Unit 10 Monetary Policy & Central Bank System

1. Unit 10Monetary Policy & Central Bank System

2. Goals of Unit 10 • 1. Look at how the nation's money supply is determined • 2. Explore the question: How should the central bank conduct monetary policy?

3. 10.1 Principles of Money Supply Determination Three groups affect the money supply • The central bank is responsible for monetary policy • Depository institutions (banks) accept deposits and make loans 3. The public (people and firms) holds money as currency and coin or as bank deposits

4. 10.2 Money Creation • The money supply in an all-currency economy • The money supply under fractional reserve banking all-currency economy = economy with no bank deposits. Fractional reserve banking = A banking system in which banks hold only a fraction of their deposits in reserve, so that the reserve-deposit ratio is less than 1

5. I. The money supply in an all-currency economy 1. A trading system based on barter is inconvenient • The creation of a central bank to print money can improve matters a. The central bank uses money it prints to buy real assets from the public; this gets money in circulation b. People accept the paper money if they believe other people will accept it in exchange c. The government often decrees that the paper money is legal tender, so that it can be used to pay off debts and the government will accept it for tax payments

6. The central bank's assets are the real assets it buys from the public; its liabilities are the paper money it issued e. That money is called the monetary base, or high-powered money In an all-currency economy, the money supply equals the monetary base In general, monetary base is the liabilities of central bank, which consists of bank reserves and currency in circulation.

7. II. The Money Supply under Fractional Reserve Banking • As an economy becomes more financially sophisticated, banks develop. • People may want to hold their money in bank deposits and none in currency • In this case, the consolidated balance sheet of banks has assets of all the currency in the economy and liabilities consisting of all the bank deposits • The balance sheet of the central bank is unchanged from the case in the all-currency economy

8. Consolidated Balance Sheet of Banks (I)(when people deposit all their currency in bank) • Bank reserves  currency that banks hold in the bank and at the central bank 1. When bank reserves = deposits  100% reserve banking 2. Reserve deposit ratio  banks are allowed to lent some of the reserves based on the ratio. If public holds no currency, then the bank deposits are the money supply, and therefore the money supply equals the total quantity of deposits

9. Consolidated Balance Sheet of Banks (II)(when banks are allowed to lent some of the reserves based on the reserve required ratio) • Suppose the commercial bank required reserve deposit ratio (rrr) is 20%, this means the banks reserve is 20 and 80 can be loan to people • Money redeposited by the public in the bank create rounds of loans. This process is known as multiple expansion of loans and deposits.

11. 10.3 THE RELATIONSHIP OF M AND BASE M = Money Supply BASE = Monetary Base DEP = Total Bank Deposits RES = Total Bank Reserves res = Reserve-Deposit Ratio = RES/DEP • Case 1: No currency held by Public • Case 2: Public holding currency and bank reserves

12. Case 1: No currency held by public • When no currency held by public M = DEP (10.1) • For any level of deposits, the amount of reserves that banks require to hold is (res)(DEP) . • At the end of the multiple-expansion process, bank reserves must equal the amount of currency distributed by the central bank. Therefore (res)(DEP) = BASE (10.2) For the case of no currency in circulation

13. Using Eqs. (10.1) and (10.2) gives M = DEP = (10.3) • So an economy with fractional reserve banking and no currency held by the public (in this example) has money supply equal to the monetary base divided by the reserve-deposit ratio • Multiple expansion of loans and deposits allows the economy to create money supply (M) that is greater than the BASE. • (example: if res = 0.04 and BASE = 100 billions => M = 2500 billions) • Each unit of monetary base allows 1/res of money to be created • The monetary base is called high-powered money because each unit of the base that is issued leads to the creation of more money

14. What is a bank run? • In the example, banks plan on never having to pay out more than 25% of their deposits • If more people wanted to get their money from the bank, the bank would be unable to give them their funds • If people think a bank won't be able to give them their money, they may panic and rush to withdraw their money, causing a bank run

