. 21
( 33)


tary policy. Monetary policy is the expan-
the Fed Ready to Hike Rat
sion or contraction of the money supply in order to
Is influence the cost and the availability of credit. The
If recent reports of unex
EW YORK (CNNfn)” Fed, as you read in the cover story, does not hesitate
N -
n™s economy are any indi
ed strength in the natio to change interest rates whenever the economy™s
is likely to raise interest
n, the Federal Reserve health is threatened.
rates sooner rather Monetary policy is a structured process. In order
than later, analysts to understand it better, it helps to understand the
said Wednesday. fractional reserve system that our banking system is
A rise in short-term based on.
rates would follow
three rate cuts by the
Fed late last year that
Fractional Bank Reserves
Interest rates on the rise?
re intended to insu-
late the United States The United States has a fractional reserve
Asia and elsewhere. . . .
m economic problems in
fro tin system, which requires banks and other
woes had spread to La
st fall] Asia™s economic
[la hit
pe and looked poised to depository institutions to keep a fraction of their
erica and much of Euro
deposits in the form of legal reserves. Legal
the shores of the U.S. . ree
action, cutting rates th reserves consist of coins and currency that
The Fed sprang into .S.
rked. By January, the U depository institutions hold in their vaults, plus
es, and the rate cuts wo
tim d
ck . . . [But now], . . . Fe
onomy was back on tra deposits with Federal Reserve district banks.
rates. . . .
officials are likely to raise Under this system, banks are subject to a reserve
”CNNf n, June 2, 1999 requirement, a rule stating that a percentage of
every deposit be set aside as legal reserves.

To illustrate, the banking system today operates net worth is placed on the right side of the balance
with a 12 percent reserve requirement against sheet, rearrange the definition of net worth from
demand deposit accounts. That means that when- Assets Liabilities Net Worth
ever someone deposits $100 to open a checking to
account, $12 must be set aside as vault cash or kept Assets Liabilities Net Worth
as a deposit at the Fed. The other $88 is called
The balance sheet in the figure is sometimes
excess reserves”legal reserves in excess of the
called a T-account because of its appearance, sepa-
reserve requirement. The excess reserves are the
rating the assets from the liabilities and net worth
funds the bank can lend to others who may want a
the same way the equal sign does in the above
equation. The T-account also works like an equal
sign in that the entries on the left must always be
equal to the entries on the right.
How Banks Operate
To understand how a bank operates, it helps to
Accepting Deposits
examine the bank™s liabilities and assets. Its liabilities
are the debts and obligations to others. Its assets are Suppose that now a customer walks in and
the properties, possessions, and claims on others. opens a checking account with $100 in currency.
Liabilities and assets generally are put together in the This transaction, shown in Panel B of Figure 15.3,
form of a balance sheet”a condensed statement is reflected on the balance sheet in two ways.
showing all assets and liabilities at a given time. The First, to indicate that the money is owed to the
balance sheet also reflects net worth”the excess of depositor, the $100 checking account (or demand
assets over liabilities, which is a measure of the value deposit) is carried as a liability. Second, to indicate
of a business. that the cash is the property of the bank, it also
appears as an asset on the balance sheet. Actually, the
$100 appears in two places on the asset side”$90
Organizing a Bank appears as cash, and $10 appears as required reserves.
Suppose someone obtains a charter to start the The size of the reserve is determined by the reserve
hypothetical State Bank of Highland Heights. The requirement, which is assumed to be 10 percent in
bank is organized as a corporation, and the owners this example. If the requirement was 15 percent, $15
supply $20 so that the bank can obtain buildings would be set aside.
and furniture before it opens for business. In return
for this investment, the owners receive stock, which
Making Loans
shows as net worth or equity. Panel A in Figure 15.3
shows how the balance sheet of the bank might Now that the bank has some cash on hand, it
look as soon as it is organized. can make loans. Specifically, it is free to loan out
The balance sheet shows the assets on the left and $90 of excess reserves, the cash and currency not
the liabilities and net worth on the right. To see why needed to fulfill the reserve requirement.
If another person enters the bank and borrows
an amount equal to the excess reserves, the $90 is
moved from the cash line to the loans, or
accounts receivable, line in the balance sheet.
These changes appear in Panel C. Note that there
is no change in total assets, only in their distribu-
tion”a change from a noninterest-earning asset
Student Web Activity Visit the Economics: Principles
(cash) to an interest-earning one (a consumer
and Practices Web site at epp.glencoe.com and click
on Chapter 15”Student Web Activities for an activ-
If the bank charged 12 percent interest on the
ity on the Fed™s monetary policy.
new loan, it would earn 12 percent of $90, or

