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Netw Rks Reading Essentials and Study Guide NAME ________________________________________ DATE _______________ CLASS _________ Reading Essentials and Study Guide netw rks Chapter 16: Monetary Policy Lesson 2 Monetary Policy ESSENTIAL QUESTION How does the government promote the economic goals of price stability, full employment, and economic growth? Reading HELPDESK Academic Vocabulary explicit openly and clearly expressed Content Vocabulary fractional reserve system system requiring financial institutions to set aside a fraction of their deposits in the form of reserves legal reserves currency and deposits used to meet the reserve requirements reserve requirement formula used to compute the amount of a depository institution’s required reserves member bank reserve (MBR) reserves kept by member banks at the Fed to satisfy reserve requirements excess reserves financial institution’s cash, currency, and reserves not needed for reserve requirements; potential source of new loans monetary policy actions by the Federal Reserve System to expand or contract the money supply to affect the cost and availability of credit interest rate the price of credit to a borrower easy money policy monetary policy resulting in lower interest rates and greater access to credit; associated with an expansion of the money supply tight money policy monetary policy resulting in higher interest rates and restricted access to credit; associated with a contraction of the money supply open market operations monetary policy in the form of U.S. Treasury bills, or notes, or bond sales and purchases by the Fed discount rate interest rate that the Federal Reserve System charges on loans to the nation’s financial institutions prime rate best or lowest interest rate commercial banks charge their customers monetarism school of thought stressing the importance of stable monetary growth to control inflation and stimulate long-term economic growth quantity theory of money hypothesis that the supply of money directly affects the price level over the long run wage-price controls policies and regulations making it illegal for firms to give raises or raise prices without government permission Copyright © McGraw-Hill Education. Permission is granted to reproduce for classroom use. classroom for reproduce to is granted Permission Education. © McGraw-Hill Copyright 1 ECON16_TX_TC_C16L02_wsresg.indd 1 06/05/15 10:04 PM Program: Texas-Economics Component: ECON-RESG PDF Pass Vendor: SPi Global Grade: H-School NAME ________________________________________ DATE _______________ CLASS _________ Reading Essentials and Study Guide netw rks Chapter 16: Monetary Policy Lesson 2 Monetary Policy, Continued TAKING NOTES: Key Ideas and Details As you read this section, complete a graphic organizer like the one below to describe the effects of each monetary policy discussed. Monetary Policy What Is It? What Is Its Effect? reserve requirement open market operations discount rate Fractional Reserves and Deposit Expansion Guiding Question How do fractional reserves allow the money supply to grow? use. classroom for reproduce to is granted Permission Education. © McGraw-Hill Copyright If we want to understand how monetary policy works, we must first understand how the fractional reserve system allows the money supply to easily grow or shrink. The fractional reserve system requires banks to keep part of their total deposits as legal reserves. Banking systems all over the world keep reserves. It is the foundation of banking in the United States. Whenever a bank accepts a deposit, it must keep some of it as legal reserves. Legal reserves are coins and currency that banks hold in their vaults, plus deposits at the Fed. The size of the reserves depends on the reserve requirement, which is the percentage of every deposit that must be set aside as legal reserves. The bank can then lend out the rest. The result is a money supply that is several times larger than the original deposit. Banking with Fractional Reserves Let’s use an example from Chapter 10 to see how a fractional reserve system works. A depositor named Kim opened a demand deposit account (DDA) by depositing $1,000 in a bank. The bank must follow a 20 percent reserve requirement. If we assume that no one else has any money, the size of the entire money supply is also $1,000. Figure 16.2 shows the monetary expansion process that happens in this situation. • Monday—The bank must set aside $200 of Kim’s deposit because of the 20 percent reserve requirement. The bank must keep the $200 as vault cash or as a member bank reserve (MBR). An MBR is a deposit a member bank keeps at the Fed to satisfy reserve requirements. 