Topic 09 - Monetary Policy

Topic 09 - Monetary Policy - BUAD 350 Topic 08 Monetary...

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BUAD 350 Topic 08 – Monetary Policy and the Fed
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Keywords The Process of Money Creation The Conduct of Monetary Policy
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Module Objectives Understand the process of money creation Define the major monetary aggregates Derive the money multiplier Discuss the instruments of monetary policy Understand the reasons for bank failures Understand the key debate on the conduct of monetary policy Explore non-neutrality Examine theories and evidence Study policy implications: rules versus discretion
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Money Creation: Monetary Aggregates Currency held by the public is denoted: C Monetary Base (B) = Currency (C) + Bank Reserves (R) M1 = Currency (C) + Checkable Deposits (D) M2 = M1 + Long-Term Deposits Broader aggregates are less “liquid”
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Money Creation: Fractional Reserve Banking Functions of banks: Match borrowers and lenders Pool “liquidity” risks Create money 100% reserve banking: banks are required to hold all deposits as reserves (R = D). Banks do not affect money supply (M1 = B = C + R) Fractional reserve banking: banks are required to hold a fraction ( rr ) of deposits as reserves. Does this imply R/D = rr ?
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Money Creation: The Money Multiplier Under the fractional-reserve system, a dollar of cash injected by the Fed will increase as it propagates through the banking system A dollar injected becomes: 1 + (1- rr ) + (1- rr ) 2 + (1- rr ) 3 + … = 1/ rr Since 1/ rr > 1, the banking system creates money. It does not create wealth. Why?
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Money Creation: The Money Multiplier (contd.) This assumes people deposit all money they get. In reality, preference for cash versus deposits captured by currency-deposit ratio ( c ) We saw: M1 = C + D, and B = C + R Use these to get: M1 = m B, where m is the money multiplier Thus the money multiplier is: m = ( c + 1) / ( c + rr )
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Money Creation: The Money Multiplier (contd.) Therefore, money supply is affected by: B: Directly controlled by the Fed. Higher the base, higher the money supply, M, is. rr : Low rr yields high M . Fed policy and bank behavior determine reserve-to-deposit ratio. c : Lower c implies higher M. Determined by household and firm behavior.
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Money Creation: Instruments of Monetary Policy The Federal Reserve System controls the monetary base: The Fed began operation in 1914 for the purpose of eliminating severe financial crises There are 12 regional Federal Reserve Banks: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco, which are owned by private banks within each district The system is made up of: Chairman, Board of Governors, Member Banks, and the FOMC
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Figure 14.5 Location of the Federal Reserve Banks
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Money Creation: Instruments of Monetary Policy (contd.) The Fed's FOMC (Federal Open Market Committee) has primary responsibility for conducting monetary policy The FOMC meets in Washington eight times a year
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This note was uploaded on 02/15/2011 for the course BUAD 350 at USC.

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Topic 09 - Monetary Policy - BUAD 350 Topic 08 Monetary...

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