ECON102 Study Guide
Unit 6: Monetary Policy and Various Complexities behind Macroeconomic Policies
6a. Compare and contrast as well as discuss fiscal policy and monetary policy
- Name some additional similarities between fiscal and monetary policy.
- What economic agency is responsible for implementing fiscal policy in the United States?
- What economic agency is responsible for implementing monetary policy in the United States?
- What is the difference in lags between fiscal and monetary policy?
- Is fiscal or monetary policy better for achieving a country's economic goals?
Governments use fiscal and monetary policy to influence the country's real GDP and price levels. They use expansionary fiscal policies and expansionary monetary policies to shift the aggregate demand curve to the right. They use contractionary fiscal policies and contractionary monetary policies to shift the aggregate demand curve to the left.
Responses to the following questions will help articulate some key differences between fiscal and monetary policy.
6b. Define the money multiplier, and explain the money creation process
- How do we calculate the total change in the money supply by using an initial deposit value and the money multiplier?
- How can banks increase or reduce money creation?
- How do individuals participate in the money creation process? Can they influence the final outcome?
- What kinds of policies can government and the central bank impose to affect the money multiplier?
To understand the process of money creation, you should study the structure of a bank's balance sheet. Notice the reserves category under the assets side of the balance sheet. Banks are required to keep a certain percentage of their deposits in the form of reserves (or required reserves). Bankers call any reserves it holds in excess of the required reserves, excess reserves.
Study the money creation process by following the path of money through the banking system from an initial new deposit. Analyze the bank's balance sheet and how it reflects the money flow.
For example, a bank splits an initial deposit into required and excess reserves. Excess reserves become a source for money lending. Once the bank lends this money out, the next bank in the banking system (or possibly the same bank) will categorize it as a new deposit, and so on. When the same money circulates between deposits and loans multiple times, it leads to a multiplication of money. The money multiplier (or deposit multiplier) is a variable that helps us measure the total amount of money creation from the initial deposit.
Money Multiplier = 1 / Required Reserves Ratio
As you review this material, think about factors that could affect the money creation process.
To review the money multiplier and money creation, see:
- The Banking System and Money Creation
- Overview of Fractional Reserve Banking
- Full Reserve Banking
- Simple Fractional Reserve Accounting (Part 1)
- Simple Fractional Reserve Accounting (Part 2)
- Fractional Reserve Banking and Money Creation Quiz
- Weaknesses of Fractional Reserve Lending
6c. Distinguish between the types of money (i.e., between commodity money and fiat money), identifying examples of each
- Define the three functions of money: medium of exchange, unit of account, and store of value.
- Define commodity money and fiat money.
- What kind of money describes most major currencies, such as the dollar, Euro, rupee, yen, etc.?
- Are these currencies backed by gold or another precious commodity?
An item needs to serve three functions to be suitable for use as money: a medium of exchange, unit of account, and store of value.
Commodity money describes money that has its own intrinsic value. For example, prisoners may use cigarettes as a form of money or payment. Fiat money does not have intrinsic value. It is backed solely by the trust the money holder places on the institution that issues it.
6d. Define money supply, and its related definitions (M1 and M2); draw and interpret a money demand curve, and explain how changes in other variables may lead to shifts in the money demand curve
- Define the M1 and M2 categories of money.
- Define liquidity.
- Is the M1 or M2 monetary category more liquid?
- Define money supply.
- What is the shape of the money supply curve?
- Name the factors that shift the money supply curve.
- Define the three main reasons people demand money: transactions, precautionary, and speculative reasons.
- How does a change in the interest rate influence the demand for money, or the motivation people have to hold onto money or cash?
- How does money demand change with fluctuations in real GDP, the price level (inflation or deflation), expectations, transfer costs, and preferences.
The money supply describes the total quantity of money in the economy. Figure 10.5 is a graph of the money demand curve. Note the relationship between the variables: the quantity of money on the horizontal axis and the interest rate on the vertical axis.