2 ECON16_TX_TC_C16L02_wsresg.indd 2 06/05/15 10:04 PM Program: Texas_Economics Component: ECON-RESG PDF Pass Vendor: SPi Global Grade: H-School NAME ________________________________________ DATE _______________ CLASS _________ Reading Essentials and Study Guide netw rks Chapter 16: Monetary Policy Lesson 2 Monetary Policy, Continued The remaining $800 is excess reserves. These are legal reserves left over after the reserve requirement. The $800 is what the bank can loan out. It represents the bank’s lending power. At the end of Monday, the total money supply in the hands of the public equals Kim’s $1,000 checking account. • Tuesday—The bank lends its $800 excess reserves to Bill. Bill decides to take the loan as a demand deposit account (DDA) so that the cash never leaves the bank. But the bank still treats Bill’s DDA as a new deposit, so it has to set aside 20 percent, or $160, as a reserve. This leaves $640 of excess reserves for the bank to lend to someone else. By the end of Tuesday, the total money supply in the hands of the public amounts to $1,800. This is the sum of Kim’s and Bill’s DDAs. • Wednesday—Maria enters the bank and borrows the $640 excess reserves. If she also takes the loan as a DDA, the bank treats it as a new $640 deposit. Then the bank would have to set aside 20 percent as a required reserve. This leaves $512 of excess reserves. By the end of the day, the money supply in the hands of the public (DDAs and cash) has grown to $2,440. This is the sum of the DDAs owned by Kim, Bill, and Maria. The $2,440 result would be exactly the same if Maria had borrowed the bank’s $640 excess reserves in cash. Then the money supply in the hands of the public would have been the $1,800 in Kim’s and Bill’s checking accounts, plus Maria’s $640. Limits on Monetary Expansion The money expansion process will now stop temporarily until the $640 cash returns to the bank as a deposit. If Maria spends the money and the person who receives it opens a new deposit, the expansion process can continue. The growth in Figure 16.2 will go on as long as the bank has excess reserves to lend and as long as lenders deposit part or all of that money. As long as every dollar of DDAs is backed by 20 cents of legal reserves, the total amount of DDAs would be: Total MBRs $1,000 = = $5,000 Reserve Requirement .20 People will always keep some cash, so the maximum size of the DDAs may never reach $5,000. But fractional reserve banking allows the sum of everyone’s DDAs to grow several times larger than the original deposit. Reading Progress Check Describing What happens to the monetary expansion if people decide to hold cash in their pockets? Copyright © McGraw-Hill Education. Permission is granted to reproduce for classroom use. classroom for reproduce to is granted Permission Education. © McGraw-Hill Copyright 3 ECON16_TX_TC_C16L02_wsresg.indd 3 06/05/15 10:04 PM Program: Texas-Economics Component: ECON-RESG PDF Pass Vendor: SPi Global Grade: H-School NAME ________________________________________ DATE _______________ CLASS _________ Reading Essentials and Study Guide netw rks Chapter 16: Monetary Policy Lesson 2 Monetary Policy, Continued Conducting Monetary Policy Guiding Question What tools does the Fed use to expand and contract the money supply? One of the most important jobs of the Fed is to direct monetary policy. Monetary policy are actions by the Fed that cause changes in the money supply to affect the availability and cost of credit. This affects interest rates and impacts economic activity. How Monetary Policy Works Monetary policy is based on supply and demand. Figure 16.3 shows that the demand curve for money has the usual shape, which shows that people will demand more money when the interest rate is low. The interest rate is the price of credit for a borrower. But the supply curve does not have its usual shape. Instead, its vertical slope shows that the supply of money is fixed at any certain time. The Fed’s monetary policy changes interest rates by changing the size of the money supply. The Fed increases the money supply under an easy money policy. This causes interest rates to fall. This kind of policy stimulates the economy because people and businesses borrow more at lower interest rates. You can see this in Panel A. The larger money supply lowers the rate from 10 to 8 percent. The Fed limits the size of the money supply under a tight money policy. You can see this in Panel B. Shrinking the money supply drives up the cost of borrowing from 10 to 12 percent. This slows borrowing and economic growth because higher interest rates normally cause people to borrow and spend less. The Fed can use three major tools to drive monetary policy. Each tool works in a different way to change the amount of excess reserves. Excess reserves are the amount of money a bank can lend to others. The Reserve Requirement The first tool of monetary policy is the reserve requirement.
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