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Chapter 15 Monetary
Our Current Events Internet Library has an interesting economics section.
I. The Demand for Money
A. Transaction D, Dt results because people hold money, often in a money market account, to use as a medium of exchange.
B. Asset Demand, Da results because people accumulate money, often held in an investment account, to buy assets.
C. The demand for money, Dm= Dt + Dt
D For more information visit Demand for money - Wiki
II. Monetary policy
A. Monetary policy is the regulation of the money supply to affect interest rates and economic activity.
B. It is part of, but not the focal point of Keynesian economics.
C. Objective is noninflationary full employment.
D. Affecting interest rates and to change investment thus affecting economic activity is one goal of the Fed.
1. Controlling reserve requirement may affect the money supply which may affect interest rates
a. Reserve requirement is the amount of demand deposits that must be kept in cash with the Federal Reserve or in the bank.
b. Often expressed as a percent called the reserve ratio.
c. Excess reserve can be loaned as demand deposits.
d. Excess reserves determine the potential money supply (M1).
2. Changes interest rates change investment causing a change in AD which changes economic activity.
a) Increasing the money supply may lower interest rates. increasing investment which increases AD which causes an increase in Real GDP.
b) Decreasing the money supply may increase interest rates lowering investment which increses AD which causes an increase in Real GDP.
c) Interactive quiz on using monetary policy from reffonomics.com
a. With Graphs
b Without graphs
3. Dollar values on this page are representative of amounts prevalent during the late 1990's (billions of dollars).
E. Affecting the non-investment components of aggregate demand
1. Lower interest rates also increase C, G, and XN
a. Consumption increases as credit purchases become cheaper.
b. Refinancing existing debt at lower interest rates by individuals, businesses, and governments frees funds for spending.
c. Lower interest rates also decrease the international value of the dollar as investors buy (demand) other currencies to
earn more interest. The lower dollar increases XN as U.S. goods are less expensive and foreign goods more expensive.
2. Higher interest rates have an opposite affect
F. Federal reserve balance sheet.
1. Assets are held in securities and loans to commercial banks.
2. Liabilities and net worth re the reserves of commercial banks, treasury deposits, federal reserve notes, and
G. A Sokratic Dialogue: Liquidity Preference, Loanable Funds, and European Hedge Funds that Fear the Collapse of U.S. Treasury Bond Prices
Brad DeLong, This article is very complex and not for the faint of heart. 6/18/11
III. Types of monetary policy
A. Quantitative controls affect the money supply.
1. Required Reserve Ratio
a. Lowering the reserve ratio creates excess reserves which banks may loan as newly created money. This is expansionary.
b. Raising the reserve ratio eliminates excess reserve so banks can not renew loans removing money and causing
2. Open-market operations
a. Buying and selling of U.S. government bonds by the Federal Reserve from banks or in the open market to change
excess reserves thus affecting the supply of M1 and interest rates is the primary tool.
b. Buying bonds is expansionary.
1) When buying from banks, the Federal Reserve pays with reserves providing excess reserves banks can loan as
2) When buying in the open market, increased demand from the Federal Reserve pushes up prices sellers receive,
lowering the effective interest sellers pay.
c. Selling bonds contracts the economy.
d. Review of Valuing bonds
1) Suppose you buy a twenty year, $10,000 bond paying 5% per year at face value of $10,000. Face value is called par value.
a) A few years go by and you need money and one choice is to sell the bond.
b) If interest rates on this type bond have gone down, people will be very anxious to buy, demand, will be
high pushing price up and your will receive more than $10,000.
c) If rate shave gone down, no one will give you $10,000, demand will be low, so if you need the money, you will sell for
less, below par.
d) You can hold for twenty years and get par and get the money some where else.
2) Therefore, interest rates and bond values (prices) go in the opposite direction, if interest rates down, old bond price up
because they are at the old higher rate.
3) This is called the interest rate risk for bonds. Other risks have to do with issuer default and monetary inflation.
e. Federal Open Market Committee minutes make interesting reading.
f. It is the most powerful of the four tools.
3. Discount rate
a. This is the rate charged by the Federal Reserve for loans to member banks.
b. It strongly affects the prime interest rate paid by a bank's best customers.
1) Lower the rate to expand economy as interest rates decrease.
2) Raise the rate to contract economy as interest rates increase.
3) Another important interest rate is the federal funds rate which is the rate at which banks loan funds to
4. Term Auction Facility
a. Initiated in 2007, it allows banks to add to their reserves at low rates.
b Done to increase bank liquidity which was low because of a loss in reserve caused by a housing crisis.
B. Other controls affect the actions of market participants.
1. Moral suasion or jawboning
a. This social pressure by influential people to encourage specific people to act in the public interest.
b. It is used to influence public opinion and political attitudes.
c. An example is when the Chairman of Board of Governors makes his Semiannual Report to Congress on the economy and
2. Margin requirements, the down payment required on stocks which is now 50%, is seldom changed.
3. Consumer credit controls, on items such as credit cards, work so well it is seldom used.
4. The Federal Funds Rate
a. Most controllable interest rate
b. Targeted by monetary policy
c. It is the overnight interest rate banks with excess fed reserve charge each banks short of fed reserve to keep the system
d. By controlling reserves, the fed controls this rate.
e. This allows them some control over short-term rates.
f. For more information visit Federal funds rate - Wikipedia, the free encyclopedia
V. Effectiveness of
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