Chapter 8

8-1a

There is a strong relationship between an economys

money supply & the economys production level,

jobs and overall price changes.

Any change in the size of money supply can change
the economys overall performance.
As such, changing the money supply is another
important way to reach the economys goals of full
production, economic growth, full employment and
price stability.
Monetary policy, or money supply to address
unemployment and inflation is in the hand of
Federal Reserve/Central Bank.

Money Creation:
Process of Money Creation
Actual Reserves
Financial

depository institutions reserve

account plus its vault cash (all the cash in the
vault and cash drawers).

Reserve Requirement
Specific percentage of

deposits that a financial

depository institution must keep as actual
reserves. For example, a bank with a reserve
requirement of 10% on demand deposit or
checking deposits it is holding.

Required Reserves
The amount of actual reserves that a financial

depository institution must keep to back its

deposits. For example, if a bank has
$60,000,000 in its demand deposits/checking
accounts, then the required reserves are
$6,000,000 which is 10% of the $60,000,000.
Bank deposits (demand deposits) are subject to
a reserve requirement.
Required
Reserve
ratio

Commercial banks
required reserves

Commercial banks
checkable-deposit
liabilities

Excess Reserves
Reserves of a financial depository institution

over the amount it is required to maintain in

actual reserves.
Excess reserves = Actual reserves minus
required reserves.
Excess reserves:
=$10,000,000 (0.10 x $60,000,000)
=$4,000,000
The bank has this amount in excess that it
does not need to have and as such can make
loan.

Excess Reserves & Loan Making

Excess reserves are important as they are the

foundation for a depository institutions

loan-making abilities.
The institution can make new loans up to
the value of its excess reserves.
When they make a new loan, they create
money. How is money created?
When the loan is repaid, money is destroyed
How is money destroyed?

 Thus excess reserves form the basis for loan-

making and thus for changing the money

supply
The supply of money can be controlled,
therefore, by controlling the amount of
excess reserves in depository financial
institutions
An increase in required reserves reduces
money supply and an decrease in required
reserves increases money supply.

MULTIPLE DEPOSIT EXPANSION PROCESS (20% RR)

Bank

Acquired reserves Required

and deposits
reserves

Excess
reserves

Amount bank
can lend - New
money created

$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
Total amount of money created by the banking system $400.00
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.21
H
20.97
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks 21.99

$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40

$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59

MULTIPLE DEPOSIT EXPANSION PROCESS

Bank

Acquired reserves Required

and deposits
reserves

Excess
reserves

Amount bank
can lend - New
money created

$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
Total amount of money created by the banking system $400.00
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.21
H
20.97
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks 21.99

$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40

$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59

Money
destruction works
in exactly the same
multiple way!

THE MONETARY MULTIPLIER

Monetary
Multiplier

Maximum
checkabledeposit
creation

= Required reserve ratio

=

Excess
reserves

Monetary
Multiplier

 Based on the table above, initial deposit is $100

Required reserve ratio is 20% or 0.2
Required amount to be deposited is (100 x 0.20) =

$20
Excess reserve = 100 20 = $80
Monetary multiplier is = 1/0.2=5
So, maximum Checkable Deposit (CD) = $80 x 5 =
$400
Or Money supply = (initial change in excess
reserves/RRR)
= 80/0.2 =$400

OUTCOME OF MONEY EXPANSION

Total = 100 + 400 = $500

$100
New reserves
$80
Excess
reserves

$400
Bank system lending
Money Created

$20
Required
reserves

$100
Initial
Deposit

Excess Reserves, Interest Rates & Spending Levels

Interest Rate Overview
Interest Rate
Price paid to borrow money.
Percentage of the amount borrowed.
Can be used to control the money supply.

Determining Interest Rates

on Loans
Interest rates for loans are
determined by the demand
for and supply of funds for
loans.