$10.80 each year. This income,
Figure 15.3
along with income earned on other
loans, would then be used to pay its
Balance Sheet Entries for a
officers and employees; its utility
bills, taxes, other business expenses;
Hypothetical Commercial Bank
and its stock dividends.
A When a bank is organized as a corporation, the owners
contribute cash used to buy buildings and furniture. In
Reaching Maturity return, the owners receive stock.
In time, the bank would grow and
Assets Liabilities + NW
prosper, diversifying its assets and
Required Reserves: Demand Deposits:
liabilities in the process. Most of the
bank™s deposits would eventually Net Worth or Equity: $20
return to the community in the
form of loans, and some of those
Buildings and Furniture: $20
loans would return to the bank in
the form of new deposits. $20 $20
The bank might even use some of
its excess reserves to buy federal,
B When a customer opens an account, some of the deposit
state, or local bonds and other secu-
is set aside as a reserve, while the excess can be loaned out.
rities. The bonds and securities are
Note that Net Worth (NW) remains unchanged.
helpful for two reasons. They earn
interest and, therefore, are more Assets Liabilities + NW
attractive than cash. They also have Required Reserves: $10 Demand Deposits: $100
a high degree of liquidity”the Cash: $90 Net Worth or Equity: $20
potential to be converted into cash Loans:
in a very short time. Liquidity adds Bonds:
to the bank™s ability to serve its cus- Buildings and Furniture: $20
tomers. When the demand for loans
$120 $120
increases, the bank can sell its
bonds and then lend the cash to
customers. C When another person wants to borrow money, the bank
The bank also might try to attract can lend all cash in excess of its required reserves.
additional funds by introducing dif-
Assets Liabilities + NW
ferent kinds of products. One prod-
Required Reserves: $10 Demand Deposits: $100
uct is a certificate of deposit, a receipt Cash:
showing that an investor has made Net Worth or Equity: $20
an interest-bearing loan to a bank. Loans: $90
Most banks also offer savings Bonds:
accounts and time deposits, interest- Buildings and Furniture: $20
bearing deposits that cannot be with- $120 $120
drawn by check. The two accounts
are similar, except that prior notice
must be given to withdraw time Using Charts The T-accounts for the hypothetical bank
deposits, while no prior notice is trace the receipt of deposits through the loan-generating
needed to withdraw savings. process. If the reserve requirement was 20 percent,
Unless costs are extremely high, how much could the bank loan?
the bank should be able to make a

profit if it can maintain a 2- to 3-percent spread Loans and Monetary Growth
between the rate it charges on its loans and the In the figure, a depositor named Fred opens a
rate it pays for borrowed funds in the form of demand deposit account (DDA) on Monday by
CDs, savings accounts, and time deposits. If a depositing $1,000 cash in a bank. By law, $200 of
bank pays 6 percent interest on money it receives, Fred™s deposit must be set aside as a reserve in the
for example, it must loan money at a minimum of form of vault cash or in a member bank reserve
8 or 9 percent to make enough income to pay (MBR)”a deposit a member bank keeps at the Fed
expenses. to satisfy reserve requirements. The remaining $800
of excess reserves represents the bank™s lending
Fractional Reserves and Monetary On Tuesday, the bank lends its excess reserves of
$800 to Bill. Bill can take the loan either in cash or
Expansion in the form of a DDA with the bank. If he decides
The fractional reserve system allows the to take the DDA, the money never leaves the bank.
money supply to grow to several times the Instead, it is treated as a new deposit, and 20 per-
size of the reserves the banking system keeps. cent, or $160, is set aside as a reserve. The remain-
Figure 15.4 uses a reserve requirement of 20 per- ing $640 are excess reserves that can be lent to
cent to show how this can happen. someone else.
On Wednesday, Maria enters the
bank and borrows $640. She, too,
Banks as Businesses can take the loan in cash or a DDA.
If she elects to do the latter, the bank
has a new $640 deposit, 20 percent of
which must be set aside as a required
reserve, leaving $512 of excess
By Wednesday, Fred has a $1,000
DDA, Bill has an $800 DDA, and
Maria has either $640 in cash or a
$640 DDA. This amounts to $2,440 in
the hands of the nonbank public by
the end of the business day”a process
that began on Monday with the
$1,000 deposit. As long as the bank
continues to have excess reserves, the
lending process can continue.

Reserves and the Money
Because each new loan is smaller
than the one before, the money sup-
ply will stop growing at some point.
A mathematical relationship exists
Services to Customers Banks provide a source of loans for between the dollar amount of
individuals and businesses that need to borrow money. Banks reserves, the reserve requirement, and
also provide safety and interest income for their depositors™
the size of the money supply. For
money. What are time deposits?
example, if the total dollar amount of

reserves equals 20 percent of the
Figure 15.4
money supply, we could write:
Total Reserves .20 (Money Supply)
Fractional Reserves and
$1,000 .20 Money Supply
the Money Supply
Therefore, $5,000 Money Supply
This shows that $1,000 of total
reserves, given a 20 percent reserve Additions to money supply
requirement, will result in a money 2,440
Existing money supply
supply of $5,000. This amount is the $640 DDA
for Maria
final outcome of the example in 1,800
Figure 15.4, after Fred made his initial $800 DDA $800 DDA
deposit. for Bill for Bill
After the money supply has
$1,000 DDA $1,000 DDA $1,000 DDA
reached its full size, further changes
for Fred for Fred for Fred
in the amount of total reserves can 0
still affect it. Using the symbol , Monday Tuesday Wednesday Nth Day
meaning change in, we see that:
Reserves .20 ( Money Supply) Using Charts With a 20 percent reserve requirement, a
or, $1,000 cash deposit will result in a fivefold expansion of the
Reserves .20 Money Supply money supply. To compute the eventual size of the money
supply, use the formula below.
Someone, for example, might
Total Reserves · Reserve Requirement = Money Supply
withdraw $5 from the bank and keep
or $1,000 · .20 = $5,000
it permanently in a wallet. The money
supply would then change by: If the initial reserves were $2,000, how large could the
Reserves .20 Money Supply money supply get?
$5 .20 $25
In other words, the money supply
This encourages sales at stores and production at
would shrink by $25, from $5,000 to $4,975.
factories. Businesses also tend to borrow and then
invest in new plants and equipment when money is
Tools of Monetary Policy cheap. Under a tight money policy, the Fed restricts
the growth of the money supply, which drives inter-
The Fed has three major and two minor est rates up. When interest rates are high, con-
tools it can use to conduct monetary pol- sumers and businesses borrow and spend less,
icy. Each tool affects the amount of excess which slows economic growth.
reserves in the system, which in turn affects the
monetary expansion process described above. The
Reserve Requirement
outcome of monetary policy is to influence the
The first tool of monetary policy is the reserve
cost and availability of credit. The direction of
requirement. Within limits that Congress sets, the
change depends on the objectives of the Federal
Fed can change this requirement for all checking,
Reserve System.
time, or savings accounts in the country.
Under an easy money policy, the Fed allows the
This tool gives the Fed considerable control over
money supply to grow and interest rates to fall,
the money supply. For instance, suppose the Fed
which normally stimulates the economy. When
lowers the reserve requirement in the previous
interest rates are low, people tend to buy on credit.

