Monetary Policy
How is it Conducted and How Does
It Affect the Economy?
What is Money?
• Money is anything that serves as three
functions:
– Money as a medium of exchange
– Money as a unit of ac...
What Counts as Money?
• M1: the most narrowly defined MS
– Measures purchasing power
– M1= currency + checkable deposits

...
Fractional Reserve Banking
• Def: Fractional reserve banking is a system in
which banks keep only a percentage of their
de...
Banker Bookkeeping
• A balance sheet is a statement of the assets
and liabilities of a bank at a given point in time
• The...
Types of Reserves
• Excess Reserves: The amount of checkable
deposits the bank holds over the required rate
the Fed mandat...
What can the bank do with the Excess
Reserves?
• Two Options:
– Hold at the bank with no interest
– Hold at the Fed with s...
Example of Creation of Money by
Banks
The Federal Reserve System (The FED)
• Def: the Fed is the central banker for the
nation and provides banking services to
...
The Fed’s Organizational Chart
• It is an independent agency of the federal
government.
• It consists of 12 central banks ...
The Twelve Federal Reserve Districts

© 2010 South-Western, a part
of Cengage Learning

11
What a Federal Reserve Bank Does
•
•
•
•
•
•

Controlling the Money Supply
Clearing Checks
Supervising and Regulating Bank...
How the Fed Controls the MS?
• The establishment of reserve requirements
for banks
• Buying and selling U.S. government se...
Recent Monetary Policy
• Increase in the monetary base from $828
billion at mid-year 2008 to $1.63 trillion in
early 2009 ...
How does Monetary Policy Influence
the Economy?
• Expansionary monetary policy
– Example

• Restrictive monetary policy
– ...
Money and Inflation
• Inflation: It is an increase in the general
(average) price level of goods & services in the
economy...
Monetary Policy As a Stabilization Tool
• A more expansionary monetary policy
• Stimulate output and employment

• A more ...
Aggregate Demand for Goods and
Services
• Quantity: the output of the entire economy
– Real GDP

• Price: the price level ...
Aggregate Demand Curve
• Aggregate Demand (AD) Curve: Shows the
various quantities of domestically produced
goods and serv...
Example of AD Curve
Price Level

AD
Final Goods &
Services
Why is it downward sloping
Three major reasons
1. A lower price level will increase the
purchasing power of money ( Real B...
Non-price Determinants of AD
•
•
•
•

Changes in Consumption
Changes in Investment
Changes in Government Purchases
Net Exp...
Aggregate Supply of Goods and
Services
• Short-run versus long-run
• Aggregate Supply (AS) curve: it is not a
reflection o...
Short-Run (SRAS) and Long-Run
(LRAS)Aggregate Supply
• Short- Run: some prices are set by prior
contracts and agreements
•...
SRAS
• What does the curve look like
• Example of Graph and implications
EXAMPLE OF SRAS
SRAS
Price Level

Real GDP
LRAS
• What does the curve look like
• Example of Graph and implications
Equilibrium in the Goods and Services
Market
Price Level

LRAS

AD

SRAS
Real GDP
L-R Equilibrium, Potential Output, and
Full Employment
• When L-R is met, then actual output (GDP)
equals potential GDP
• ...
What Happens When the Economy’s
Output Differs From Its L-R Potential
• Output is Greater than L-R Potential

• Output is ...
Shifts in AS
• This shift depends on if it is S-R or L-R.
• L-R changes in AS is when it is possible to
achieve and sustai...
Changes in LRAS
• Changes in resource base
• Changes in level of technology
• Institutional arrangements that affect its
p...
Changes in SRAS
• Changes in resource prices
• Changes in the expected rate of inflation
• Supply shocks
The Housing Crisis of 2008
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Monetary policy

