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ECON102: Principles of Macroeconomics

Unit 6: The Money Supply and the Monetary Policy   *What is money?  Most people probably think of bills and coins, but in this course, we will define it as the asset most commonly used to buy things, or the medium of exchange commonly used by buyers and sellers.  In today’s economy, money can take many forms, from checks to electronic payments to e-money and a variety of other instruments that facilitate production and trade.  Money is also a unit of account; it helps us measure value in an economy and is a store of purchasing power over time.  The ways in which we define and measure money, in addition to the institutions we have built around it, help us understand the role of money and its importance in a well-functioning economic system.  Interest rates, or the prices that coordinate economic activity over time, also play a significant role in the supply and demand of money as a form of savings and investment.

As an economy grows, financial innovations develop new assets measured as money while central banks develop appropriate aggregates to measure them.  These measures include M1 (currency, checking account deposits, and travelers checks) and M2 (money market accounts and other assets such as savings accounts and repurchasable agreements).  Of course, because our behavior and beliefs determine what we will accept as money, money measurement is an ever-expanding subject in macroeconomics.*

Unit 6 Time Advisory
This unit should take approximately 13.25 hours to complete.

☐    Subunit 6.1: 1 hour

☐    Subunit 6.2: 2 hours

☐    Subunit 6.3: 1 hour

☐    Subunit 6.4-6.5: 3.25 hours

☐    Assessments: 4 hours (Please spend no more than 2 hours on each quiz.)

Unit6 Learning Outcomes
Upon successful completion of this unit, the student will be able to: - Define money and discuss its three basic functions. - Distinguish between the types of money, i.e. between commodity money and fiat money, giving examples of each. - Define money supply and the related definitions of it (M1 and M2). - Explain the functions of a bank and describe a bank’s balance sheet. - Describe the process of money creation (destruction) using the concept of the deposit multiplier. - Explain the primary functions of the central bank and describe the tools used by the Fed for money market operations. - Explain and illustrate how the bond market works and discuss the relationship between the price of a bond and that bond’s interest rate. - Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity. - Explain and illustrate how the foreign exchange market works and how a change in demand for a country’s currency or a change in its supply affects macroeconomic activity. - Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve. - Use graphs to explain how changes in money demand or money supply are related to changes in the bond market, in interest rates, in aggregate demand, and in real GDP and the price level.

6.1 What Is Money?   - Reading: Principles of Macroeconomics: “Chapter 9, Sections 1-2: Nature and Creation of Money” Link: Principles of Macroeconomics: “Chapter 9, Sections 1-2: Nature and Creation of Money” (PDF)

 Instructions: Read sections 1 and 2 of chapter 9, including the
introduction.  This material will cover subunits 6.1, 6.2, and all
inclusive sub-subunits.  

 Terms of Use: This text was adapted by The Saylor Foundation under
a [Creative Commons Attribution-NonCommercial-Share-Alike 3.0
License](http://creativecommons.org/licenses/by-nc-sa/3.0/) without
attribution as requested by the work’s original creator or licensee.

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style="font-size: 10pt; font-family: Calibri, sans-serif; background-position: initial initial; background-repeat: initial initial;"></span>

6.1.1 The Three Functions of Money   Note: The three functions of money are acting as a medium of change (that is, a means of payment), a store of value (that is, a “safe” or “vault,” for assets) and a unit of account (that is,the total cost of an item).

6.1.2 Two Types of Money   Note: The two types of money are currency (paper money) and checkable deposits (checks).

6.1.3 Measuring Money: M1 and M2   Note: M1 money involves checkable deposits.  M2 money involves M1 (checkable deposits), small time deposits, money market mutual funds, and funds held by individuals.

6.1.4 Commercial Banking   Note: Commercial banking includes the financial intermediaries that buy, sell, invest, and save money for businesses and the public.

6.2 Money Creation   6.2.1 Defining Total, Required, and Excess Reserves   Note: Total reserves are the checkable deposits that the public has placed in a commercial bank.  Required reserves are a percentage of the checkable deposits that must remain in a commercial bank as required by the Federal Reserve.  Required reserves are set by the Federal Reserve to protect banks from customers “running” on the bank, i.e., reserves protects a bank from customer panic.  Excess reserves are a percentage of checkable deposits that a bank is authorized by the Federal Bank to lend out.  Consequently, required reserves are deposits that the banks actually earn a profit from.