example from 20 to 10 percent. More money could selling of government securities in financial mar-
be loaned to Bill, Maria, and others, and the kets. Open market operations are one of the meth-
money supply could reach $10,000. If the Fed ods the Federal Reserve can use to influence
raises the reserve requirement to 40 percent, how- short-term interest rates. Open market operations
ever, less money would be loaned, and the money involve the purchase or sale of government securi-
supply would be smaller. The effects of different ties by the Federal Reserve. When the Fed pur-
reserve requirements are shown in Figure 15.5. chases government securities, it increases the
Historically, the Fed has been reluctant to use supply of money, putting downward pressure on
the reserve requirement as a policy tool, in part interest rates. When the Fed sells government secu-
because other monetary policy tools work better. rities, it decreases the supply of money, putting
Even so, the reserve requirement can be a very upward pressure on interest rates. Open market
powerful tool should the Fed decide to use it. operations affect the amount of excess reserves in
Figure 15.6 summarizes the impact of a change in the banking system and, therefore, the ability of
the reserve requirement on the money supply in banks to support new loans.
the manner just described, along with the impact Suppose the Fed decides to increase the money
of the other monetary tools described below. supply. To do so, it buys government securities from
a dealer who specializes in large-volume transactions
of those securities. The Fed pays for the securities by
Open Market Operations writing a check drawn on itself. The dealer then
deposits the check with his or her bank. The bank
The second and most popular tool of monetary
forwards the check to the Fed for payment. At this
policy is open market operations”the buying and

payments between subsidiaries into euros. Step 3
includes the changeover of human resource func-
THE EURO: TODAY AND tions, including payroll and benefits and paying

taxes in eurodollars.
What does the changeover mean for con-
sumers? The old currency units won™t disappear
European industry is transferring to a single cur-
until mid-2002, and many consumers may use them
rency, the euro. Monetary union means that
till the last minute. Even if consumers aren™t yet
industries can build plants, sell products, and
using euro notes and coins, their bank accounts,
raise capital in other European markets without
retirement funds, and in many cases paychecks will
worrying about currency fluctuations.
be expressed in euros.
Retooling is costly, however. Most multinational
”Business Week, December 14, 1998
corporations will need to invest millions of dollars.
Some are converting their entire operations to the
euro system immediately. Other companies are Critical Thinking
instituting the changes in phases. In step 1, for
1. Analyzing Information What is the pur-
example, companies adapt their computers to bill
pose of the euro?
customers and pay suppliers in euros. At the same
time, they will maintain dual accounting in euros 2. Sequencing Information What steps are
and national currencies. Step 2 includes converting involved in the transition to the euro?
transactions such as budget allocations and 3. Drawing Conclusions What might be draw-
backs that Europe could face during the

Figure 15.5

The Reserve Requirement as a Tool of Monetary Policy
A Monetary Expansion (10% Reserve Requirement)
Additions to money supply
Existing money supply

Money Supply
$810 $810
$900 $900 $900
$1,000 $1,000 $1,000 $1,000

Monday Tuesday Wednesday Thursday Nth Day

B Monetary Expansion (40% Reserve Requirement)
Additions to money supply $2,500
Existing money supply $2,176

Money Supply
$360 $360
$600 $600 $600

$1,000 $1,000 $1,000 $1,000

Monday Tuesday Wednesday Thursday Nth Day

Understanding Percentages If the Fed wants to control the size of the money supply, it can
change the reserve requirement. A low requirement, such as 10 percent, can be used to expand the
money supply. A higher requirement, such as 40 percent, has the opposite effect.
Low reserve requirement:
$1,000 · .10 = $10,000
High reserve requirement:
$1,000 · .40 = $2,500
What is the size of the money supply if the Fed sets the reserve requirement at 25 percent?

Tools of the Federal Reserve

Changes in Interest The most important job of the Federal Reserve System is to maintain a stable sup-
ply of money for the economy. The Fed uses several basic tools to carry out this responsibility. How do
changes in the discount rate affect other interest rates?

Discount Rate
point, the Fed “pays” the check by increasing the
bank™s MBR with the Fed. As a central bank, the Fed makes loans to other
The result is that whenever the Fed writes a depository institutions. The discount rate”the
check, more reserves are pumped into the banking interest the Fed charges on loans to financial insti-
system. Because only some of these additional tutions”is the third major tool of monetary policy.
reserves are needed to back existing deposits, the Private individuals and businesses cannot bor-
excess reserves can be loaned out, thus increasing row from the Fed. Banks can, and frequently do.
the money supply. If the discount rate goes up, fewer banks will want
If the Fed wants to contract the money supply, to borrow from the Fed. This will reduce the
it can sell billions of dollars of government secu- amount of money these banks have available to
rities back to dealers. Dealers pay for the securities loan to their customers and will force interest
with checks drawn on their own banks. The Fed rates up. Changes in the discount rate usually
then processes the checks by reducing the MBRs result in similar changes in other interest rates.
of dealers™ banks. With fewer reserves in the bank- A bank might obtain a loan from the Fed for two
ing system, fewer loans are made and the money reasons. First, it could have an unexpected drop in
supply contracts”driving interest rates up. its MBRs, which would shrink its excess reserves. In
The Federal Open Market Committee (FOMC) this case, the bank could go to the Fed and arrange
conducts open-market operations. Normally the a short-term loan to cover the shortfall.
FOMC decides if interest rates and monetary Second, a bank could be faced with seasonal
growth are too high, too low, or just right. After demands for loans. A bank in an agricultural area,
the committee votes to set targets, officials at the for example, might face a heavy demand for loans
trading desk take over. The trading desk is the during the planting season. In that case, it would
physical location at the Fed™s New York district need additional MBRs to support the loans made
bank where the buying and selling actually takes in the spring.
place. The officials at the desk buy and sell bonds Most institutions can borrow from the Federal
daily to maintain the targets set by the FOMC. Reserve, including member and nonmember
The desk is permanently located in New York to be banks, savings institutions, and even credit
close to the nation™s financial markets. unions. The Fed, however, views borrowing as a

