Transcript Chapter Five POF - HCC Learning Web

Chapter 5
Policy Makers and the Money
Supply
© 2011 John Wiley and Sons
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 2
Chapter Outcomes
(Continued)



Describe U.S. Treasury tax policy &
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
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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
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National Economic Policy
Objectives

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
Economic Growth
High Employment
Price Stability
Balance in International
Transactions
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National Economic Policy:
Important Terms

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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
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Four Policy Maker Groups
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FEDERAL RESERVE SYSTEM
Sets Monetary Policy
THE PRESIDENT
Helps set Fiscal Policy
CONGRESS
Helps set Fiscal Policy
U.S. TREASURY
Conducts Debt Management Policy
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Policy Makers & Economic Objectives
Figure 5.1 in text depicts the:
 four policy maker groups (Federal Reserve
System, the President, Congress, and U.S.
Treasury),
 three types of policies or decisions
(monetary policy, fiscal policy, and debt
management) they make, and
 four economic objectives (economic
growth, high employment, price stability,
and balance in international transactions)
they are trying to achieve
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Policy Makers in the European
Economic Union

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Members of the European Union (EU):
signed the Maastricht Treaty in 1991 with
the objective to converge economies, fix
exchange rates, & introduce the euro
European Monetary Union (EMU):
initially twelve members of the EU adopted
the euro as their common currency
European Central Bank (ECB):
focuses on maintaining price stability
while each member country is responsible
for its own fiscal policy
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Government Influence on Economy


Fiscal Policy:
the government influences economic
activity through taxation and
expenditure plans
the government raises funds to pay
for its activities in three ways:
Levies taxes
Borrows
Prints money for its own use
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Example of Joint Monetary and
Fiscal Policy Efforts

Government Deficits:
when the government spends more than
it’s tax income, it must compete with other
borrowers in the financial system

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
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Fiscal Policy: Stabilizing Factors

AUTOMATIC STABILIZERS:
Continuing federal programs that
help stabilize economic activity
EXAMPLES:
-Unemployment insurance
-Welfare payments
-Pay-as-you-go progressive income
tax
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Fiscal Policy: Stabilizing Factors
(continued)

TRANSFER PAYMENTS:
Government payments for which no
current services are given in return
EXAMPLES:
-Unemployment benefits
-Welfare benefits
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Effects of Tax Policy

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Tax Policy:
Setting the level and structure of taxes to
affect the economy
Deficit Financing:
How a government finances its needs
when spending is greater than revenues
Crowding Out:
Lack of funds for private borrowing
caused by the sale of government
obligations to cover large federal deficits
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Recent Financial Crisis-Related
Activities
Treasury’s Role in Helping U.S.
Survive the 2007-09 Financial Crisis:

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Assisted, sometimes in cooperation with
the Fed, financially weak institutions merge
with stronger institutions
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
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Debt Management
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Debt Management:
Various Treasury decisions connected
with refunding debt issues
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
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Changing the Money Supply
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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
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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
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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
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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
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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
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Important Definitions of Reserves
in the Banking System
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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
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Important Definitions of Reserves
in the Banking System
(Continued)
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Excess Reserves:
The amount that total reserves are
greater than required reserves
Deficit Reserves:
The amount that required reserves
are greater than total reserves
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Transactions Affecting
Bank Reserves
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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
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Non Bank Public Transactions
Affecting Bank Reserves

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
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Fed System Transactions Affecting
Bank Reserves
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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 Fed Accounts
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U.S. Treasury Transactions
Affecting Bank Reserves
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Change in Treasury spending out of
accounts held at Reserve Banks
Change in Treasury cash holdings
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Monetary Base and
Money Multiplier
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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
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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
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Complex Money Multiplier (m)
Example
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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 = (1 + .40)/[.20(1 + .15 + .10) + .40]
= (1.40)/[.20(1.25) + .40]
= 1.40/.65 = 2.15
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Link Between Money Supply and
Gross Domestic Product
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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
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Example of Link Between Money
Supply and Real GDP
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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%
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Web Links
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www.treas.gov
www.stlouisfed.org
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