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Unformatted text preview: Chapter 14 Monetary Policy and the Federal Reserve System Learning Objectives I. Goals of Chapter 14 A) Look at how the nation’s money supply is determined B) Explore the question: How should the central bank conduct monetary policy? 1. Should the central bank offset cyclical fluctuations? 2. Should the central bank follow simple rules? 3. How should policy-making institutions be designed? II. Notes to Fourth Edition Users A) Section 14.2 has been modified to reflect the new procedures for discount loans that the Fed began to use in 2003 B) A new application, “How the Federal Reserve’s Response to the 2001 Recession Affected Short-Term and Long-Term Interest Rates” has been added Teaching Notes I. Principles of Money Supply Determination (Sec. 14.1) A) Three groups affect the money supply 1. The central bank is responsible for monetary policy 2. Depository institutions (banks) accept deposits and make loans 3. The public (people and firms) holds money as currency and coin or as bank deposits B) The money supply in an all-currency economy 1. A trading system based on barter is inconvenient 2. The creation of a central bank to print money can improve matters a. The central bank uses money it prints to buy real assets from the public; this gets money in circulation b. People accept the paper money if they believe other people will accept it in exchange c. The government often decrees that the paper money is legal tender , so that it can be used to pay off debts and the government will accept it for tax payments d. The central bank’s assets are the real assets it buys from the public; its liabilities are the paper money it issued e. That money is called the monetary base, or high-powered money 3. In an all-currency economy, the money supply equals the monetary base Chapter 14 Monetary Policy and the Federal Reserve System 309 C) The money supply under fractional reserve banking 1. As an economy becomes more sophisticated financially, banks develop 2. If currency is easily lost or stolen, people may want to hold all their money in bank deposits and none in currency a. In this case, the consolidated balance sheet of banks has assets of all the currency in the economy and liabilities consisting of all the bank deposits b. The balance sheet of the central bank is unchanged from the case in the all-currency economy 3. The currency that banks hold is called bank reserves a. When bank reserves are equal to deposits, the system is called 100% reserve banking b. To make money, banks would have to charge fees for deposits, since they earn no interest on reserves 4. Rather than holding reserves that earn no interest, suppose a bank lent some of the reserves a. It could do this, since the flow of money in and out of the bank is fairly predictable and only a fraction of reserves are needed to meet the need for outflows b. If the bank needs to keep only 25% of the amount of its deposits on reserve to meet the demand for funds, it can lend the other 75%...
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