MONETARY POLICY

Monetary policy refers to the actions taken by the Central Bank (i.e. Bangladesh Bank) to affect
monetary and financial conditions in the money market as well as capital market and foreign
exchange market to help achieving economic objectives of low inflation, low unemployment,
sustainable economic growth and a stable balance of payments.
Bangladesh Bank is the Governments monetary authority and is responsible for formulating and
administrating monetary policy. To achieve low-inflationary growth, Bangladesh Bank sets a
targeted call money rate (the market rate of interest on overnight funds) and also fix Statutory
Liquid Reserve (SLR) of 19% of total demand and time liabilities, 6% of which is to be
maintained as cash reserve ratio (CRR) for conventional scheduled banks and the rest 13% on
approved securities. But for seven Islamic banks SLR is only 11% of which 6% CRR is to be
maintained since Islamic banks cannot purchase treasury bills that involve receipt of interest.
Bangladesh Bank also buys and sells bonds in the open market through repos and reverse repos.
Bangladesh Bank has Three Major Tools of Monetary Policy
A. Open market operations refer to the BBs buying and selling of government bonds.
1. Buying securities by BB will increase bank reserves and the money supply.
a. If BB buys directly from banks, then bank reserves go up by the value of the securities sold
to Bangladesh Bank.
b. If BB buys from the general public, people receive checks from BB and then deposit the
checks at their bank. Banks customer deposits rise and therefore bank reserves rise by the
same amount.
i. Banks lending ability rises with new excess reserves.
ii. Money supply rises directly with increased deposits by the public.
c. When BB buys bonds from bankers, reserves rise and excess reserves rise by same amount
since no checkable deposit was created.
d. When BB buys from public, some of the new reserves are required reserves for the new
checkable deposits.
e. Conclusion: When Bangladesh Bank buys securities, bank reserves will increase and the
money supply potentially can rise by a multiple of these reserves.
B. The reserve ratio is another tool of monetary policy. BB has SLR (Statutory Liquid
Ratio) and CRR (Cash Reserve Ratio). It is the fraction of reserves required by banks
relative to their customer deposits.
1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of
excess reserves shrinks banks lending ability and, therefore, the potential money supply by a
multiple amount of the change in excess reserves.
2. Lowering the reserve ratio decreases the required reserves and expands excess reserves.
Gain in excess reserves increases banks lending ability and, therefore, the potential money
supply by a multiple amount of the increase in excess reserves.
3. Changing the reserve ratio has two effects.
a. It affects the size of excess reserves.
b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent
to 20 percent, the multiplier falls from 10 to 5.
4. Changing the reserve ratio is very powerful since it affects banks lending ability
immediately. It could create instability and credit crunch. So Bangladesh Bank rarely
changes it.

C. The third tool is the discount rate or call money rate, which is the interest rate that
BB charges to commercial banks that borrow from Bangladesh Bank for overnight
lending or inter-bank borrowing rate.
1. An increase in the call money rate signals that borrowing reserves is more difficult and will
tend to shrink excess reserves.
2. A decrease in the call money rate signals that borrowing reserves will be easier and will tend
to expand excess reserves.
3. BB could reduce the call money rate, although this has little direct impact on the money
supply since it is lent for only one night.
Changes in monetary stance
Loosening/expansionary monetary policy
To ease monetary stance, Bangladesh Bank purchases bonds from the banks and other financial
institutions in the money market. This leads to an increase in the supply of funds in the market
when Bangladesh Bank transfers payments to the exchange settlement accounts of the banks.
The increase in the supply of funds puts downward pressure on both the call money rate and the
market rates of interest. For example, a loosening of monetary policy occurred on 15 th
November 2011 when the call money rate declined from over 20% to less than 12.75%. It was
primarily intended to channel through funds from money market to share market to ease the
ongoing liquidity crisis.
INFLUENCE OF MONETARY POLICY ON OUTPUT AND PRICE LEVEL
The effects of monetary policy are easy to show graphically. Here we begin with money supply,
money demand, and an equilibrium interest rate. It shows how both an increase and a decrease in
the money supply affect interest rates.
Definition of theory of liquidity preference: Keyness theory that the interest rate adjusts to bring
money supply and money demand into balance. The demand for money as an asset was theorized
to depend on the interest foregone by not holding bonds. Interest rates, Keynes argues, cannot be
a reward for saving as such because, if a person hoards his savings in cash, keeping it under his
mattress say, he will receive no interest, although he has nevertheless refrained from consuming
all his current income. Instead of a reward for saving, interest in the Keynesian analysis is a
reward for parting with liquidity.
According to Keynes, demand for liquidity is determined by three motives:
1. the transactions motive: people prefer to have liquidity to assure basic transactions, for their
income is not constantly available. The amount of liquidity demanded is determined by the
level of income: the higher the income, the more money demanded for carrying out increased
spending.
2. the precautionary motive: people prefer to have liquidity in the case of social unexpected
problems that need unusual costs. The amount of money demanded for this purpose increases
as income increases.
3. speculative motive: people retain liquidity to speculate that bond prices will fall. When the
interest rate decreases people demand more money to hold until the interest rate increases,