Money demand represents the relationship between the quantity of money people demand, or want to hold onto as ready cash or in a readily-available, non-interest-bearing account (for transactional, precautionary, or speculative reasons), and the opportunity cost of money, or interest rate (what you would earn if you invested your money into an interest-bearing account).
The Demand Curve for Money
The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope shows a negative relationship between the quantity of money demanded and the interest rate.
Money Market Equilibrium
- How does a shift of the money demand curve, due to changes in factors of money demand, affect the equilibrium interest rate?
- What about shifts in the money supply curve?
In Figure 10.8, we put money demand and money supply together on the same graph to analyze the relationship between the money market and equilibrium interest rate. The supply curve for the money supply is a vertical line because it represents the fixed, total amount of money that exists in various bank deposits or reserves, as determined by the U.S. Federal Reserve. The market for money is in equilibrium when the quantity of money demanded equals the total quantity of money supplied. In this figure, equilibrium occurs at interest rate r.
Money Market Equilibrium
To review the money supply and the money demand curve, see:
- What Is Money?
- Demand, Supply, and Equilibrium in the Money Market
- Interest as Rent for Money
- Money Supply and Demand Impacting Interest Rates
6e. Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity
- Define bond, face value, coupon rate, bond market, secondary market.
- What is the difference between the interest rate and the coupon rate of bonds?
- How does an increase in government borrowing (reflected as a new issue of bonds) affect the economy's interest rate?
- How do bonds compare with stocks?
The bond market is a financial market that allows firms and government to borrow money directly from the public without going through financial intermediaries, such as banks. When an institution issues and sells a bond, it is essentially borrowing an amount of money (the bond's face value), at a predetermined interest rate (the bond's coupon rate), for a specific period of time (the bond's maturity date).
Once bonds are issued, investors can resell them on the secondary market. The demand and supply of bonds in the bond market determines the equilibrium price of bonds.
The bond price is negatively related to the interest rate. This means that when the price of a bond increases, the bond yield will decrease. This occurs because bonds have a fixed face value and a fixed coupon rate (if they have a coupon rate at all). Paying more for an existing bond will reduce its rate of return.
The Bond Market
The equilibrium price for bonds is determined where the demand and supply curves intersect. The initial solution here is a price of $950, implying an interest rate of 5.3 percent. An increase in borrowing, all other things being equal, increases the supply of bonds to S2 and forces the price of bonds down to $900. The interest rate rises to 11.1 percent.
6f. Explain the functions of a bank, and describe a bank's balance sheet
- Define commercial bank.
- Why do banks consider checkable deposits a liability?
- What happens to a bank when loans going bad during a financial crisis?
- What does it mean when a bank's net worth is too low?
- Describe the relationship among assets, liabilities, and net worth?
A bank is a financial intermediary – an institution that facilitates the flow of money among borrowers and lenders. When you deposit money into a savings or checking account you are essentially lending your money to a bank. In turn, the bank will lend your deposit out to other individuals and businesses in the form of a loan. The bank charges these individuals and businesses interest for the privilege of being able to borrow money.
The bank reimburses you with a portion of the proceeds it earns from its borrowers, in the form of an interest rate. A higher interest rate serves as a form of encouragement – it encourages you to make more deposits so the bank can offer even more loans, and earn even more money).
This table illustrates the components of a bank's balance sheet.
The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012
Liabilities and Net Worth
This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, in January 2012.
6g. Explain the primary functions of the Federal Reserve, and describe the three tools it can use as part of monetary policy
- Define reserve requirement, the discount rate, and open market operations.
- How does the U.S. Federal Reserve use each of these three monetary policy tools to affect the money supply?
- Which of these three monetary policy tools does the U.S. Federal Reserve use most widely?
- How does the U.S. Federal Reserve structure support its independence from politics and government?