6.2.2 Money Creation Process, Required Reserve, and T-Accounts   - Reading: The Federal Reserve’s “Statistical Release H6: Money Stock Measures of Money Supply of M1 and M2 for the Year 2011” Link: The Federal Reserve’s “Statistical Release H6: Money Stock Measures of Money Supply of M1 and M2 for the Year 2011” (PDF)

 Instructions: This report by the Federal Reserve differentiates
between the various levels of the money supply from one period of
time to another in order to learn about the growth and wealth of the
United States’ economy.  

 Terms of Use: This work is in the Public Domain.
  • Reading: Professor Robert Schenk’s CyberEconomics: “Monetary Policy and Balance Sheets”

    Link: Professor Robert Schenk’s CyberEconomics: “Monetary Policy and Balance Sheets” (HTML)

    Instructions: This material explains the money creation process in the economy.

    Terms of Use: The linked material above has been reposted by the kind permission of Robert Schenk, and can be viewed in its original form here.  Please note that this material is under copyright and cannot be reproduced in any capacity without explicit permission from the copyright holder.

  • Web Media: YouTube: Money and Markets’ “Soft Commodities Discussion”

    Link: YouTube: Money and Markets’ “Soft Commodities Discussion” (YouTube)

    Instructions: Watch the entire video, which discusses soft commodities.

    Watching this video should take approximately 13 minutes.

    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Reading: Cengage Learning: William Boyes and Michael Melvin’s Economics: “Chapter 7: Foreign Exchange Market and the Balance of Payments Interactive Quiz” Link: Cengage Learning: William Boyes and Michael Melvin’s Economics: “Chapter 7: Foreign Exchange Market and the Balance of Payments Interactive Quiz” (Flash)
     
    Instructions: Click on the links for “Test 1” and “Test 2” beneath Chapter 7 and complete each assessment.  Once you have selected an answer choice, a note at the bottom of the screen will indicate whether or not your choice was correct.
     
    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Web Media: Khan Academy’s “Money Supply – M0, M1, and M2”

    Khan Academy’s “Money Supply – M0, M1, and M2” (YouTube)

    Instructions: The above link will bring you to a video lecture about the money supply – M0, M1, and M2.

    Watching this video should take approximately 10 minutes.

    Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License.  It is attributed to the Khan Academy.

6.2.3 Money Creation Process and the Money Multiplier   - Lecture: YouTube: The Khan Academy’s “Money Multiplier and the Money Supply” Link: YouTube: The Khan Academy’s “Money Multiplier and the Money Supply” (YouTube)
 
Instructions: Watch this video lecture (11:07). It discusses the money multiplier.
 
Terms of Use: This video is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 United States License. This resource is attributed to The Khan Academy and the original version can be found here

6.3 The Federal Reserve System   6.3.1 Origins of the Fed   - Reading: Federalreserveeducation.org’s “History of the Federal Reserve” Link: Federalreserveeducation.org’s“History of the Federal Reserve” (PDF)
 
Instructions: Read this article for a chronological study of how the Federal Reserve System came into being.
 
Terms of Use: The above material is reposted from federalreserveeducation.org.  The original version can be found here.  The content owners have stipulated that this material can be freely used and shared for the purpose of education, provided that users comply with the terms of use outlined here.

6.3.2 Components and Functions of the Federal Reserve System   - Reading: Principles of Macroeconomics: “Chapter 9, Section 3: The Federal Reserve System” Link: Principles of Macroeconomics: “Chapter 9, Section 3: The Federal Reserve System” (PDF)

 Instructions: Read section 3 of chapter 9, which will cover
subunits 6.3.2 and 6.3.3.  

 Terms of Use: This text was adapted by The Saylor Foundation under
a [Creative Commons Attribution-NonCommercial-Share-Alike 3.0
License](http://creativecommons.org/licenses/by-nc-sa/3.0/) without
attribution as requested by the work’s original creator or licensee.

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style="font-size: 10pt; font-family: Calibri, sans-serif; background-position: initial initial; background-repeat: initial initial;"></span>

6.3.3 The Federal Reserve Balance Sheet   - Assessment: PEOI.org: John Petroff’s Macroeconomics: “Chapter 10: Money”

Link: PEOI.org: John Petroff’s *Macroeconomics*: [“Chapter 10:
Money”](http://www.saylor.org/site/wp-content/uploads/2012/07/Chapter-10-Money.pdf) (PDF)
and [“Chapter 10
Quiz”](http://www.saylor.org/site/wp-content/uploads/2012/07/Chapter-10-Money-Quiz.pdf) (PDF)


 Instructions: Review the material in the above section and then
take the quiz .  