Effects of Change in Excess Reserves on the Interest

Rate and the Quantity of Loans
Decreases in excess reserves will cause

interest rates to rise and the amount of

loans made to fall.
Increases in the excess reserves will cause
interest rates to fall and the amount of
loans made to rise.

Effect of excess reserves..

Relationship among excess reserves, interest rates, loan

making and the level of economic activity)

 Monetary Policy Overview:

Monetary Policy

Changing the money supply to influence the levels

of output, employment, and/or prices in the
economy.

Types of Monetary Policy

Easy Money Policy

Policy by the Federal Reserve to increase excess
reserves and decrease interest rates to increase
spending.

 Tight Money Policy

Policy by the Federal Reserve to reduce

excess reserves and raise interest rates to
reduce spending.

Tools of Monetary Policy

Federal Reserve has three major tools

to change excess reserves in the

financial depository institutions
system:
Open market operation
Reserve Requirement Ratio

Discount Rate

 Open Market Overview

Open Market Operations

Buying and selling of securities, primarily

the government securities, on the open
market by the Federal Reserve.
Open Market Committee
Committee that determines the general
policy on Federal Reserve open market
operations.

Open-Market Operations Involves:

Buying Securities

From commercial banks...

Bank gives up securities

FED pays bank
Banks have increased reserves

From the public...

Public gives up securities

Public deposits check in bank
Banks have increased reserves

Selling Securities

To commercial banks...

FED gives up securities

Bank pays for securities
Banks have decreased reserves

To the public...
FED gives up securities
Public pays by check from bank
Banks have decreased reserves

The Reserve Requirements

Involves:
Raising the Reserve Ratio
Banks must hold more reserves
Banks decrease lending
Money supply decreases
Lowering the Reserve Ratio
Banks may hold less reserves
Banks increase lending
Money supply increases

The Discount Rate:

Bank borrows reserves from FED
Reserve account increases
Bank repays the FED
Reserve account decreases

Federal Funds Market:

Bank borrows reserves from another
banks
Does not have potential for multiplying money
supply as the money already in the system

To expand the economy requires:

Easy Money Policy
Buy Securities from banks and dealers
on OMO
Lower/Decrease Reserve Ratio
Lower Discount Rate

To fight demand-pull inflation requires:

Tight Money Policy
Sell Securities to banks and the
dealers on the OMO
Increase Reserve Ratio
Raise Discount Rate

MONETARY POLICY, REAL GDP,

AND THE PRICE LEVEL

Cause-Effect Chain
Money supply impacts interest
rates
Interest rates affect investment
Investment is a component of AD
Equilibrium GDP is changed

MONETARY POLICY AND EQUILIBRIUM GDP

Real rate of interest, i

Sm1 Sm2

Sm3

10

10

Investment
Demand

Dm
0

Quantity of money demanded and supplied

Price level

AS

Amount of investment, i

If the Money Supply

Increases to Stimulate
the Economy
Interest Rate Decreases

P3
P2
P1

Investment Increases
AD & GDP Increases
with slight inflation

AD3(I=$25)
AD2(I=$20) Increasing money supply
continues the growth
AD1(I=$15)
but, watch Price Level.
Real domestic output, GDP

MONETARY POLICY AND THE

INTERNATIONAL ECONOMY

Net export effect

Macro stability and the
trade balance

 Government Deficits & Monetary Policy

Crowding Out

Occurs when borrowing by the federal

government increases the interest rate and
reduces borrowing by households and
businesses.

Federal Reserve & Monetary Policy

Advantages & Disadvantages of Monetary

Policy
Advantages:

Speedy & Flexibility: can be implemented

quickly in comparison to fiscal policy
Isolated from political pressures: Largely
removed from politics (often done by CB which
is not disclosed a priori)

Disadvantages:
Loan-making link

Someone must be willing to borrow and a

bank must be willing to lend. The Federal
Reserve cannot force the loan-making
process.

Inflation

As the money supply is tightened, interest

rates increase, and businesses that borrow at
this high rate may raise prices on their
products to compensate.