privilege rather than a right. As a result, the Fed Because credit was easily obtained and because
may limit the number of times a borrower can margins were so low, the margins were easy to for-
borrow from the Fed. feit when modest declines in stock prices
occurred. In fact, many investors lost everything
they had when stock prices crashed in 1929.
Margin Requirements Today, most margin requirements are set at 50 per-
Before the Great Depression, people speculated cent, meaning an investor has to put up at least
wildly in the stock market. Easy credit in the form half the money needed to buy eligible stocks and
of margin requirements, minimum deposits left bonds. The Federal Reserve sets the margin
with a stockbroker to be used as down payments to requirement and also monitors activity on the
buy other securities, made much of the speculation stock market. It also publishes a list of stocks that
possible. are eligible for margin loans.
For example, with a margin requirement as low The Fed seldom uses margin requirements as an
as 10 percent, a person only had to deposit $100 active tool of monetary policy. Instead, it uses
with a stockbroker to purchase $1,000 worth of them very selectively to dampen or stimulate
stocks. The stockbroker would supply the remain- spending on equities in the stock market.
ing $900. If the stock rose to $1,300, it could be
sold and the investor would net $400 after repaying
Other Tools
$900 to the broker. If, however, the stock dropped
to $900, the broker would sell the stock to protect The Fed may also use two other methods to con-
his or her own loan if the investor could not come trol the money supply. These are moral suasion
up with additional money. and selective credit controls.

Figure 15.6

Summary of Monetary Policy Tools
Money Supply
Tool Fed Action Effect on Excess Reserves
Reserve Lower Frees excess reserves because fewer are needed to back existing Expands
Requirement deposits in the system.
Raise More reserves are required to back existing deposits. Excess reserves
Open Market Buy bonds Checks written by the Fed add to excess reserves in the system. Expands
Operations Sell bonds Checks written by buyers are subtracted from reserves. Excess Contracts
reserves in the system contract.
Discount Rate Lower Additional reserves can be obtained at lower cost. Excess reserves Expands
Raise Additional reserves through borrowing are now more expensive. Contracts
Excess reserves are not added.

Using Charts The key to monetary policy is to see how the excess reserves in the system are
affected. What happens to the money supply when the Fed increases excess reserves? When
it decreases excess reserves?

Moral suasion is the use of persuasion such as
Tools of the Federal Reserve
announcements, press releases, articles in newspa-
pers and magazines, and testimony before
Congress. Moral suasion works because bankers
often try to anticipate changes in monetary policy.
Suppose that the chairperson of the Fed is called
before Congress to give his or her view on the state
of the economy. Assume also that the chair states
that interest rates seem somewhat low, and that it
might be good for the economy if they should rise.
These statements might lead bankers to expect a
tighter money policy in the next few weeks. As a
result, they might be less willing to loan their
excess reserves, and they might even raise their
interest rates by a small amount. In the end, the
money supply might contract just slightly, even if
the Fed did no more than offer its views.
A second method is selective credit controls”
credit rules pertaining to loans for specific com-
modities or purposes. These controls took the form
Margin Requirements Depositors besiege a
of minimum down payments on cars and other
merchant bank in Passaic, New Jersey, following
consumer goods during World War II and the
the Wall Street crash in 1929. During the 1920s,
the common practice of buying on margin Korean War. Selective credit controls during those
attracted thousands of people to pour their sav-
periods were imposed to free factories to produce
ings into stocks. What are margin requirements?
war materials.

Checking for Understanding Applying Economic Concepts
1. Main Idea What is the purpose of monetary 6. Fractional Bank Reserves Your local national
policy? bank is required to keep its reserves in the
form of vault cash and member deposits with
2. Key Terms Define monetary policy, fractional
the Fed. Why do you suppose that other
reserve system, legal reserves, reserve require-
assets, such as common stocks or real estate,
ment, excess reserves, liabilities, assets, balance
are not suitable reserves?
sheet, net worth, liquidity, savings account,
time deposit, member bank reserve, easy
money policy, tight money policy, open market
operations, discount rate, margin requirement,
7. Drawing Conclusions At times, someone
moral suasion, selective credit controls.
with a good credit rating may not be able
3. Explain how fractional reserves are used.
to get a loan. When this happens, the
4. Describe the relationship between the reserve potential customer may be told to try again
requirement, reserves, and the size of the in the near future. What does this tell you
money supply. about the bank™s reserves? How should the
customer react to a situation like this?
5. Describe the three major tools of monetary
policy. Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

JULY 20, 1998
banks initially boost
Bank mergers are becoming more com-
interest rates after the
mon. Supporters and nonsupporters of
bank mergers debate whether these con-
to gain customers”
solidations benefit customers.
they subsequently
lower rates even
more. Thus, their
Bank Mergers: depositors lose
out over the long

