Excess reserves are deposits at Fed banks in excess of the required amount. If a bank holds excess reserves, it can loan these monies to customers. When a bank makes a loan, the borrower spends the money. The sellers of goods who received the cash deposit these funds in their banks. This action creates additional loanable funds because only a fractional amount is required by law to be held as reserves. This process of lending, spending and depositing continues until the amount of excess reserves available for lending is zero. Therefore, the amount of money created by the original amount of excess reserves is a multiple of the excess reserves. This is the deposit expansion multiplier and is equal to the reciprocal of the required reserve ratio or the inverse of the proportion of each dollar in deposits required to be on deposit at the Federal Reserve System.

The lower the reserve requirement percentage, the greater the potential money supply expansion that will result from the creation of new reserves. The fractional reserve requirement places a ceiling on potential money creation from new reserves.

d: Explain the relationship among the required reserve ratio, potential deposit expansion multiplier, and actual deposit expansion multiplier.

The “potential” deposit expansion multiplier will be reduced if some people decide to hold currency rather than deposit it into the bank. Also, the “actual” deposit expansion multiplier may be less than expected if banks refuse to loan out excess reserves. It is important to note that money is created only when banks make loans. A single bank can only lend out its excess reserves. It is the banking system as a whole that expands the money supply.

e: Explain how a central bank can use monetary tools to implement monetary policy.

The Fed sets the required reserve ratio. As the required reserve ratio drops, each dollar of excess reserves can be "multiplied" more times. In other words, if the required reserve ratio falls, the money stock rises.

The Fed’s most powerful tool is open market operations. Here, the Fed buys and sells treasury bonds, notes and bills as a way to control the monetary base. The base is equal to the currency and coin plus bank reserves. Therefore, if the Fed sells government securities, it sells a bond and receives cash in return. The individual who bought the bond must withdraw cash from his bank to pay the Fed.

The Fed sets the interest rate that it charges banks when they borrow from the Fed. This interest rate is called the discount rate. As the discount rate falls, it becomes more attractive for banks to borrow from the Fed to meet reserve requirements. So, as the discount rate falls, the money supply rises. It should be noted that borrowing from the Fed is not looked upon favorably. However, as the discount rate falls, banks will let excess reserves fall and expand their loans because it is less costly for them to turn to the Fed in case of an emergency. The discount rate thus has little impact on the supply of money.

f: Discuss potential problems in measuring an economy's money supply.

There is widespread use of the U.S. dollar outside the U.S. As much as two-thirds of U.S. currency is held abroad, this substantially reduces the reliability of M1.

The increasing availability of low fee stock and bond mutual funds has caused a shift of funds out of M2 components of the money supply.

Debit card and electronic money make it easier to transfer funds without the use of money. As the public holds less currency, reserves will accumulate in the banks causing the money supply to grow rapidly if the Fed does not take offsetting action.

2.C: Modern Macroeconomics: Monetary Policy

a: Discuss the determinants of the demand for and supply of money.

The demand schedule is downward sloping because at higher interest rates, the opportunity cost of holding money increases and people will desire to hold less money and more interest-earning assets. Alternatively, the supply of money is determined by the Fed and is independent of the interest rate.

Notice that as the Fed increases the money supply, the interest rate falls, which reduces the opportunity cost of holding money.

As inflation increases, households and businesses need more money to buy costlier goods and services. Similarly, if GDP rises indicating more goods and services are bought and sold, more money is needed to conduct the transactions.

The supply of money is determined by the monetary authorities and is not affected by changes in interest rates. Thus the supply of money curve is vertical.

b: Explain how monetary policy affects interest rates, output, and employment.

An expansionary monetary policy or a faster growth rate in the money supply will most likely be implemented by the Fed via open market operations. Remember that an easy monetary policy is implemented by buying securities on the open market. Thus Fed buying will force the prices of bonds up and their rate of return down. Therefore, expansionary policy results first in a lower real interest rate. This lower rate will spur investment and consumer demand. Hence, AD will shift to the right resulting in higher prices and increased output at least in the short run.

The resulting increase in investment spending shifts AD to the right. In the short run investment, output and prices increase with a decrease in interest rates.

c: Discuss how anticipating the effects of monetary policy can reduce the policy's effectiveness.

When policy is fully anticipated, contracts will reflect expected higher prices.? Hence, both prices and interest rates will rise rapidly to their long-run equilibrium levels, leaving output unchanged.? Many labor contracts in anticipation of inflation write escalator clauses (cost of living agreements) into the wage agreement.? These clauses adjust money wage rates upward as the price level rises.

d: Compare and contrast the impact of monetary policy on major economic variables in the short run and long run, when the effects are anticipated or unanticipated.

In the long run, an increase in the growth rate of money will be reflected fully in the price level. At the same time, individuals will begin to build expectations regarding future inflation. When inflationary expectations are revised upward, the nominal interest rate also rises. (Remember that the nominal rate equals the real rate plus expected inflation). Don't be confused. Just remember that, given expansionary monetary policy, the real interest rate falls in the short-run and the nominal rate rises in the long run.