which would drive down the price of an existing bond to keep its yield in line with the
interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).
The liquidity-preference relation can be represented graphically as a schedule of the money
demanded at each different interest rate. The supply of money together with the liquiditypreference curve in theory interacts to determine the interest rate at which the quantity of money
demanded equals the quantity of money supplied.
Note: Famous economist Murray Rothbard rejected Keynes theory of liquidity preference and
argued it should the theory of time preference instead.
Equilibrium in the Money Market:
1. If the interest rate is higher than the equilibrium interest rate, then
2. The quantity demanded of money is less than the quantity supplied of money which is fixed
by the central bank,
3. People will try to buy bonds or deposit funds in an interest bearing account,
4. This increases the funds available for lending, pushing interest rates down.
Interest rate, r
Money Supply
Excess Su of Money
r1

r*
Money Demand
0

Md1

Qs

Quantity of Money

Figure 5.4

Equilibrium in the Money Market

1. If the interest rate is lower than the equilibrium interest rate,
2. The quantity demanded of money is more than the quantity supplied of money which is fixed
by the central bank,
3. People will try to sell bonds or withdraw funds in an interest bearing account,
4. This decreases the funds available for lending, pushing interest rates up.

Interest rate, r
Money Supply

r*
r2
Excess D of Mo.

Quantity fixed by
Bangladesh Bank

Money demand

Md2

Quantity of
Money

Figure 5.5
The Downward Slope of the Aggregate-Demand Curve (Keyness interest-rate effect)
1. Price level

(P1 P2) Quantity of money that people need to hold

2. Demand for money

3. Interest rate

Money demand curve shifts to the right (MD1 MD2)

to balance the supply and demand for money (r1 r2)

Cost of borrowing

(Investment) & Return on saving

(Consumption)

Quantity of goods and services demanded in the economy

4. GDP

(Y1 Y2)
The Money Market and the Slope of the Aggregate-Demand Curve

Figure 5.6
We already know that monetary policy is changes in interest rates and the quantity of money in
the economy.
Concept of monetary base/ high powered money

currency + bank reserve deposits

controlled by the central bank

Monetary base
Monetary base is the total amount of a currency that is either circulated in the hands of the public
or in the commercial bank deposits held in the central bank's reserves. The monetary base is
highly liquid money that consists of coins, paper money (both as bank vault cash and as currency
circulating in the public), and commercial banks' reserves with the central bank.
The monetary base is also called high-powered because an increase in the monetary base can
result in a much larger increase in the supply of bank money, an effect often referred to as the
money multiplier. An increase of 1 billion currency units in the monetary base will allow (and
often be correlated to) an increase of several billion units of "bank money".
Factors affecting the monetary base:
Factor

Effect on
Monetary Base

Open Market Purchase

Open Market Sale
Increase in discount
window borrowing
Increase in the
discount rate
A Monetary Injection

Effect on
Money Supply

Figure 5.7
From the figure 6.7 we can see a fall in interest rates increases the money supply in the money
market and thus boost consumption and investment which helps to increase the aggregate
demand in an economy but at a cost of higher price level (inflation).
Money Market
Learning Objectives:
1.
2.
3.
4.
5.
6.
7.
8.
9.

The definition and functions of money.

What constitutes the supply of money?
What backs BBs money supply?
The components of money demand.
How the equilibrium interest rate is determined in the money market?
About the structure of the financial system of Bangladesh.
About recent developments in money and banking.
How banks create money?
How to create a bank?

I.
The Definition and Functions of Money
Money is what money does. Anything that performs the function of money is money.
A. Medium of exchange: Money can be used for buying and selling goods and services.
B. Unit of account: Prices are quoted in dollars and cents.
C. Store of value: Money allows us to transfer purchasing power from present to future.
It is the most liquid (spendable) of all assets, a convenient way to store wealth.
1) Inflation can erode the value of money to some extent.
The Characteristics of Money: 1. Portability, 2. Divisibility, 3. Durability, 4.Stability
II.