Who Benefits? term.
Why don™t the
merged banks follow
Although the number of commercial banks the lead of their
in the U.S. fell from 13,123 in 1988 to 9,215 in unmerged competitors Questions remain as to
1997, there™s still no end in sight to the bank- whether bank mergers
by lowering their
ing industry™s rapid consolidation. But is the benefit or hurt the customer.
interest rates over the
merger wave beneficial to consumers? long term? The authors speculate that service
declines so much after a merger that merged
Advocates claim that mergers produce effi-
banks have to pay slightly higher interest rates
ciencies that lower costs and thus permit better
than their rivals to retain customers.
service to customers. Skeptics worry that merg-
In any case, the study™s overall conclusion is
ers allow banks to cut services because they now
that banks tend to pay lower interest rates in
face less competition. A recent study by
markets that become more concentrated. And
Katerina Simons and Joanna Stavins of the
that, say the authors, is something that antitrust
Federal Reserve Bank of Boston tends to sup-
regulators need to look at more
port the latter view.
Drawing on nationwide
data covering some 500 ”Reprinted from July 20, 1998 issue of Business Week,
by special permission, copyright © 1998 by The
banks from 1985 to 1995, McGraw-Hill Companies, Inc.
the two economists looked
at how market concentra-
tion and mergers affected
interest rates on customers™
Examining the Newsclip
deposits. They found that
merged banks actually 1. Analyzing Information Describe how
tend to lower deposit rates advocates and skeptics view mergers
in the wake of a merger between banks.
(but only in the first year 2. Understanding Cause and Effect How
following the merger). are interest rates on customer deposits
More important, while affected by bank mergers?
rivals of newly merged

Monetary Policy, Banking,
and the Economy
Main Idea Objectives
Changes in the money supply affect the interest rate, After studying this section, you will be able to:
the availability of credit, and the price level. 1. Explain how monetary policy affects interest rates
in the short run.
Reading Strategy 2. Relate monetary expansion to inflation in the
Graphic Organizer As you read the section, complete long run.
a graphic organizer similar to the one below by list- 3. Identify the two major definitions of money.
ing the components of M1 and M2. 4. Describe how interest rates are affected by political

M1 M2
Applying Economic Concepts
Money Where do you keep your money? On your
person? In a savings or checking account? Read to
Key Terms find out why the answers to these questions make
prime rate, quantity theory of money, monetizing the definition of money more complicated than it
the debt, real rate of interest, M1, M2 seems.

Cover Stor y he impact of monetary policy on the econ-
omy is complex. In the short run, monetary
policy affects interest rates and the availabil-
Fed Worried About Future ity of credit. In the long run, it affects inflation,
Federal which”as we saw in the cover story”is one of the
Members of the
WASHINGTON (AP)” tion at
erns about future infla Fed™s major concerns. In addition, no one can be
Reserve expressed conc te unanimously for sure how long it will take for the effects of monetary
eeting, leading them to vo
their May m
policy to impact the economy.
a policy directive lean-
ing toward an increase
Short-Run Impact
according to minutes of
the meeting released In the short run, an increase or a decrease
Thursday. in the money supply affects the interest
While the FOMC
rate, which is the price of credit. When the Fed
members agreed that s.
tion can affect many good expands the money supply, the cost of credit
provements Infla
recent im
goes down. When the Fed contracts the money
in the nation™s produc- lationary economic
ed more room for noninf supply, the cost of credit goes up.
tivity allow , which came in at a
ey worried that growth This short-run relationship between money
growth, th quarter, was still too
t annual rate in the first and interest rates is shown in Figure 15.7. The
4.3 percen
under control. . . .
rapid to keep inflation demand curve for money has the usual shape,
1, 1999
”The Washington Post, which shows that more money will be demanded

when the price of credit is low. The supply curve,
Figure 15.7
however, does not have its usual shape. Instead, it
is vertical, indicating that the supply of money is
Short-Run Impact of
fixed at any given time.
Before the market is disturbed, the interest rate,
Monetary Policy
as shown in Panel A, is at 10 percent. If the Fed
expands the money supply to S1S1, the interest rate
falls to 8 percent. A contraction of the money sup- A Monetary Expansion
ply, as shown in Panel B, increases the rate from 10
to 12 percent.
Although the Fed tries to do what it thinks is best

Interest Rate in Percent
for the economy, people do not always agree with
its decisions. In 1981, for example, the Fed was crit-
icized for allowing interest rates to get too high. In
that year, the prime rate”the best or lowest interest 10
rate commercial bankers charge their customers” 8
reached 21.5 percent. Critics felt that the economy
would have been better off if the Fed had expanded
the money supply, thus lowering interest rates. D
Supporters, however, understood that these policies S1
were necessary to achieve long-run goals.
Quantity of Money

Long-Run Impact B Monetary Contraction
In the long run, changes in the supply of
money affect the general level of prices.
This relationship, formally known as the quantity
Interest Rate in Percent

theory of money, has been demonstrated repeatedly
in history.
Historical Precedents
When the Spanish brought gold and silver back to
Spain from the Americas in the 1700s, the increase in
the money supply started inflation that lasted for 100 D
years. When the Continental Congress issued $250 S1 S
million of currency during the Revolutionary War,
Quantity of Money
the economy suffered severe inflation. A similar
thing happened during the Civil War when nearly
$500 million of greenbacks were printed.
Using Graphs In the short run, monetary
policy impacts interest rates, or the price of
Monetizing the Debt
credit. When the money supply expands, the
When the federal government financed the price of credit goes down. When the money
Vietnam War with deficit spending in the 1960s, supply contracts, the price of credit goes up.
interest rates started to rise. To keep the rates from Why is the supply curve of money, SS,
going up too high, the Fed decided to monetize shown as a vertical line?
the debt”create enough extra money to offset the

ECONOMICS expansion of the money supply, making inflation
Figure 15.8
AT A GLANCE worse.