 Terms of Use: The article above is released under a [Creative
Commons Attribution-NonCommercial-Share-Alike
License](http://creativecommons.org/licenses/by-nc-sa/3.0/deed.en). 
You can find the original version of this
article [here](http://www.peoi.org/Courses/Coursesen/mac/fram10.html).

6.4 Three Tools of Monetary Policy   - Reading: Federal Reserve Bank of New York's “Monetary Policy” Link: Federal Reserve Bank of New York’s “Monetary Policy” (PDF)

 Instructions: Read the section entitled “How does the Federal
Reserve implement monetary policy?”  This material will cover
subunits 6.4.1-6.4.3.  

 Terms of Use: The above material is reposted
from [http://www.federalreserve.gov](http://www.federalreserve.gov/). 
The content owners have stipulated that this material can be freely
used and shared for the purpose of education, provided that users
comply with the terms of use outlined
[here](http://federalreserveeducation.org/faq/topics/use_fed_products.cfm).

6.4.1 Required Reserve Ratio   Note: The required reserve ratio is set by the Federal Reserve to encourage full employment, economic growth, and price stability by controlling the money supply.  Typically, the required reserve ratio is between 1 and 3 percent; it may even increase to ten percent based on the Federal Reserve’s desire to minimize recessionary or inflationary gaps.

6.4.2 Discount Rate   Note: The discount rate is the rate at which the twelve district Federal Reserve Banks charge other banks to borrow money.

6.4.3 Open Market Operations   - Assessment: PEOI.org: John Petroff’s Macroeconomics: “Chapter 12: Monetary Policy” Link: PEOI.org: John Petroff’s Macroeconomics: “Chapter 12: Monetary Policy” (PDF) and “Chapter 12 Review Quiz” (HTML)

 Instructions: Review the material in this chapter and then take the
review quiz.  

 Terms of Use: The article above is released under a [Creative
Commons Attribution-NonCommercial-Share-Alike
License](http://creativecommons.org/licenses/by-nc-sa/3.0/deed.en). 
You can find the original version of this
article [here](http://www.peoi.org/Courses/Coursesen/mac/fram12.html).
  • Reading: Principles of Macroeconomics: “Chapter 10: Financial Markets and the Economy” Link: Principles of Macroeconomics: “Chapter 10: Financial Markets and the Economy” (PDF)

    Instructions: Read this chapter its entirety to learn how financial markets fit into the model of aggregate demand and aggregate supply and how they relate to the real GDP level as well as the price level.  The money market model explains the determination of equilibrium rate of interest.  This reading will cover subunits 6.4.4-6.5 and all inclusive sub-subunits.

    Terms of Use: This text was adapted by The Saylor Foundation under a Creative Commons Attribution-NonCommercial-Share-Alike 3.0 License without attribution as requested by the work’s original creator or licensee.

6.4.4 The Money Supply Curve and Shifting Factors   Note: This topic is covered in the reading under sub-subunit 6.4.3.

6.5 The Interest Rate   6.5.1 The Money Demand Curve and Shifting Factors   Note: One of the interpretations of the money demand curves is based on an economy’s interest rate.  This interpretation rests on the position of the supply of money and the interest rates on money.  Regarding shifting factors, the money supply can increase based on lower interest rates or decrease based on higher interest rates.

6.5.2 The Money Market (A Graphical Representation)   Note: Graphical representations of money markets are visualizations of a combination of an economy’s transactional demands plus an economy’s asset demands.

6.5.3 The Equilibrium Interest Rate   Note: Equilibrium interest rates are the balance or combination of the market for money plus the investment demand for money.  Consequently, equilibrium real GDP and the price level will determine the equilibrium based on transactional demand and investment demand.

  • Assessment: Cengage Learning: William Boyes and Michael Melvin’s Economics: “Chapter 14 Review” and “Chapter 14: Monetary Policy – Test 1 and Test 2” Link: Cengage Learning: William Boyes and Michael Melvin’s Economics: “Chapter 14 Review” (Flash) and “Chapter 14: Monetary Policy – Test 1 and Test 2” (Flash)

    Instructions: Click on “Chapter 14 Review” and read the brief overview of topics in Boyes and Melvin’s Chapter 14 on monetary policy.  Then, click on “Chapter 14: Monetary Policy – Test 1 and Test 2.”  In this application, click on the links for tests 1 and 2 under Chapter 14 and complete the questions for each test.  Once you have selected an answer choice, a note at the bottom of the screen will indicate whether or not your choice was correct.

