hey econ students this is jacob clifford i've made a lot of videos about monetary policy but this one i'm going to completely explain everything you need to know using this first let's do an overview the money market graph that you've already learned shows the supply and the demand for money and that sets the equilibrium nominal interest rate and the interest rate determines how much investment spending and consumer spending on interest-sensitive consumer goods takes place in the economy so if the money supply increases the interest rate's going to fall and that will lead to more investment
and more spending and if the money supply decreases then interest rates will go up and that will lead to less investment and less spending and this process of controlling the money supply to affect interest rates is called monetary policy okay so how does the central bank change the money supply well there's three ways they could twist it pull it or bop it stay with me it's gonna make sense first we have to differentiate between the monetary base and the money supply the monetary base is made up of bank reserves which are not part of the
money supply and currency and circulation which is part of the money supply and the rest of the money supply is made up of checkable deposits this is money in checking accounts that you can use to buy goods and services and the ratio of the monetary base to the money supply is the money multiplier so if the reserve requirement was 20 making the money multiplier five the money supply would be five times bigger than the monetary base okay now that you have that down let's talk about monetary policy let's assume there's a recession so gdp is
down and unemployment is high and the central bank wants to increase the money supply to decrease interest rates and increase spending now to do that to change the money supply the central bank can do three things the first one is changing the reserve requirement instead of requiring banks to hold 20 in reserves they can tell banks to hold only ten percent in reserves so if someone deposits a hundred dollars of cash into the bank the bank doesn't need to hold twenty dollars it only needs to hold ten so the bank's excess reserves the amount they're
actually going to loan out is ninety dollars instead of just eighty and when the bank loans it out that's when the whole money creation process takes place it ends up in somebody's pocket that person puts another bank the bank holds 10 percent loans about somebody else it makes its way back in the banking system that keeps happening over and over again that initial cash deposit of a hundred dollars can generate up to nine hundred dollars of new money but notice that's way bigger than the four hundred dollars it could have been if the reserve requirement
was twenty percent the point here is that the central bank can increase or decrease the money supply by changing the reserve requirement and twisting the rules for the bank they're changing the money supply by changing that reserve requirement and changing the money multiplier now the second thing the central bank can do to change the money supply is to pull it that's the discount rate remember that the central bank doesn't have the authority or the ability to tell private banks what interest rates to charge they just can't tell commercial banks what to charge for mortgages or
student loans or car loans but there is one interest rate the central bank does have direct control over it's the discount rate it's the rate they charge banks for loans again let's assume the economy is doing poorly and the central bank wants to increase the money supply and decrease interest rates to do this they can decrease the discount rate making it cheaper and easier for banks to borrow from the central bank and that'll lead to more loans for the banks now that making loans is more profitable than owning other assets they're going to loan out
more money the banks are going to cash out those other assets and that'll increase the monetary base and when they loan that money out that's going to increase the money supply and that increased money supply will decrease interest rates and lead to more spending and that's monetary policy and the third way the central bank can change the money supply is the most important one is the name of the game open market operations in addition to making loans commercial banks have all sorts of assets like car loans and student loans and mortgages and government bonds these
are all assets and they're not part of the monetary base or the money supply open market operations are when the central bank buys those government bonds from commercial banks putting more money in bank reserves so let's see what happens when the central bank buys a 100 treasury bond from a bank instead of owning the bond now the bank has more money in reserves which is going to eventually loan out but notice that the money supply doesn't actually increase until the bank loans out that money which we assume they will when they do lend it out
someone's going to spend that money it's going to end up in another bank they're going to hold a portion loan the rest out and that keeps happening over and over again and that increases the money supply but unlike the example that we did earlier where someone deposited a hundred dollars of cash into the bank and they had to hold some in reserves the bank does not need to hold any of this in reserve when the central bank buys bonds all that money becomes excess reserves and all of it can get loaned out and again that's
when the whole money creation process takes place the money gets loaned out makes its way back to another bank that bank holds a portion lends the rest out and eventually the total increase the money supply will be a thousand dollars when a central bank uses open market operations to buy bonds that increases the monetary base and increases the money supply and of course it could go the other way the central bank could sell bonds so now the bank has less money to lend out and that would decrease the monetary base and decrease the money supply
and here's a trick that's going to help you remember if we want to increase the money supply and make it bigger then the central bank has to buy bonds if we want to decrease the money supply and make it smaller the central bank is going to sell bonds in addition to the three ways of changing the money supply that i've talked about there's other ones like quantitative easing that's when the central bank buys other assets other than bonds like mortgages or car loans but the point is these are the three that you definitely have to
know also in the real world monetary policy is a whole lot more complicated than you learn in a macroeconomics class in your class we assume that banks hold no excess reserves and they loan all the money out all that money makes its way back in the banking system in real life it doesn't look like that coffee but if you understand that monetary policy is changing the money supply to affect interest rates and there's three ways the central bank changes money supply you're gonna be fine and of course to help you remember that i'm gonna add
bop it to my wall by the way i know your teacher would love a jacob clifford autograph sign bop it and so i'm gonna raffle both of these off and there's only three things you need to have to be eligible number one is you have to be a teacher so sorry students you're not eligible number two is you must have purchased licenses from my worksheets or the ultimate review packet for all your students either this school year or next school year and number three you gotta enter the raffle by filling out the form in the
description of this video remember only teachers are eligible so make sure to tell your teacher because i bet you they want one of these but don't go anywhere there's still two things we have to do first if you like this video you're gonna love the ultimate review packet includes everything you need to get an a in your class and rock your exams and the second thing we gotta do it's time for a pop quiz you're out the questions won't be on the screen for very long so pause the video see how you do and look
in the first comment below for the answer key thanks for watching until next time you
