradeoff will be inflation.
AD shifts to left.
Money is removed from economy, cooling the spending by all.

23. Money Market Money Market MS 3 reasons to demand $: Transactions
Precaution
Speculation
MD also depends on the PL and the level of rGDP
Nominal interest rate nir MD
Quantity of Money
Activity

24. Fisher Equation
r = i – p
real interest rate = nominal interest rate - inflation rate
Short run: MS↑=>↓i & r
Long run: MS↑=>↑PL and only i↓ (not r)
Activity

25. Returning… the TRIFECTA!!!

26. Contractionary monetary policy
Aggregate S & D Money Market Investment
rGDP Quantity of money Quantity of investment PL
Nom. Int. rate
Real Interest rate

27. Expansionary monetary policy
Aggregate S & D Money Market Investment
rGDP Quantity of money Quantity of investment PL
Nom. Int. rate
Real Interest rate
4.6.42

28. Expansionary fiscal policy
Aggregate S & D Loanable Funds Market Investment
rGDP Quantity of loanable funds Quantity of investment PL
Real Int. rate
Real Interest rate

29. Open Market Operations
In an open­ -­ market operation the Federal Reserve buys or sells U.S. Treasury bills, normally through a transaction with commercial banks—banks that mainly make business loans, as opposed to home loans.
To alter the money supply, the Fed can buy or sell U.S. Treasury bills. How?
When the Fed buys U.S. Treasury bills from a commercial bank, it pays by crediting the bank’s reserve account by an amount equal to the value of the Treasury bills.
For example, if the Fed buys $100 million of U.S. Treasury bills from commercial banks, this increases the monetary base by $100 million because it increases bank reserves by $100 million.
When the Fed sells U.S. Treasury bills to commercial banks, it debits the banks’ accounts, reducing their reserves.
For example, when the Fed sells $100 million of U.S. Treasury bills, bank reserves and the monetary base decrease.
Note: Remind the students that the change in bank reserves caused by an open­ -­ market operation doesn’t directly affect the money supply. Instead, it starts the money multiplier in motion.
If the Fed buys $100 million in T-bills from the commercial banks, the banks would lend out their additional reserves, immediately increasing the money supply by $100 million. Some of those loans would be deposited back into the banking system, increasing reserves again and permitting a further round of loans, and so on, leading to a rise in the money supply.
An open­ -­ market sale has the reverse effect: bank reserves fall, requiring banks to reduce their loans, leading to a fall in the money supply.