Monetary policy can seem complex at first — but once you break it down, the big picture becomes clear. In this post, I’ll summarize the core concepts from Module 2: Monetary Policy, including what I learned from our course and follow-up discussions. I hope this helps others preparing for the exam or trying to understand how central banking really works.

💡 Key Concepts from Module 2

1. 💵 Money, Deposits & Fractional Banking

🔹 Monetary Base (MB)

\(\text{MB} = \text{Reserves} + \text{Physical Currency (held by public)}\) This is the total amount of “high-powered money” controlled by the central bank. It includes:

• Reserves: Cash held by banks in vaults or on deposit at the central bank
• Physical Currency: Cash and coins held by the public (not inside banks)

🔹 Money Supply Measures

🔹 Demand Deposits vs. General Deposits

• Demand Deposits:
  • Funds in checking accounts
  • Can be withdrawn anytime
  • Used for everyday spending
  • ✅ Counted in M1
• Other Deposits (e.g. savings, CDs):
  • Not instantly spendable
  • May have withdrawal limits or penalties
  • ❌ Not in M1, but included in M2

✅ Only demand deposits are considered “money” in the strict M1 sense, because they’re liquid and usable immediately.

🔹 Fractional Reserve Banking

Banks are only required to keep a fraction of deposits as reserves. The rest is loaned out, which increases the money supply.

2. 🏦 Central Bank Tools & Implementation

• Central banks implement policy using:
  • Open Market Operations
  • Overnight Lending Rate (e.g. Federal Funds Rate)
  • Discount Rate
  • Reserve Requirement (rarely changed)
• More reserves = more lending = lower interest rates = more investment and spending.

3. 📉 AS/AD Curve Analysis

• Aggregate Demand (AD) = C + I + G + (X – Im)
• AD slopes down due to:
  • Wealth effect
  • Interest rate effect
  • Foreign exchange effect
• Aggregate Supply (AS) slopes upward (short run) and is affected by input costs, productivity, and regulations.
• Shocks to AD or AS shift the curves and impact GDP and price level.

4. 🎯 The Dual Mandate

The Federal Reserve is tasked with:

• Price Stability
• Full Employment

Key ideas:

• NAIRU = Natural rate of unemployment (too low = inflation risk)
• Potential GDP = Output at full resource utilization
• Output gap = Actual – Potential GDP
• Stagflation = Inflation + High unemployment (usually due to supply shocks)

5. 📊 The Taylor Rule

Used to guide interest rate policy: \(\text{Target Fed Funds Rate} = 1.5 \times \text{Inflation} + 0.5 \times \text{GDP Gap} + 1\)

• “Inflation Hawks” prioritize inflation control (higher rates)
• “Doves” prioritize employment (lower rates)
• Taylor Rule suggests a balanced response to inflation and economic output

6. 🗣️ Central Bank Statements

Central bank language follows a pattern:

• Business as Usual
• Wait and See
• Slow and Steady
• Time to Act
• All Systems Go

Interpretation helps forecast rate decisions and economic direction.

🧠 Clarifications from Our Discussions

• M1 is NOT MB + deposits
  • ✅ M1 = Demand Deposits + Currency Held by Public
  • ❌ Reserves are not added again — they support the deposits

• MB includes reserves (bank-held) and physical currency (public-held), but not deposits directly

• Only demand deposits are part of M1
  • Savings, CDs → counted in M2
• M1 vs M2 vs M3 help economists track how liquid the money is

✅ Example: MB and M1 in Action

Suppose Customer A deposits $1,000:

• Bank keeps $100 as reserves (10%)
• Loans out $900 → redeposited

Then:

• MB = $100 (bank reserve only; public holds no currency)
• M1 = $1,900 (all in demand deposits)

Reserves are not added again to M1 — no double-counting.

✍️ Final Thoughts

Monetary policy isn’t just theory — it shapes interest rates, job markets, and inflation. By understanding tools like the money multiplier, AD/AS analysis, the Taylor Rule, and how the Fed speaks through its statements, we get a clear view of how economies are managed.

Hope this helps others reviewing for the EMBA course or anyone trying to understand how central banks influence our daily financial reality.