Monetizing the Debt Taming Inflation
Much of the federal debt was monetized from
the late 1960s until the late 1970s. During this
Supply of Supply of
Interest Rate in Percent

money before money after period, the money supply grew at rates of 12 per-
expansion expansion
cent or more for several years in a row. As inflation
D D1
worsened, the price of most goods and services”
Demand after including interest rates”also went up. Attempts by
the Fed to keep interest rates low by increasing the
supply of money worked at first, but eventually the
policy intensified inflation.
Demand before
government By 1980 the Fed realized that it had to choose
between interest rates and inflation”and it chose
to control inflation by restricting the growth of
Quantity of Money
the money supply. When this happened, the
prime rate rose and by 1981 reached 21.5 percent.
Using Graphs When the government Most people did not like the high interest rates at
borrows to cover a debt in the federal the time, but today they recognize that the tight
budget, interest rates tend to rise because of money policies were necessary to bring down
the increased demand for credit. This raises inflation.
the possibility of crowding out. If the Fed Because inflation distorts our economic statistics,
expands the money supply just enough to it is useful to consider the real rate of interest”the
offset the borrowing, interest rates may market rate of interest minus the rate of inflation.
remain unchanged. What are the long-run
To illustrate, the 21.5 percent interest rate in 1981
effects of monetizing the debt?
was not as bad as it seemed when you consider that
the inflation rate was 10.5 percent. Subtracting the

deficit spending in order to keep interest rates
from changing. The process of monetizing the
debt is illustrated in Figure 15.8, where DD and
SS represent the initial demand and supply of
Suppose that the government borrows $25 bil- The Prime Rate The prime rate is a loan rate
lion, shifting the demand curve for money from charged by banks to their best or “prime” cus-
DD to D1D1. If the Fed does not take any action, tomers. The rate is determined by general trends
the interest rate would rise from 8 to 10 percent. in interest rates. As rates decline, the prime rate
will also move lower. However, it does not typically
If the Fed wants to keep the interest rate from ris-
move on a day-by-day basis. Prime-rate changes
ing, it could increase the money supply from SS
are usually led by major money center banks.
to S1S1 and push interest rates back down to their
Normally, the prime rate will move in steps and
original level.
then remain constant until a major rate change
In the short run, then, the Fed can increase has been made. This usually happens when the
the money supply just enough to keep the interest Federal Reserve makes major changes in monetary
rate from rising. This procedure is effective policy.
if done infrequently. Repeated short-run attempts
to keep rates low, however, result in a long-term

inflation rate from the interest rate results in an 11.0 away, before prices get even higher. Or, if they feel
percent real rate of interest for that year. that prices are likely to remain stable or go down,
they may put off some spending until later. Either
way, expectations about inflation affect the alloca-
Other Monetary Policy Issues tion of resources between present and future uses.
When the Fed conducts monetary policy, it
Defining Money
has several other issues to consider. The first
issue involves the timing and burden of monetary With so many financial institutions offering dif-
policy. ferent ways for people to deposit or hold their
money, the Fed has had to develop some new defi-
nitions to keep track of it.
Timing and Burden
Figure 15.9 lists a number of components of the
Sometimes a tight money policy will show results money supply, or ways that people have chosen to
in six months. At other times, the impact might not keep money. The Fed groups these together accord-
be felt for two years. The same happens when the ing to function and gives them names. The first is
Fed follows an easy money policy. Such variations M1, which represents the transactional components
in timing make it difficult to use monetary policy to of the money supply, or the components of the
fine-tune the economy. money supply that most closely match money™s role
A second problem is that monetary policy has an as a medium of exchange. This definition of money
uneven impact on the economy. If the Fed follows includes traveler™s checks, coins, currency, demand
a tight money policy to control inflation, interest
rates go up. This increase hurts some industries like
homebuilding and auto manufacturing more than
others because of higher borrowing costs. If the Fed
follows an easy monetary policy, interest rates may
go down”thereby benefiting homebuilding and
auto making more than other industries.
Actuaries design insur-
ance and pension plans.
Present vs. Future Allocation
The Work
The Fed also realizes that interest rates and
inflation affect the allocation of scarce resources Actuaries gather and
between present and future uses. When interest analyze statistics on
rates are low, people find it easier to finance the death, sickness, injury,
purchase of a car, house, or college education disability, unemploy-
ment, retirement, and
right away. When people spend more today, how-
property loss. This infor-
ever, they end up saving less”and therefore they
mation is then used to establish how much the insured
consume less in the future.
loss will be. Actuaries calculate premium rates, ensuring
High interest rates have the opposite effect.
that the price of the insurance is high enough to cover
When rates are high, some purchases are delayed
any claims and expenses the company might have to
until rates come down or until people have saved
enough to buy the products they desire. As a result,
people have more money to spend in the future, Qualifications
and so the use of some resources shifts from the Actuaries must be knowledgeable in subjects that can
present to the future. affect insurance practices, including general economic,
Inflation also makes a difference in investment social, health, and legislation trends. Many actuaries
decisions. For example, if people expect prices to hold a degree in mathematics or statistics and they must
go up, they may try to make certain purchases right pass actuarial examinations.

Figure 15.9

Major Components of the Money Supply
Components of the
Money Supply
Traveler™s Checks $8 = M1 = $1,101 billion
+ = M2 = $4,523 billion
Other Checkable Deposits $246
Demand Deposits $363
Coins and Currency $484

Retail Money Market Funds $802
Small Denomination Time Deposits $927
Savings Deposits $1,694





















Billions of Dollars
Source: The Federal Reserve System Statistical Release H.6, 1999

Using Graphs This figure shows the different components of the money supply that comprise M1
and the money supply components that have to be added to MI to get M2. What component
makes up the largest part of the money supply?

