Review The Market for Money Monetary Policy Test Review

Monetary Policy

Alex Peden

International College of Manitoba

July 6, 2020

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Homework

Assignment #2 available
Due date July 13th at midnight
Assignment #3 is also available
Due date not until July 27th
Can be useful to help prepare for the second test

Test #2 is July 13th in class.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Review: Money Multiplier

The money multiplier describes how we get from the monetary

base to the money supply.

M = MB ∗ money multiplier
1 + cr
Multiplier =
rr + cr

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Exercise

If the central bank prints $5000, which is handed to citizens with a

currency ratio of 0.2 and a bankers’ reserve ratio of 0.2, what will
happen?
What is the final change to the money supply? What is the money
multiplier?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Exercise

What about in the opposite scenario? If the central bank

withdraws $5000 from circulation, in a population with a currency
ratio of 0.05 and a reserve ratio of 0.1, what is the final effect on
the money supply?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Fill in the Blank Exercise

If the currency ratio increased, that would cause the money

multiplier to .
If the reserve ratio increased, that would cause the money supply
to .
If the currency ratio decreased, that would cause the monetary
base to .

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Financial Panics

A financial panic sequence can occur when the public loses

confidence in bank deposits
Customers rush to withdraw deposits, known as a bank run
Banks will call for central bank support
Central bank acts as a lender of last resort
This may lead to government take-over of the bank, and/or
liquidation
Customers may also be protected by deposit insurance

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money Supply Function

1 + cr
M0 =∗ MB0
rr + cr
The money supply depends on three variables:
1 MB - monetary base
2 cr - the public’s currency ratio
3 rr - the bank’s reserve ratio

So if the central bank controls MB, it controls M, provided that cr

and rr are constant.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

The Market for Money: Supply

Like anything else, there is a market for money with demand,

supply and a price.
So far, we have covered the money supply (M). It is
determined by:
The monetary base
The money multiplier (determined by cr and rr)

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

The Market for Money: Price

The interest rate (i) is commonly called the price of money

Why is that?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

The Market for Money: Price

The interest rate (i) is commonly called the price of money

When you borrow money from a bank, the interest rate is the
price you pay to have it
When you deposit money to a bank, the interest rate is the
price they pay you to hold it

How does the interest rate affect people’s desire to hold money?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

The Market for Money: Price

The interest rate (i) is commonly called the price of money

When you borrow money from a bank, the interest rate is the
price you pay to have it
When you deposit money to a bank, the interest rate is the
price they pay you to hold it

How does the interest rate affect people’s desire to hold money?
Higher i makes people less likely to borrow money, so asset
demand decreases
Lower i makes people more likely to borrow money, as asset
demand increases

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

The Market for Money: Demand

Demand for money comes from the two main uses of money:
Transactions demand for money
Related to money’s use as a medium of exchange
Varies directly with GDP
Assest demand for money
Related to money’s use as a store of value
Varies inversely to the interest rate

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

The Market for Money

Demand combined with the supply for money determines the
equilibrium interest rate

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money Supply

What should the central bank do with the money supply?

What happens if the central bank prints a lot of money?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money Supply

What should the central bank do with the money supply?

What happens if the central bank prints a lot of money?
Printing too much money leads to inflation.
This is most problematic when the money is used to finance
government spending instead of taxes.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money Supply

What should the central bank do with the money supply?

What happens if the central bank stops printing money?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money Supply

What should the central bank do with the money supply?

What happens if the central bank stops printing money?
Since GDP and population size are generally growing, if there
is no increase in money, there can be major problems
occurring from deflation.

As a result, central banks are tasked with printing some money to

keep the inflation rate low and stable.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Monetary Policy

Monetary policy describes policies taken by the central bank to

manage the money supply, interest rates, and economic
performance
Central banks have several different goals, including:
Keeping inflation low and stable
Helping the economy achieve full employment and sustained
growth
Altering the money supply to influence interest rates

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Monetary Policy

Two major tools of monetary policy:

Open-market operations
The central bank buying and selling government securities in
the open market
Bank rate
The interest rate the central bank charges on its loans to
commercial banks

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Open-Market Operations

Open-market operations are the main tool for long-term

management of the monetary base
By buying and selling government bonds on the open market,
they introduce or withdraw money from circulation.
Buying government bonds from the public introduces more
money into the monetary base
Selling government bonds takes money out of the monetary
base

