im17 - Part 5 The Money Supply Process and Monetary Policy...

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Part 5 The Money Supply Process and Monetary Policy Chapter 17 The Money Supply Process Overview Most instructors will consider this one of the most important chapters in the book. It integrates material sometimes treated separately: the money supply process and the effect of changes in the Fed’s balance sheet on the money supply process. The author presents a simplified version of the Fed’s balance sheet and then uses it to explain the money supply process. This approach has the advantage of keeping the Fed’s role at the center of the analysis and makes it easier for students to keep track of the point of the discussion. Many students have difficulty understanding the deposit expansion process, so significant class time should be devoted to it. Some instructors are tempted to go through the deposit expansion process fairly quickly in order to focus on the money multiplier. However, in order to appreciate the money multiplier material, students need to have a firm grasp of the deposit expansion process. The Case Study at the end of the chapter is particularly valuable. Outline I. The Fed and the Monetary Base A) One way the Fed manages the nation’s money supply is by controlling the monetary base, which is comprised of all currency in circulation and reserves held by banks. B) The Fed’s principal liabilities are currency in circulation and reserves. 1. The Fed’s currency outstanding includes currency in circulation , which is currency held by the nonbank public, and vault cash , which is currency held by depository financial institutions. 2. Bank reserves equal vault cash in banks plus deposits by commercial banks and savings institutions with the Fed. a. Total reserves are made up of amounts the Fed compels depository institutions to hold, called required reserves , and extra amounts that depository institutions elect to hold, called excess reserves . b. The Fed specifies a percentage of deposits that banks must hold as reserves, which is known as the required reserve ratio .
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95 Hubbard • Money, the Financial System, and the Economy, Sixth Edition C) The Fed’s principal assets are government securities and discount loans. 1. The Fed’s portfolio of government securities consists principally of holdings of U.S. Treasury securities. 2. When the Fed lends to depository institutions, the loans are called discount loans and the interest rate on the loans is called the discount rate . D) The Fed increases or decreases the monetary base by manipulating the levels of its assets. 1. The most direct method the Fed uses to change the monetary base is open market operations , which is buying or selling U.S. government securities. a. In an open market purchase the Fed buys government securities. b. An open market purchase increases either bank reserves or currency in circulation; therefore it increases the monetary base, which is the sum of reserves plus currency ( B = C + R ).
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