Supply of Money
A. Narrow definition of money: M1 includes currency and demand deposits.
1. Currency (coins + paper money) held by public.
a. All coins are token money, which means its intrinsic value is less than the face
value of the coin. The metal in a 50 paisa is worth less than 50 paisa itself.
b. All paper currency consists of Bangladesh bank Notes issued by the
Bangladesh Bank.
2. Demand deposits are included in M1, since they can be spent almost as readily as
currency and can easily be changed into currency.

a. Chartered banks are a main source of demand deposits for households and
businesses.
B. Money Definition: M2 = M1 + personal saving deposits and non-personal notice
deposits at chartered banks.
C. Money Definition: M2+ = M2 + deposits at trust and mortgage loans companies,
deposits at and credit unions, plus money market mutual funds, and at other non-bank
deposit taking institutions.
D. Which definitions are used? M1 will be used in this text, but M2 and M2+ are
watched closely by the Bangladesh Bank in determining monetary policy.
1. M2 and M2+ are important because they can easily be changed into M1 types of
money and influence peoples spending of income.
2. The ease of shifting between M1, M2, and M2+ complicates the task of
controlling spendable money supply.
3. The definition becomes important when authorities attempt to measure control
and the money supply.
E. CONSIDER THIS Are Credit Cards Money?
Credit cards are not money, but their use involves short-term loans; their convenience
allows you to keep M1 balances low because you need less for daily purchases.
III.

What backs the money supply?

A. The governments ability to keep its value stable provides the backing.
B. Money is debt; paper money is a debt of Bangladesh Bank. Demand deposits are
liabilities of chartered banks because depositors own them.
C. Value of money arises not from its intrinsic value, but its value in exchange for goods
and services.
1. It is acceptable as a medium of exchange.
2. Currency is legal tender or fiat money. It must be accepted by law (Chahiba
Matro eher Bahok ke dita baddo thakeba). (Note that cheques are not legal tender
but, in fact, are generally acceptable in exchange for goods, services, and
resources.)
3. The relative scarcity of money compared to goods and services will allow money
to retain its purchasing power.
F. Moneys purchasing power determines its value. Higher prices mean less purchasing
power.

G. Excessive inflation may make money worthless and unacceptable. An extreme

example of this was German hyperinflation after World War I, which made the mark
worth less than 1 billionth of its former value within a four-year period. And also the
recent example of Zimbabwean currency.
1. Worthless money leads to use of other currencies that are more stable.
2. Worthless money may lead to barter exchange system.
H. Maintaining the value of money
1. The government tries to keep supply stable with appropriate fiscal policy.
2. Monetary policy tries to keep money relatively scarce to maintain its purchasing
power, while expanding enough to allow the economy to grow.
IV.

The Demand for Money: Two Components

A. Transactions demand, Dt, is money kept for purchases and will vary directly with
GDP.
B. Asset demand, Da, is money kept as a store of value for later use. Asset demand
varies inversely with the interest rate, since that is the price of holding idle money.
C. Total demand will equal quantities of money demanded for assets plus that for
transactions.

V.

The Money Market: Interaction of Money Supply and Demand

A. Key Graph at page 8 shows the money market. It combines demand with supply of
money.
B. Figure at page 8 shows how equilibrium changes with a shift in the supply of money.
C. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds
to get money. This causes bond supply to rise, bond prices to fall, and a higher
market rate of interest.
D. If the quantity supplied exceeds the quantity demanded, people reduce money
holdings by buying other assets, like bonds. Bond prices rise, and lower market rates
of interest result (see example in text).
E. Monetary authorities can shift supply to affect interest rates, which in turn affect
investment and consumption and aggregate demand and, ultimately, output,
employment, and prices.

VI.

Recent Developments in Money and Banking

A. Convergence of services provided has made financial institutions more similar.
B. Globalization of financial markets: Significant integration of world financial markets
is occurring and recent advances in computer and communications technology
suggest the trend is likely to accelerate.