deposits, and other checkable deposits such as monetary authority. Even so, the Fed often comes
NOW accounts and credit union share drafts. under political pressure because it has the ability to
The simple M1 definition includes only items move interest rates one way or the other.
directly and immediately useable as a medium of The president or members of Congress up for
exchange. A second and broader definition of reelection may call for low interest rates to stimu-
money is M2. M2 is a measure of money that late the economy. Incumbent politicians know that
includes those components most closely conform- their reelection chances are better if voters are
ing to money™s role as a store of value. M2 includes happy”and voters normally prefer lower interest
M1, small denomination time deposits, savings rates to higher ones.
deposits, and money market funds. The president and Congress can gain some
influence over monetary policy by appointing new
members to the Board of Governors as existing
terms expire. After new appointments are made,
The Politics of Interest Rates however, the Board of Governors usually conducts
monetary policy as it sees fit.
Because the Fed is privately owned by its
Sometimes, political leaders have tried to influ-
member banks, and because the members of
ence monetary policy by criticizing the Fed or by
the Board of Governors have 14-year terms of office,
threatening to introduce legislation to make the
the Fed is widely regarded as being an independent

Fed less independent. Fortunately, no
The Fed
such laws have been passed.
The Fed is usually reluctant to accom-
modate demands for lower interest rates
in the short term because of the long-run
fear of inflation. Unlike many politi-
cians, who frequently focus on interest
rates and thereby take a short-term view
of monetary policy, the Fed is more con-
cerned about the long-run health of the
People tend to use the interest rate,
like the unemployment rate, as a meas-
ure of the overall health of the economy.
In particular, they think the economy is
healthy when interest rates are low, and
unhealthy when rates are high. This
makes it more difficult for the Fed to
raise interest rates, especially during elec-
tion years when incumbents want voters
to think that they are doing a good job
with the economy. As a result, the Fed is
Political Pressure While the president and Congress
always conscious of its unique role in the
largely control taxation and spending, they have little con-
economy and often goes to great lengths
trol over the Fed. How can the president and Congress
to avoid political confrontations that influence monetary policy?
could threaten its independence.

Checking for Understanding considerably over the years. Describe one or
two ways you think United States money
1. Main Idea How do changes in the money
might change even more in the future.
supply affect the cost of credit?
2. Key Terms Define prime rate, quantity theory
of money, monetizing the debt, real rate of
interest, M1, M2.
8. Making Generalizations Historically, expan-
3. Describe the short-run impact of monetary
sions in money supply have set off inflation.
Something similar might have happened to
4. Explain the long-run impact of monetary you. Identify a period in your life when you
policy. had a little more money than usual. How
did you spend the extra cash? Were prices
5. Describe the two definitions of money.
as important to you then as they were at
6. Describe the political nature of interest rates. times when you did not have as much to
spend? Why do prices tend to increase
Applying Economic Concepts
faster when more money is available?
7. Money Our money supply, as well as the dif-
ferent forms or ways to hold it, has changed Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

Making Generalizations
Generalizations are judgments that are usually true, based on the facts at hand.
If you say, “We have a great soccer team,” you are making a generalization.
If you also say that your team is undefeated, you are providing evidence to
support your generalization.

Learning the Skill order to fight inflation. In the early
1980s, Federal Reserve actions
To make a valid generalization,
helped force interest rates to very
you must first collect factual
high levels. These high interest
information relevant to the topic.
rates contributed to the recession of
Follow these steps:
1981“82, but eventually helped to
• Identify the subject matter. reduce the high rate of inflation.
Some politicians and econo-
• Gather related facts and
mists feel the Fed has made many
mistakes. Others feel that it has
• Identify similarities among done a good job most of the time. It
these facts. is clear at least that the Federal
Reserve is an important power in
• Use these similarities to
our economic system.
form some general ideas
about the subject.
Based on the information presented
The Fed has a strong say in how above, identify whether each of the
Practicing the Skill banks do business. generalizations stated below is valid.
Read the excerpt below, then
1. Raising interest rates is the Fed™s most important goal.
complete the activity that follows.
2. There is disagreement over the proper role of the
Federal Reserve actions that are intended to
Federal Reserve System.
stabilize the economic system make up what is
called monetary policy. The Fed uses open mar- 3. Monetary policy is intended to help keep our
ket operations most frequently to carry out economic system from going into a recession or from
monetary policy. For example, if the Fed having inflation.
wanted banks to have more money to lend, it
4. The largest part of spending in this country is done
would buy government securities. This would
with checks.
add more money to the expansion process and
increase the ability of banks to make loans.
Over the past 50 years, the Fed has had
different objectives for its monetary policy. In
World War II it tried to keep interest rates
For one week, read the editorials in your local
low to help the government pay for the war. newspaper. Then write a list of generalizations
In the mid-1960s it tried to reduce the about the newspaper™s position on issues such as
amount of money banks had available in unemployment or the environment.
Practice and assess key social studies skills with the
Glencoe Skillbuilder Interactive Workbook, Level 2.
Section 1 • Monetary policy affects the size of the money sup-
ply, and therefore the level of interest rates.
The Federal Reserve System • The tools of monetary policy include: a change in
the reserve requirement; open market operations,
(pages 407“413)
which involves the buying and selling of government
• The Federal Reserve bonds; and a change in the discount rate.
System was estab-
• Two lesser tools include moral suasion and selective
lished as the credit controls such as margin requirements.
nation™s central
bank in 1913.
Section 3
• The Fed is unique
in that it is owned
Monetary Policy, Banking, and
by private member
banks rather than by the
the Economy (pages 426“431)
• Monetary policy affects interest rates in the short
• Today, the Fed regulates financial institutions, main-
run and inflation in the long run”forcing the Fed
tains the payments system, enforces consumer pro-
into a trade-off between lower interest rates today
tection laws, provides services to the government,
and more inflation later on.
and conducts monetary policy.
• The impact of monetary policy varies, sometimes
• The Fed supervises its state member banks, and it
affecting the economy sooner, and sometimes later.
has broad authority over bank holding companies,
Monetary policy
the international operations of all commercial banks,
also affects some
some mergers, check clearing, consumer truth-in-
sectors of the econ-
lending laws, and the maintenance of the nation™s
omy differently than
• The interest rate
Section 2 affects the allocation
of resources between
Monetary Policy (pages 415“424) present and future
uses. Expectations of
• Modern banks operate on a fractional reserve inflation also affect
system. Under this system excess reserves can be the allocation of
loaned out to other customers. resources between
• Commercial banks charge interest on their loans and present and future
use the income to pay expenses, keeping the remain- uses.
der as profit.
• The interest rate is
• The size of the money supply is determined by the one of the most vis-
reserve requirement and the reserves in the system. ible and politically sensitive prices in the economy.
An increase in the reserve requirement will shrink For political reasons, the Fed is often pressured to
the money supply. A decrease in the requirement keep interest rates low, even at the expense of
will expand the money supply. future inflation.

