Unit 4 Banking & Monetary Policy (Macro)

Unit 4 Overview & Video Lessons: Top 10 things you need to know about money, banking, monetary policy, money markets, and the deposit expansion multiplier. This video lecture is geared toward college-level principles of macro courses and students enrolled in AP Economics. Below the Top 10 video, you will find mini lessons, essential questions, graphs and models on specific concepts. Take notes and pause when necessary.

Top 10 concepts discussed in this video: 

#1. Functions of Money

#2. Defining Money Supply

#3. Bank’s Balance Sheet

#4. Interest Rates and Spending

#5. Monetary Policy

#6. “Easy” Monetary Policy in Short Run

#7. “Tight” Monetary Policy in Short Run

#8. Interest Rates and Bond Prices

#9. Money Multiplier

#10. Present and Future Value of Money.

Side Note: The ample reserves framework & the reserves market model are now included in the latest edition of the No Bull Review book on Amazon. 

NB4. Bank Balance Sheet (Macro)

What is a balance sheet?

A balance sheet (or t-account) keeps record of a commercial bank's assets and liabilities after each banking transaction.

An example of a liabilitiy is a demand deposit (checkable deposit) because the bank must pay its depositors on demand.  An example of an asset is a loan issued by the bank because the debtor must repay the loan amount to the bank.

The No Bull Review video above explains how to record a bank's transactions using a balance sheet. It also discusses the role of required reserves (a limited reserves monetary policy tool) and excess reserves in money creation.

Learning objectives:

1. Students will be able interpret a commercial bank's balance sheet (or T-account).

2. Students will be able to differentiate between a bank's assets and liabilities. 

3. Students will be able to calculate the reserve requirement from a balance sheet.

4. Students will be able to adjust a bank's balance sheet after a financial transaction.

5. Students will be able to determine how a bank meets its reserve requirement when reserves are low - Limited Reserves Framework

What are the tools of monetary policy?

The Federal Reserve (central bank) has an expanding and evolving toolbox to implement its monetary policy. Here are some of the major monetary policy tools:

1. Interest on Reserve Balances: As a result of the Great Recession (2007-2009), the Fed began paying interest to banks for reserves held in an account with the central bank. This is an administered interest rate that causes a change to the policy rate which leads to changes in consumption and investment in the AD/AS model. When the Fed lowers the interest on reserves, it incentivizes increases in household consumption and business investment spending. When it increases interest on reserves, the opposite will occur. Interest on reserves is represented by the lower bound of the reserves demand curve in a reserves market.

2. Discount Rate: The Fed can increase or decrease the interest rate it charges banks for short-term loans. When the Fed lowers the discount rate, it can lower the policy rate that causes an increase in household consumption and business investment spending. When it raises the discount rate, the opposite will occur. The discount rate is an administered interest rate represented by the upper bound of the reserves demand curve in a reserves market.

3. Open Market Operations: The buying and selling of government securities is known as open market operations. When the Fed buys treasury bonds, the money supply in the money market and the supply of reserves in the reserves market increase. In limited reserves banking systems, interest rates will fall as a result. The Fed traditionally targeted the federal funds interest rate (bank-to-bank interest rate for short-term loans) through its open market operations. This would eventually lead to an increase in investment spending and consumption. Aggregate demand increases, price level increases, and real GDP increases, and unemployment falls. In an ample reserves system, this will simply maintain a large enough supply of reserves in the banking system as the Fed will administer interest rates (discount rate and interest on reserves) directly.

When the Fed sells government bonds, the money supply in the money market and the supply of reserves in the reserves market decreases. In limited reserves systems, interest rates rise as a result of the sales. Investment and consumption decreases, aggregate demand decreases, price level falls, real GDP falls, and unemployment rises. If operating in an ample reserves system, this will reduce the supply of reserves in the banking system. If it's on a large enough scale it can contribute to a transition back to a limited reserves banking system.

4. Reserve Requirement: Typically associated with limited reserves banking systems as the US currently operates at a 0% reserve requirement in its ample reserves system. If the Fed changed the reserve requirement (percentage of deposits banks must keep as reserve) in a limited reserves framework, it would change excess reserves, bank lending, and money creation.

NB4. Limited Reserves Monetary Policy (Macro)

Learning objectives:

1. Students will be able to identify the appropriate open market operation for recessionary gaps and inflationary gaps in a limited reserves system.

2. Students will be able to demonstrate effects of the open market operation using the AD/AS model. 

3. Students will be able to illustrate open market operations using a money market graph in a limited reserves system. 

4. Students will be able to explain the Keynesian transmission mechanisms (cause-effect chains) of "easy" and "tight" monetary policies.