Monetary Policy and the Money Multiplier

Abstract

The objective of this note is to provide an overview of monetary policy tools and the primary policy objectives. The mechanics behind the money multiplier are explained, and an algebraic derivation is provided. The note also provides examples of how parameters associated with the money multiplier influence its magnitude, including the propensity of the public to hold currency relative to demand deposits and the propensity of banks to hold reserves relative to demand deposits. The companion exercise allows students to walk through the mechanics of expansionary monetary policy.

Excerpt

UVA-BP-0455

MONETARY POLICY AND THE MONEY MULTIPLIER

When a monetary authority conducts monetary policy, its objective is either to stimulate economic activity (expansionary monetary policy) or dampen it (contractionary monetary policy). To implement monetary policy, the monetary authority—for example, a central bank like the U.S. Federal Reserve—has three primary tools at its disposal: open market operations (OMO) [the buying or selling of government securities], the discount rate [the rate at which commercial banks borrow from the central bank], or the required reserve ratio [the fraction of deposits that commercial banks must send to the central bank for safekeeping]. In the United States, for example, the Federal Reserve (the Fed) uses all three tools, but open market operations have become the dominant method by which monetary policy is conducted. Monetary authorities enjoy varying degrees of independence from central governments when formulating policy, and the Fed is considered to be on the independent end of the spectrum. For purposes of exposition, this note will focus on how the Fed conducts monetary policy.

The Fed conducts expansionary monetary policy by purchasing government securities like Treasury bills (T-bills) through open market operations, lowering the discount rate, lowering the required reserve ratio, or through some combination of the three. Conversely, if the Fed wished to conduct contractionary monetary policy, it would sell T-bills, raise the discount rate, raise the required reserve ratio, or some combination of the three. The ultimate policy objectives of monetary policies are to influence the levels of gross domestic product (GDP), unemployment, and inflation. (Note: in keeping with contemporary economic convention, GDP rather than GNP is used in this note.)

Although the ultimate policy objectives of monetary policy are to influence the “Big 3,” intermediate targets bridge the policy action with the ultimate objectives. These intermediate targets include market-determined interest rates, such as the interest rate at which banks borrow from each other, called the federal funds rate, or monetary aggregates like M1 or M2, which are different measures of the money supply. While the Fed's ultimate policy objectives have remained unchanged, its main intermediate target has changed over time. For example, shortly after Paul Volcker became the chair of the Federal Reserve in 1979, the Fed switched from targeting interest rates to targeting monetary aggregates. The Fed has since switched back to targeting interest rates.

How Monetary Policy Works

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Keywords: money management, macroeconomics, policy formulation, political economy