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Monetary policy

  1. 1. Monetary Policy How is it Conducted and How Does It Affect the Economy?
  2. 2. What is Money? • Money is anything that serves as three functions: – Money as a medium of exchange – Money as a unit of account – Money as a store of value
  3. 3. What Counts as Money? • M1: the most narrowly defined MS – Measures purchasing power – M1= currency + checkable deposits • M2: adding near monies to M1 – M2= M1 +near monies – Includes passbook savings accounts – Money market mutual funds – Small time deposits
  4. 4. Fractional Reserve Banking • Def: Fractional reserve banking is a system in which banks keep only a percentage of their deposits.
  5. 5. Banker Bookkeeping • A balance sheet is a statement of the assets and liabilities of a bank at a given point in time • The balance sheet is known as the T-accounts – Liabilities- the right-hand side of the balance sheet • The amounts the bank owes to other entities – Assets- the left-hand side of the balance sheetassets are amount the bank owns • Any physical property or financial claim owned by the bank
  6. 6. Types of Reserves • Excess Reserves: The amount of checkable deposits the bank holds over the required rate the Fed mandates • Required Reserves: The amount of checkable deposits the Fed requires the bank to keep – $0 to 10.7 million – 0% – $10.7 million to $55.2 million- 3% – Greater than $55.2 million- 10%
  7. 7. What can the bank do with the Excess Reserves? • Two Options: – Hold at the bank with no interest – Hold at the Fed with some interest • Typically, banks are going to go with option two, because they earn interest off the excess reserves. • What actions can they do with the excess reserves? – Make loans or – Purchase interest-bearing assets • E.g.- Government bonds
  8. 8. Example of Creation of Money by Banks
  9. 9. The Federal Reserve System (The FED) • Def: the Fed is the central banker for the nation and provides banking services to commercial banks, other financial institutions, and the federal government. • They regulate, supervise, and they are responsible for policies concerning money.
  10. 10. The Fed’s Organizational Chart • It is an independent agency of the federal government. • It consists of 12 central banks and other financial institutions within each of the Federal Reserve districts. • Board of Governors.
  11. 11. The Twelve Federal Reserve Districts © 2010 South-Western, a part of Cengage Learning 11
  12. 12. What a Federal Reserve Bank Does • • • • • • Controlling the Money Supply Clearing Checks Supervising and Regulating Banks Maintaining and Circulating Currency Protecting Consumers Maintaining Federal Government Checking Accounts & Gold
  13. 13. How the Fed Controls the MS? • The establishment of reserve requirements for banks • Buying and selling U.S. government securities and other financial assets in the open market • The volume of loans extended to banks and other institutions • The interest rate it pays banks on funds held as reserves
  14. 14. Recent Monetary Policy • Increase in the monetary base from $828 billion at mid-year 2008 to $1.63 trillion in early 2009 to more than $2 trillion in 2010. • Lower interest rates
  15. 15. How does Monetary Policy Influence the Economy? • Expansionary monetary policy – Example • Restrictive monetary policy – Example
  16. 16. Money and Inflation • Inflation: It is an increase in the general (average) price level of goods & services in the economy. • “…more money chasing the available goods and services.” http://www.youtube.com/watch?v=t_LWQQrpSc4&featu • What happens when it gets out of control? Hyperinflation: http://www.youtube.com/watch?v=WI1i5yhwOz8
  17. 17. Monetary Policy As a Stabilization Tool • A more expansionary monetary policy • Stimulate output and employment • A more restrictive ( or contractionary) monetary policy • Reduce total demand and place downward pressure on the general level of prices
  18. 18. Aggregate Demand for Goods and Services • Quantity: the output of the entire economy – Real GDP • Price: the price level in the entire economy – Price Index: CPI, GDP deflator • Since demand in the goods and services market aggregates, then the purchases of all consumers, investors, government, and foreigners is called Aggregate Demand (AD
  19. 19. Aggregate Demand Curve • Aggregate Demand (AD) Curve: Shows the various quantities of domestically produced goods and services consumers are willing to buy at different price levels in the economy. • It shows the level of real GDP purchased by Households, government, and foreigners (net exports) at different possible price levels during a time period – Example of the Curve • What does it mean to be downward sloping? – Is this is same as individual demand?
  20. 20. Example of AD Curve Price Level AD Final Goods & Services
  21. 21. Why is it downward sloping Three major reasons 1. A lower price level will increase the purchasing power of money ( Real Balances Effect) 2. The interest rate effect 3. Domestic goods become cheaper than foreign goods (the net exports effect)
  22. 22. Non-price Determinants of AD • • • • Changes in Consumption Changes in Investment Changes in Government Purchases Net Exports
  23. 23. Aggregate Supply of Goods and Services • Short-run versus long-run • Aggregate Supply (AS) curve: it is not a reflection of changes in the relative prices of goods
  24. 24. Short-Run (SRAS) and Long-Run (LRAS)Aggregate Supply • Short- Run: some prices are set by prior contracts and agreements • Long-Run: A time period long enough that people are able to modify their behavior in response to price changes
  25. 25. SRAS • What does the curve look like • Example of Graph and implications
  26. 26. EXAMPLE OF SRAS SRAS Price Level Real GDP
  27. 27. LRAS • What does the curve look like • Example of Graph and implications
  28. 28. Equilibrium in the Goods and Services Market Price Level LRAS AD SRAS Real GDP
  29. 29. L-R Equilibrium, Potential Output, and Full Employment • When L-R is met, then actual output (GDP) equals potential GDP • Correspond with full employment of resources
  30. 30. What Happens When the Economy’s Output Differs From Its L-R Potential • Output is Greater than L-R Potential • Output is Less than L-R Potential
  31. 31. Shifts in AS • This shift depends on if it is S-R or L-R. • L-R changes in AS is when it is possible to achieve and sustain a larger rate of output. • S-R changes in one that is temporarily in its altering of production capacity
  32. 32. Changes in LRAS • Changes in resource base • Changes in level of technology • Institutional arrangements that affect its productivity and the efficient use of its resources
  33. 33. Changes in SRAS • Changes in resource prices • Changes in the expected rate of inflation • Supply shocks
  34. 34. The Housing Crisis of 2008

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