Modern analysis indicates that the long run effect of rapid monetary growth differs from the short run effects of an unanticipated shift. In the long run, the major consequences of rapid monetary growth are inflation and higher nominal interest rates. Rapid monetary growth will neither reduce unemployment nor stimulate real output in the long run.

e: Identify the components of the equation of exchange and discuss the implications of the equation for monetary policy.

The quantity theory of money states that an increase in the money supply will be reflected exclusively by an increase in prices. To fully explain this theory, we need to define the velocity of money. Velocity is the average number of times per period each dollar is used to buy goods and services (velocity = GDP/money). Therefore, the money supply multiplied by velocity must equal nominal GDP. If we break GDP into the price level and its real output component (price x real output), the following identity (called the equation of exchange) will hold:

(Money)(Velocity) = Nominal GDP = (Price)(Real Output)

MV = PY

The original proponents of the quantity theory felt that velocity and output are determined by institutional factors other than the money supply and were thus constant. Therefore, if the money supply increases while velocity and quantities are fixed, prices must rise. On the exam, remember that MV = PY and that V and Y are fixed. Knowing this, the answer will jump right out at you. On the exam, you may also be given nominal GDP instead of PY, so remember nominal GDP and PY are the same thing. (Y is the symbol for real GDP, and nominal GDP is equal to real GDP times the price level.)

2.D: Stabilization Policy, Output, and Employment

a: Explain the role expectations play in determining the effectiveness of fiscal and monetary policy.

Knowing the difference between an economic adjustment process when changes in supply/demand are fully anticipated and when they are unanticipated or unexpected is important. The two adjustment paths are very different from one another. If an increase in the growth rate in the supply of money is fully anticipated, then prices, wages and interest rates will rise quickly in response to an increase in the money supply. However, if the increase in the money supply catches the economy by surprise, then there will be a temporary but real increase in output and drop in unemployment since decision makers will at first think the increase in the money supply is an increase in demand.

b: Contrast the adaptive expectations hypothesis and the rational expectations hypothesis.

Adaptive and rational expectations differ in two important ways:

How long it takes people to adjust to a change in the economy

The probability of systematic forecasting errors

Supporters of adaptive expectations feel that ordinary people don’t have the time, knowledge or interest to obtain and process the information necessary for rational expectations to work. Therefore, if the inflation rate begins to rise, people will be slow to factor higher future inflation rates into their decisions. Supporters of rational expectations respond that a wide range of experts research the issues and disseminate their findings to the public, enabling the public to make informed decisions.

c: Explain a non-activist strategy for monetary policy and fiscal policy.

Those who believe in rational expectations and/or the existence of timing problems generally take a nonactivist view of stabilization policy. They believe that greater economic stability will result if the government avoids discretionary economic policy. Regarding monetary policy, nonactivists advocate either:

maintaining a stable money supply growth of perhaps 3 percent per year to match the long-run growth potential of the economy, or

managing the money supply with a focus on maintaining stable prices. For fiscal policy, nonactivists advocate pursuit of a balanced budget over the life of a business cycle. Unfortunately, implementing such a policy would be very difficult as there is no consensus on how to accomplish this.

There appears to be a consensus view emerging about several aspects of economic stabilization.

Price stability should be the focus of monetary policy.

In the long run, demand stimulus cannot reduce the unemployment rate below the natural rate.

Governments should avoid wide swings in both monetary and fiscal policy.

It is impractical to use discretionary fiscal policy as a stabilization tool in countries like the U.S., which have checks and balances that make quick implementation impossible.

2.E: The Phillips Curve: Is There a Trade-off between Inflation and Unemployment?

a: The candidate should be able to describe the Phillips curve and discuss the trade-off between unemployment and inflation in the context of expectations.

The early view of the Phillips curve depicts the relationship between inflation and unemployment. The relationship is inverse in nature: when inflation is high (wages are high), unemployment is low and vice versa. The graph illustrates the standard convex Phillips curve. This trade-off between inflation and unemployment is consistent with adaptive expectations. With adaptive expectations, individuals underestimate inflation when inflation is accelerating. When inflation is underestimated, actual inflation will prove to be unexpected. With unexpected inflation, real wages will be reduced for a time while the price level is rising. Lower real wages induce firms to hire more labor--hence the unemployment rate falls. You may be wondering why the real wage falls as prices are rising. Remember that the real wage is equal to the nominal wage divided by the price level (W/P). If the denominator rises and nominal wages are unchanged, the whole term falls in value. The reduction in real wages occurs because the higher prices were unexpected. Had the high prices been fully anticipated, individuals would have demanded a higher nominal wage (W) to compensate for rising prices (P), leaving the real wage (W/P) unchanged (no change in unemployment). After individuals realize that prices have risen, they will demand a higher nominal wage and unemployment will return to normal.

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