    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

6.5.4 Money Supply and Demand Shifts and the Equilibrium Interest Rate   - Web Media: Khan Academy’s “Money Supply and Demand Impacting Interest Rates”

Khan Academy’s [“Money Supply and Demand Impacting Interest
Rates”](http://www.khanacademy.org/finance-economics/macroeconomics/v/money-supply-and-demand-impacting-interest-rates) (YouTube)  

 Instructions: The above link will bring you to a video lecture
about money supply and demand impacting interest rates.  

 The video is approximately 8 minutes long.  

 Terms of Use: This video is licensed under a [Creative Commons
Attribution-NonCommercial-ShareAlike 3.0 United States
License](http://creativecommons.org/licenses/by-nc-sa/3.0/us/).  It
is attributed to the Khan Academy.
  • Assessment: International Excellence Business School: Javier Carrillo’s Multimedia Documentation: “Interactive Graph of Aggregate Demand Policies”

    Link: International Excellence Business School's Multimedia Documentation by Javier Carrillo: “Interactive Graph of Aggregate Demand Policies” (Flash Activity)

    Instructions: Click “Enter” on the web page to access the interactive graph and the exercises.

    Note that on the left hand side, the graphs show how expansionary or restrictive fiscal and monetary policies affect the monetary sector and the real sector.  On the right-hand side are ten exercises that will test your understanding of the topic.  Review the material on the left thoroughly with the help of interactive graphs before attempting the exercises.

    Terms of Use: The materials above are released under a Creative Commons Attribution-NonCommercial-NoDerivatives License 3.0.  You can find the original International Excellence Business School version of these materials here.

6.6 Notes on the 2008 Financial Crisis   6.6.1 The Economic Meltdown   - Web Media: PBS: Frontline’s “The Economic Meltdown”

Link: PBS: Frontline’s **[“The Economic
Meltdown”](http://www.pbs.org/wgbh/pages/frontline/meltdown/view/) **(HTML
and Flash)  

 Instructions: Scroll down and read the article in its entirety to
learn about one of the unconventional policies that the government
can adopt to stabilize the financial system in the economy.  Then,
watch the video to understand the current state of the macroeconomy
and the government’s role in it.  

 Reading this article and watching the video should take
approximately 1 hour.  

 Terms of Use: Please respect the copyright and terms of use
displayed on the webpage above

6.6.2 Government Policies to Stabilize the Economy   - Web Media: Adam Davidson and Alex Blumberg’s “Quantitative Easing, Explained”

Link: NPR: Adam Davidson and Alex Blumberg’s *[*“Quantitative
Easing,
Explained”*](http://www.npr.org/blogs/money/2010/10/07/130408926/quantitative-easing-explained)* (HTML)  

 Instructions: Read this article to learn about one of the
unconventional policies that the government can adopt to attempt to
stabilize the financial system.  

 Terms of Use: Please respect the copyright and terms of use
displayed on the webpage above.
  • Reading: Massachusetts Institute of Technology News: Peter Dizike’s “Explained: Quantitative Easing” Link: Massachusetts Institute of Technology News: Peter Dizike’s “Explained: Quantitative Easing” (PDF)

    Instructions: Read the entire article to learn one of the unconventional policies that the government can adopt to stabilize the financial system in the economy.

    Terms of Use: Terms of Use: The above material is reposted from MIT News. The original version can be found here. The content owners have stipulated that this material may be republished provided that users comply with the terms outlined here. Reprinted with permission of MIT News (http://web.mit.edu/newsoffice/).

  • Assessment: International Excellence Business School: Javier Carrillo’s Multimedia Documentation: “Interactive Graph of Aggregate Demand Policies”

    Link: International Excellence Business School: Javier Carrillo’s Multimedia Documentation: “Interactive Graph of Aggregate Demand Policies” (Flash)

    Instructions: Click on “Economic Environment” on the left-hand tab and scroll down to “Interactive Graph of Aggregate Demand” and “Interactive Graph of the Aggregate Supply and Demand Model.”  Follow the instructions on the linked sites to use these interactive modules.

    Note that on the left-hand side the graphs show how expansionary or restrictive fiscal and monetary policies affect the monetary sector and the real sector.  On the right-hand side are ten exercises that will test your understanding of the topic.  Review the material on the left thoroughly with the help of interactive graphs before attempting the exercises.

    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Assessment: Econ100’s “Chapter 14: Money Quiz” and “Chapter 15: Monetary Policy Quiz”

    Link: Econ100’s “Chapter 14: Money Quiz” and “Chapter 15: Monetary Policy Quiz” (HTML)

    Instructions: Click on the “Quiz” tab on the left hand side menu and then go to chapters 14 and 15 to take the quizzes.  Attempt each portion of both quizzes.

    Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.