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Open-Market Operations

If the central bank buys $100 million worth of government bonds

(an open-market purchase):
Those in the public who sell bonds deposit their money in
banks
When commercial banks receive more money, they will
increase lending , which magnifies the effect on the money
supply

If cr = 0 and rr = 0.05, what is the final effect on the money

supply?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Open-Market Operations

By increasing M through open-market operations, the central bank

is able to lower the interest rate

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Open-Market Operations

How would the situation change if the central bank were to sell
bonds to the public?
Explain how it will affect the money supply as well as the interest
rate.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Bank Rate

In the short-term, the central bank uses the overnight bank rate to
make to the interest rate.
The bank rate is the interest rate the Bank of Canada
charges on loans to commercial banks
As a result, changes in the bank rate are passed on to the
interest rate banks charge to their customers
In addition, the bank rate is used as the central bank’s target
for open-market operations

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Interest Rate & Aggregate Expenditures

In our AE model, why would the central bank care about the
interest rate?
What factors would the interest rate affect?

AE = C + I + G

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Interest Rate & Aggregate Expenditures

More advanced models might consider the effect of i on

consumption, but in our model we will focus on its effect on
investment.
How does the interest rate affect I ?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Interest Rate & Aggregate Expenditures

Investment and the interest rate are inversely related. When the
price of money drops, businesses are more likely to borrow money
to finance projects.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Expansionary Monetary Policy

When the economy faces a recession, the Bank of Canada will:

lower the target for overnight lending rate
use open market purchases

What do both of these accomplish?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Expansionary Monetary Policy

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Restrictive Monetary Policy

What should the central bank do in periods of rising inflation?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Restrictive Monetary Policy

With rising inflation, the Bank of Canada will:

raise the target for overnight lending rate
use open market sales

to:
decrease the money supply
increase the interest rate

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Restrictive Monetary Policy

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Leakages & Injections

How does monetary policy affect leakages & injections?

In a recession?
In a boom?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Advantages of Monetary Policy

Two key advantages over fiscal policy:

Speed & flexibility
Isolation from political pressure

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Difficulties with Monetary Policy

Cyclical asymmetry
Monetary policy is often much more effective at controlling
inflation than fighting recessions
Central banks can provide expansionary policies, but their
control ends there
Banks can build reserves instead of lending money out
Businesses can choose not to borrow money even at a lower i
This situation is known as a liquidity trap
At times, goals for stabilizing inflation and promoting growth
can be at odds

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Exercise

If an economy is entering a recession, describe one way in which a

government could help with fiscal policy and one way the central
bank could help with monetary policy. Demonstrate each with a
graph.
What is one benefit and one drawback of using monetary policy?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Test Information

Test #2 will be very similar in format to the first test

Test begins at the start of class, July 13th lasts 90 minutes
30-35 multiple choice questions (1 mark each)
2 short answer questions (5 marks each)
Overall mark worth 20% of your final grade

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Test Information

Bring:
Pencil/pen, calculator (non-programmable), ruler (optional)
Do not bring:
Notes, textbooks, cell phones, scrap paper

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Role of Government

G is a new component of spending (an injection)

NT, a portion of income, is a new leakage
Induced consumption is now based on YD instead of all income

How do net taxes affect the multiplier? Explain in a sentence

without writing out the equation.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Fiscal Policy

Fiscal policy involves changes to G or t to move the economy back

to equilibrium.
Briefly describe automatic fiscal stabilization.
With the aid of an AE = Y graph, show how both a change
in G or t can be useful to correct for an inflationary gap.
Using the leakage-injection framework, briefly explain using
words how both G and t can be useful to correct for a
recessionary gap.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Government Budgets

Do governments need to run a balanced budget every year? What

numbers do they need to be concerned with?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money

Describe one reason why money is advantageous in our economy.

How are the monetary base, the money supply and the money
multiplier related? Show an equation and a brief explanation of
what it means.
If the currency ratio in a population increases, what does that
mean in practice? How does this affect banks ability to lend?

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Money Exercise

If the public has a currency ratio of 0, and the banks have a

reserve ratio of 0.05, what will happen when the public begins with
$100? What’s the final MB? M? Confirm your answer with the
money multiplier.

Alex Peden ECON1020 - Macro Week 7 Lecture

Review The Market for Money Monetary Policy Test Review

Monetary Policy

Work backwards through the Bank of Canada decisions when they

are faced with an inflationary gap to determine their response.

List one major advantage and one disadvantage of using monetary

policy.

Alex Peden ECON1020 - Macro Week 7 Lecture