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CHAPTER 14

CHAPTER 14. Monetary Policy and the Federal Reserve System. The Players. 3 groups that affect the money supply: The central bank - is responsible for monetary policy. - uses money it prints to buy real assets from the public to get money in circulation.

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CHAPTER 14

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  1. CHAPTER 14 Monetary Policy and the Federal Reserve System

  2. The Players • 3 groups that affect the money supply: • The central bank - is responsible for monetary policy. • - uses money it prints to buy real assets from the public • to get money in circulation. • - legal tender is used to pay off debts government tax. • - the central bank's assets = real assets it buys from the public; liabilities = the paper money it issued. • - money = the monetary base = high-powered money. • 2. Depository institutions (banks) - accept deposits and make loans. • 3. The public (people and firms) - holds money as currency & coin • or as bank deposits

  3. Fractional Reserve Banking Bank reservesisthe currency that banks hold. When bank reserves = deposits, the system is called 100% reserve banking. To make money, banks would have to charge fees for deposits, since they earn no interest on reserves. To lend some of the reserves, only a fraction of reserves are needed. i.e. If the bank needs to keep only 25% of the amount of its deposits on reserve to meet the demand for funds, it can lend the other 75%. The reserve-deposit ratio would be 25%. When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking.

  4. Multiple Expansion of Loans and Deposits If the monetary base is $1 million, - banks would make $3 million in loans. - so their total assets would be $4 million. In loaning the $3 million, - banks create $3 million in new deposits. Adding the $3 million in new deposits to the $1 million in existing deposits gives total liabilities in the banking system of $4 million. The process stops only when - the banks' currency holdings (reserves) are exactly 25% of their total deposits and loans equal to 75% of total deposits.

  5. Monetary base vs Money supply Let: M = money supply, BASE = monetary base, DEP = bank deposits, RES = bank reserves, res = banks' desired reserve-deposit ratio Since no currency is held by the public, M = DEP (14.1) Banks want to hold res xDEP in reserves, which must equal the amount of currency distributed by the central bank, so res x DEP = BASE (14.2). Eqs. (14.1) and (14.2) gives: M = DEP = BASE/res (14.3) So in an economy in which no currency is held by the public, its money supply equal to the monetary base divided by the reserve-deposit ratio.

  6. “Bank Run” Banks plan on never having to pay out more than 25% of their deposits. If more people wanted to get their money from the bank, the bank would be unable to give them their funds. If people think a bank won't be able to give them their money, they may panic and rush to withdraw their money, causing a “bank run”.

  7. M = CU + DEP The money supply consists of currency held by the public & deposits, so M = CU + DEP (14.4) The monetary base is held as currency by the public & as reserves by banks, so BASE = CU + RES (14.5) Taking the ratio of these two equations gives M/BASE = (CU + DEP)/(CU + RES) (14.6) Or divide all by DEP: M/BASE = [(CU/DEP) + 1]/[(CU/DEP) + (RES/DEP)] (14.7)

  8. The Money Multiplier From M/BASE = [(CU/DEP) + 1]/[(CU/DEP) + (RES/DEP)], The currency-deposit ratio (CU/DEP, or cu) is determined by the public. The reserve-deposit ratio (RES/DEP, or res) is determined by banks. Rewrite: M = [(cu + 1)/(cu + res)]BASE (14.8) The term (cu + 1)/(cu + res) is the money multiplier. The money multiplier is: greater than 1 for res less than 1(fractional banking) 1/res when cu = 0, (when all money is held as deposits) The multiplier decreases when either cuorres rises. Money multiplier = M/BASE = (cu + 1)/(cu + res)

  9. Open-market operations To change money supply by raising or lowering the monetary base through open-market operations. To increase the monetary base, conduct an open-market purchase - the central bank prints money - uses it to buy assets in the market [If the central bank wishes to ↑Ms by 15%, it purchases 15% more assets, its liabilities increase by 15% = the currency it issues] To decrease the monetary base, conduct an open-market sale - the central bank sells assets in the market - retires the money it receives For a constant money multiplier, the decline or fall in the monetary base of 15% is matched by a decline or fall in the money supply of 15%

  10. End of Lecture 1 Week 13 The Players Fractional Reserve Banking Multiple Expansion Of Loans And Deposits “Bank Run” M = Cu + Dep Monetary Base Vs Money Supply The Money Multiplier Open-market Operations

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