Reviewing the Facts
Section 1 (pages 407“413)
1. Describe the ownership of the Fed.
Self-Check Quiz Visit the Economics: Principles
2. Identify the membership of the Board of
and Practices Web site at epp.glencoe.com and
click on Chapter 15”Self-Check Quizzes to pre- Governors and the FOMC.
pare for the chapter test.
3. Identify the most important regulatory responsibil-
ities of the Fed.

Identifying Key Terms Section 2 (pages 415“424)
Write the key term that best completes the following sentences. 4. Explain how banks operate under a fractional
reserve system.
a. balance sheet j. M1
b. Board of Governors k. M2 5. Identify the conditions that enable a bank to make
c. certificate of deposit l. monetary policy new loans.
d. Regulation Z m. monetizing the debt
6. Describe the three major tools of monetary policy.
e. easy money policy n. moral suasion
f. excess reserves o. open market
Section 3 (pages 426“431)
g. FOMC operations
7. Identify the major short-run impact of monetary
h. holding company p. selective credit
i. legal reserves controls
8. Explain how the long-run impact of monetary
1. The main governing body of the Fed is the _____ .
policy differs from its short-run impact.
2. A(n) _____ would expand the money supply and
9. Explain how M1 differs from M2.
tend to lower interest rates.
10. Explain why the level of interest rates is politically
3. _____ are the funds that banks use to satisfy the
reserve requirement.
4. If a bank has _____ , it is able to make additional
Thinking Critically
loans to customers.
1. Understanding Cause and Effect What are the
5. The most popular and effective tool of monetary
effects of the Federal Reserve instituting an easy
policy is that of _____ .
money policy? Complete a graphic organizer simi-
6. When the Fed increases the money supply to offset
lar to the one below to answer to the question.
the effects of government borrowing, it is _____ .
Easy Money Policy
7. The transactional component of the money supply
is _____ .
8. One of the most important responsibilities of the of credit
Fed is _____ .
Effects on: Interest rates
9. The part of the Fed that buys and sells government
bonds as part of monetary policy is the _____ . Investment

2. Drawing Conclusions Defend or refute the fol- bill and coin. Create fields such as the following:
lowing statement: The independence of the Federal portrait, paper/coin, value, Federal Reserve Bank seal,
Reserve System is essential to the health of the and so on. Arrange the fields and text in an appealing
economy. way, including clip art, decorative fonts, and color.
Use words that will easily be understood by someone
with limited knowledge of the English language, or
Applying Economic Concepts translate the database into another language if possi-
ble. Distribute a copy of your databank to your local
1. Money Ask your parents how they keep their
visitor™s center or Chamber of Commerce.
money (CDs, traveler™s checks, savings accounts,
time deposits, banks, etc.). How many categories
mentioned in this chapter do they use?
2. Balance Sheet Make a list of all your assets and all Making Generalizations Read the following
your liabilities. Then, prepare a balance sheet that passage and answer the questions.
shows your assets, liabilities, and net worth. Although there are effective checks and
balances on powers held by the Congress
and the president, there are few checks on
Math Practice the monetary power of the Federal
Reserve System™s Board of Governors.
Assume that total reserves in the banking system Under current law, the Board is free to act
within broad limits established by
amount to $1,000 and that the fractional reserve
Congress and the president.
requirement is 15 percent. If all banks are fully loaned Actions taken by the Fed are important
out, and if the Fed sells an additional $100 of bonds to the success of government economic
to investors, how large will the money supply be? policy, yet there is no guarantee that mem-
bers of the Board of Governors will coop-
erate with Congress and the president in
Thinking Like an Economist implementing economic plans. Some polit-
ical leaders have suggested that the pow-
ers of the Fed™s Board of Governors should
If the Fed were to expand the money supply, it
be limited, or that the Board should be
would face a trade-off between lower interest rates made responsible to the president.
today and higher inflation later on. Explain how an Supporters of controlling the Fed
economist would use cost-benefit analysis to examine believe such a policy would assure the
country of a unified economic policy.
the implications of these outcomes.
Some argue that it is wrong for people
with so much power not to be elected by
the people.
Technology Skill Identify each generalization below as valid or
invalid based on the information presented.
Using a Database For one week, analyze the cur-
rency that comes into your possession. In your jour- 1. Politicians are too slow to act, and there-
fore monetary power should remain with
nal, keep track of the features that appear on the
the Federal Reserve System.
front and back of each bill, noting the similarities
2. Some people criticize the Fed because it
and differences among the various currencies.
holds a great deal of power without having
Create a database for foreign visitors that describes the to answer to the voters.
specific features and purposes of each United States 3. The powers of the Fed should be limited.
Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

One of our nation™s
most important goals
is to create an economic environ-
ment favorable to growth and
stability. In Chapter 16, you will
learn about the policies and
factors that influence our
economic stability. To learn
about theories for controlling
economic cycles, view the
Chapter 23 video lesson:
Economic Growth and Stability

Chapter Overview Visit the Economics: Principles


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