The U.S. Federal Reserve (the Fed) serves as the central bank for the United States government. The system includes 12 regional banks located in different regions of the country. We do not consider the Federal Reserve System part of the federal government. It is a semi-private institution that is not financed nor regulated by the U.S. government.
As with most central banks, the U.S. Federal Reserve performs the following functions:
- Serves as the central bank for the federal government;
- Serves as the bank for its member banking institutions;
- Regulates banks in the United States;
- Conducts U.S. monetary policy;
- Oversees and stabilizes the U.S. financial system.
The U.S. Federal Reserve has three main tools at its disposal to control the U.S. money supply: the reserve requirement, the discount rate, and open market operations.
To review the U.S. Federal Reserve system and the monetary policy tools, see:
- The Federal Reserve System
- Everyday Economics
- Federal Reserve Statistical Release
- Pitfalls for Monetary Policy
6h. Explain how the bond market works, and discuss the relationship between bond prices and interest rates
Review how the bond market works and the relationship between bond prices and interest rates in learning outcome 6e above.
6i. Describe the relationships among changes in money demand or money supply, in the interest rate, in the prices of stocks and bonds, in aggregate demand, in real GDP, and in the price level
- What steps would you follow to analyze contractionary monetary policy?
The most widely used monetary policy tool of the U.S. Federal Reserve is open market operations. Be sure to review how the U.S. Federal Reserve affects the following interconnected markets: bond market, money market, goods and services market, foreign exchange market.
The figure below illustrates the effects the U.S. Federal Reserve will have on these four markets when it employs an expansionary monetary policy to close a recessionary gap.
Expansionary Monetary Policy
The U.S. Federal Reserve starts the process by buying government bonds on the bond market. This creates an increase in demand for bonds on the bond market – a shift of demand for bonds to the right. The increased demand causes bond prices to increase, and interest rates to decrease (bonds prices and the interest rate are negatively related). See panel b.
When the U.S. Federal Reserve buys bonds, it essentially adds reserves in the banking system (the U.S. Federal Reserve prints the extra money it needs to buy the bonds out of thin air, or simply adds the additional assets it buys to its balance sheet). This is graphically illustrated in the money market as a shift of the money supply curve to the right, and a decrease in the equilibrium interest rate. See panel c.
Lower interest rates encourage households and businesses to spend money (especially spending on credit). The consumption and investment components of aggregate demand increase, causing a shift of the aggregate demand curve to the right in the goods and services market. The price level rises in equilibrium. See panel a.
Finally, the higher price level makes domestic goods and services appear more expensive to foreigners, which discourages U.S. exports. At the same time, foreign goods appear relatively cheaper, which encourages Americans to increase imports. These effects put pressure on the value of the dollar as follows: demand for dollars decreases and the supply of dollars increases, leading to a cheaper dollar in the foreign exchange market. See panel d.
Expansionary Monetary Policy to Close a Recessionary Gap
In Panel (a), the economy has a recessionary gap YP − Y1. An expansionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed buys bonds, shifting the demand curve for bonds to D2 and increasing the price of bonds to Pb2. By buying bonds, the Fed increases the money supply to M′ in Panel (c). The Fed's action lowers interest rates to r2. The lower interest rate also reduces the demand for and increases the supply of dollars, reducing the exchange rate to E2 in Panel (d). The resulting increases in investment and net exports shift the aggregate demand curve in Panel (a).
6j. Identify and discuss domestic policies that contribute to economic growth
Review domestic policies that contribute to economic growth in learning outcome 6i above.
6k. Explain the linkages among income, consumption, and net investment, relating them to economic growth
- Define the sources of economic growth: labor, capital, raw materials (land), and entrepreneurship.
- How does a small difference in growth rates among countries lead to large differences in total production over an extended period of time?
- How does an increase in saving contribute to increased investment?
- Will a household's decision to consume less and save more (increase total investment) enhance a country's long-term economic growth?