15. Case 2: Public holdings of currency and Fractional Reserve Banking • If there is both public holding of currency and fractional reserve banking, the picture gets more complicated • The money supply consists of currency held by the public (CU) and deposits, so M = CU + DEP (10.4) • The monetary base is held as currency by the public and as reserves by banks, so BASE = CU + RES (10.5) Taking the ratio of these two equations gives • (10.6)

16. This can be written as • (10.7) • The currency-deposit ratio cu = CU/DEP • -is determined by the public • The reserve-deposit ratio res = RES/DEP • -is determined by banks • Rewrite Eq. (10.7) as • (10.8)

17. The term is the money multiplier • The money multiplier is greater than 1 for res less than 1 (that is, with fractional reserve banking) • If cu = 0, the multiplier is 1/res, as when all money is held as deposits • The multiplier decreases when either cuor resrises

18. 10.4 How Does CB Control Money supply? • To change money supply, CB must change the amount of monetary base (BASE) or change the money multiplier (1/res). • For any value of money multiplier (constant), a change in BASE will cause a proportional change in money supply. Methods • Open-Market Operation • Discount Window Lending • Required Reserve Ratio

19. I. Open-Market Operation • The most direct and frequently used way of changing the money supply is by raising or lowering the monetary base through open-market operations -To increase the monetary base, the central bank prints money and uses it to buy assets in the market; this is an open-market purchase -To decrease the monetary base, the central bank sells assets in the market and retires the money it receives; this is an open-market sale Open-market purchases and sales collectively are called open-market operations.

20. Open-Market Operation • If the central bank wishes to increase the money supply by 15%, it purchases 15% more assets and its liabilities increase by 15%, which is the currency it issues.

21. II. Discount Window Lending • Discount window lending is lending reserves to banks so that they can meet depositors’ demand or reserve requirements. • The interest rate on such borrowing is called the discount rate. • A discount loan increases the monetary base. •  discount rate, discourage borrowing and reduce monetary base

22. Summary: Factors affecting the monetary base, the money multiplier, and the money supply • An increase in res, cu, or reserve requirements • has no effect on the monetary base, • decreases the money multiplier, • decreases the money supply • An open-market purchase, an increase in discount window borrowing, or a decrease in the discount rate • increase the monetary base, • have no effect on the money multiplier, and • increase the money supply

23. III Required Reserve Ratio(rrr) • The CB sets the minimum fraction of deposits that a bank must hold as reserve. • An increase in rrr forces banks to hold more reserves, thus reducing money multiplier.

24. 10.5 Intermediate Targets • Intermediate targets are macroeconomic variables that CB cannot directly control but can influence predictably. They are related to the CB goals. • CB can use intermediate targets to guide policy as a step between its tools or instruments and its goals (price stability and stable economic growth) • Frequently used targets are monetary aggregates (M1 and M2) and short term interest rates such as the discount rate • The CB cannot target both the monetary aggregates and discount rate simultaneously.

25. 10.6 MONETARY POLICY IN PRACTICE • IS-LM model makes monetary policy look easy – just change the money supply to move the economy to the best point possible. • In reality it is not so easy because of lags in the effect of policy and uncertainty about the ways MP works. • Take fairly long time for changes in MP to have impact on the economy. • Interest rate change quickly (if not control by CB) but output and inflation barely respond after few months of changes in money growth.

26. 10.6 Channel of Monetary Policy Transmission • The three channels of monetary policy transmission are • the interest rate channel, • the exchange rate channel, and • the credit channel.

27. The interest rate channel arises because tighter monetary policy raises the real interest rate, which reduces aggregate demand, leading to lower output and prices. • The exchange rate channel comes about as tighter monetary policy raises the real exchange rate, leading to lower net exports, which reduces aggregate demand and thus reduces output and prices. • The credit channel occurs when tighter monetary policy reduces the supply of credit, as banks lend less, and the demand for credit, as firms and consumers borrow less. With less borrowing and lending, consumption and investment decline, so aggregate demand falls, leading to declines in output and prices.

28. Thank you