This was a lecture on the Monetary Policy as an Adjunct Professor of Economics at a California Community College

1. Lesson plan for the day
• Last week, we discussed fiscal policy.
• Today, we will be discussing monetary policy.

2. The Monetary Policy
Using Monetary Policy to control
Economic activities.
Taiye Doherty, MBA

3. Student Learning Outcomes
• After Learning about this chapter, you should
know:
– How interest rates are set in the economy
– How monetary policy are used to control the
economy

4. Core Issues
• In this chapter we explore the effectiveness of
monetary policy, specifically
– What’s the relationship between money supply,
interest rates, and aggregate demand?
– How can the Fed use its control of the money
supply or interest rates to control the economy

5. Monetary Policy
• Control over the money supply is a critical
policy tool used for altering macroeconomic
outcomes.
– The quantity of money in circulation influences its
value in the marketplace.
– Interest rates and access to credit are basic
determinants of spending behavior.

6. Reserve Requirements
• Private banks are required to keep a fraction
of deposits “in reserve,” either as cash or on
deposit at the regional Fed bank.
– Banks cannot loan out these required reserves
– By changing reserve requirements, the Fed can
directly alter the lending capacity of the banking
system.

7. The Discount Rates
• Private banks earn income by making loans, so
they try to fully lend out their excess reserves.
• At times, a bank might fall short of satisfying
the reserve requirement.
– It can borrow excess reserves overnight from
another bank and pay interest at the fed fund
rate.
– It can borrow reserves overnight from the Fed and
pay interest at the discount rate.

8. Open Market Operations
• This is a principal mechanism to directly alter
the reserves of the banking system.
– When the Fed buys government bonds from the
public, reserves increase, more loans can be
made, and money supply grows.
– When the Fed sells government bonds to the
public, reserves decrease, fewer loans can be
made, and the money supply shrinks.

9. Question For The Class
• Is money a commodity, or a store of value?

10. The Money Market
• Money is a commodity that is traded in a
marketplace, the money market.
– The money supply is controlled by the Fed and
society has a money demand.
– The market determines the “price” of money, the
interest rate.
– (M1): currency held by public, plus balances in
transactions accounts.
– (M2): M1 plus balances in savings & MMF

11. Portfolio Decision
• Portfolio decision: the choice of how and
where to hold idle funds: cash, savings
account, or interest generating bonds.
– Should you keep idle funds in a savings account or
purchase government bonds?
– The Fed influences this decision by making bonds
more or less attractive.

12. The Money Market
• Money Demand: quantities of money the
public wants to hold at alternative interest
rates.
– If people hold cash as M1, they suffer an
opportunity cost: the forgone interest they could
have earned.
– At low interest rates, the opportunity cost of
holding money is low, so people will hold more of
it, and vice versa.

13. Money Market Equilibrium
• Money demand: the
quantity of money people
are willing to hold (demand)
increases as interest rates
fall, and vice versa.
• Money Supply: since the
Fed controls the money
supply, it is represented by
a vertical line.

14. Money Market Equilibrium
• If interest rates are higher
than the equilibrium there
is a money surplus.
– People will hold more M1
than they want to.
– They will move money from
M1 into M2 or other assets.
– The interest rate will then fall
to E1

15. Money Market Equilibrium
• If interest rates are lower
than equilibrium, there is a
money shortage.
– People will hold less money
as M1 than they want to.
– They will move money into
M1 from M2 or other assets.
– The interest rate will then rise
to E1.

16. Changing Interest Rates
• The Fed controls the money supply.
• The Fed can use its policy tools to change the
equilibrium rate of interest.
– By increasing the money supply (causing a
surplus), the Fed tends to lower the equilibrium
rate of interest.
– By decreasing the money supply (causing a
shortage), the Fed tends to raise the equilibrium
rate of interest.

17. Interest Rates and Spending
• Lowering interest rates: a tactic of monetary
stimulus, to increase aggregate demand (AD).
– Reduce the cost of investment spending
– Reduce the cost of holding inventory
– The investment spending increase will kick off a
positive multiplier effect. AD will shift right
because of this.

18. Interest Rates and Spending
• Raising interest rates: a tactic of monetary
stimulus, to decrease aggregate demand (AD).
– Increase the cost of investment spending
– Increase the cost of holding inventory
– The investment spending decrease will kick off a
negative multiplier effect. AD will shift left
because of this.

19. Summary
• If the goal: to stimulate the economy.
– An increase in the money supply leads to…
– Lower interest rates, which lead to…
– An increase in aggregate demand.

20. Summary
• If the goal: to restrain/contract the economy.
– A decrease in the money supply leads to…
– Higher interest rates, which lead to…
– A decrease in the aggregate demand.

21. Looking Ahead
• Comparing fiscal policy with monetary policy,
and which of the lever is more effective.