Economic growth refers to the national increase in potential output, which is often determined by the country's available resources: labor, capital, raw materials (land), and entrepreneurship.
Countries often generate long-term economic growth by increasing investment in physical and human capital. Worker productivity can increase via improvements in technology and education, which leads to higher output.
Consider a typical household decision regarding how to divide income between spending and saving.
6l. Describe how crowding out occurs and its connections to fiscal and monetary policies
- Define crowding out.
- Why does an increase in government borrowing increase interest rates? Think about the effect of increased demand for loanable funds on the incentives of lenders.
The crowding-out effect is a negative effect of expansionary fiscal and monetary policy. Expansionary fiscal policy not only increases the government budget deficit, but causes interest rates to increase which can squeeze, reduce, or "crowd out" private investment. Higher interest rates will hurt businesses that borrow capital to expand or sustain their operations.
To review crowding out, see Government and Fiscal Policy.
6m. Discuss the arguments for side supply approaches to economic growth separating macroeconomic and microeconomic variables
- How does a rightward shift in the aggregate supply curve affect real GDP and the price level?
- What type of fiscal policies promote an increase in aggregate supply?
- Describe some positive and negative elements of this type of policy.
- Name some examples of past U.S. governments that promoted supply-side policies.
Supply-side economics describes a fiscal policy that promotes increasing the aggregate supply curve.
To review, see Supply-Side Economics.
6n. Summarize the bases of the philosophical differences between the Classics and Keynesians
- Describe the classical school of macroeconomic theory that preceded the U.S. Great Depression (1929–1933)?
- How did the Great Depression shatter these classical macroeconomic beliefs?
- Define and describe how the Keynesian school of macroeconomic theory differs from the preceding classical school.
- What policy prescriptions did classical and Keynesian economists promote?
- What economic thought prevailed during the economic expansion in the 1960s?
- How can we reconcile the existence of contradictory schools of economic thought?
Economic events during the past century have influenced how economists analyze the effects the economy has on a country's real GDP and price level.
To review classical and Keynesian thought, see A Brief History of Macroeconomics Thought and Policy and The Phillips Curve.
6o. Describe the key components of the monetarist perspective
Review the key components of the monetarist perspective in learning outcome 6n above.
6p. Explain why the Phillips curve is vertical in the long run
Review the short-run Phillips curve in Unit 3. In the long run, the economy operates at its full employment levels. The unemployment rate includes only structural and frictional unemployment. Consequently, the long-run aggregate supply curve is vertical at the potential level of real GDP. This means that in the long-run, real GDP is fixed and the unemployment rate is also fixed at the natural rate of unemployment.
Changes in aggregate demand can only lead to changes in the price level with no permanent effects on real GDP. Consequently, the long run the Phillips curve is vertical at the natural rate of unemployment and shows no trade-off between inflation and unemployment.
The Phillips Curve in the Long Run
Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with price level of P0, the same as in the last period. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. If the aggregate demand curve shifts to AD2, in the short run output will increase to Y1, and the price level will rise to P1. In Panel (b), the unemployment rate will fall to U1, and the inflation rate will be π1. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2, and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the long-run, the Phillips curve is vertical.
Unit 6 Vocabulary
- Balance sheet
- Bond market
- Central bank
- Classical economics
- Commercial bank
- Commodity money
- Contractionary monetary policy
- Coupon rate
- Crowding out
- Deposit multiplier
- Discount rate
- Excess reserves
- Expansionary monetary policy
- Face value
- Federal funds rate
- Federal reserve
- Fiat money
- Financial intermediary
- Fiscal policy
- Fractional reserve banking system
- Interest rate
- Keynesian economics
- Long-run Phillips curve
- Maturity date
- Medium of exchange
- Monetarist economics
- Money demand
- Money multiplier
- Money supply
- Monetary policy
- Net worth
- Open market operations
- Phillips curve
- Required reserves
- Required reserves ratio
- Secondary market
- Store of value
- Unit of account