C. Electronic transactions: Internet buying and selling, electronic cash and smart cards
are examples.
1. In the future, nearly all payments could be made with a personal computer or
smart card.
2. Unlike currency, E-cash is issued by private firms rather than by government.
To control the money supply the Bangladesh bank will need to find ways to
control the total amount of E-cash, including that created through Internet loans.
1.1 How Banks Create Money
A. Creating a Bank
1. Obtaining a License
A new bank must first apply for a charter license to the Bangladesh bank and the
Department of Finance, The Peoples Republic of Bangladesh for permitting it to
operate as a commercial bank.
2. Raising Financial Capital
The next step is to raise capital. At first to pay from the sponsors and directors and
later on by selling shares through IPOs.
3. Buying Equipment
It is necessary to buy office equipment, software, and other essentials to get the
bank started.
4. Accepting Deposits
The bank will then need to advertise to the public that it is accepting deposits.
5. Establishing a Reserve Account
a. The banks required reserves equal the required reserve ratio multiplied by the
amount of deposits.
b. Excess reserves equal actual reserves minus required reserves. The bank can
loan only its excess reserves.
6. Clearing Checks
Banks clear checks so that the bank whose depositor wrote the check loses
deposits and reserves while the bank in which the check is deposited gains
deposits and reserves. Clearing checks does not change the quantity of money.
7. Buying Government Securities
Government securities provide a bank with an income and are a safe asset that is
easily converted back into reserves when necessary.
8. Making Loans
Commercial banks use their excess reserves to make loans to the public.
a. Loans are an asset to the bank because the borrower is committed to repaying
the loan on an agreed-upon schedule.

b. When a borrower is granted a loan, the bank gives the borrowers the funds by
creating a checkable deposit in the borrowers name and depositing the
amount loaned in the account.
B. The Limits to Money Creation
Excess reserves give a single bank the ability to make loans. As these loans are spent,
they create additional checkable deposits in other banks that create more reserves for
additional lending. The loan creation process is limited by the amount of initial excess
reserves and the required reserve ratio.
C. The Deposit Multiplier
1. The deposit multiplier is the number by which an increase in bank reserves is
multiplied to find the resulting increase in bank deposits.
1

2. The deposit multiplier equals Requiredreserveratio.

12.2. Influencing the Quantity of Money
A. How Required Reserve Ratios Work
1. If the BB increases the required reserve ratio, the banks must increase their
reserves and decrease their lending, which decreases the quantity of money.
2. If the BB decreases the required reserve ratio, the banks can decrease their
reserves and increase their lending, which increases the quantity of money.
B. How the Call Money Rate Works
1. When the rate increases, banks are less willing to borrow reserves, so they
decrease their lending and the quantity of money decreases.
2. When the rate decreases, banks are more willing to borrow reserves, so they
increase their lending and the quantity of money increases.
3. Changes in the call money rate have limited effect on the quantity of money
because banks rarely borrow from the BB.
C. How an Open Market Operation Works
Open market operations are the BBs major policy tool. When the Bangladesh Bank
buys securities in an open market operation, it pays for them with newly created bank
reserves and money.
1. The BB Buys Securities
a. When the Bangladesh Bank buys securities from banks it does so by
increasing the banks reserves. This action increases the monetary base and
increases the reserves of the banking system.
b. When the BB buys securities from the nonbank public, the seller deposits the
check received from the BB in a bank, whose reserves now increase by the
amount of the check.

2. The BB Sells Securities

Whether the transaction is with a bank or the nonbank public, the end result is a
decrease in reserves, a decrease in the monetary base, and a decrease in the
quantity of money.
D. The Multiplier Effect of an Open Market Operation
1. An open market purchase increases bank reserves and also increases the monetary
base. The increase in the monetary base equals the amount of the open market
purchase and equals the increase in banks reserves.
2. Excess reserves are created, and banks lend these excess reserves.
3. Bank deposits increase and the quantity of money increases. The multiplier
process means that the quantity of money increases more than the initial increase
in the monetary base.
4. A currency drain is an increase in currency held outside the banks. A currency
drain decreases the amount of money that banks can create from a given increase
in the monetary base because currency drains from their reserves and decreases
the excess reserves available.
E. The Money Multiplier
1. The money multiplier is the number by which a change in the monetary base is
multiplied to find the resulting change in the quantity of money.
2. The money multiplier decreases in magnitude when the currency drain increases
or when the required reserve ratio increases.
1

a. The money multiplier equals (1 L) , where L = (1 C) (1 R) and C is the

currency drain (the percentage of an increase in money held as currency) and R is
the required reserve ratio.
The Economic Functions of Monetary Institutions
Banks and other monetary institutions perform four economic functions:
1. Create Liquidity
A liquid asset is an asset that can be easily, and with certainty, converted into money. A
bank creates liquid assets by borrowing short and lending long.
2. Lower Costs
Banks lower the cost of lending and borrowing funds.
3. Pool Risk
By lending to a large number of businesses and individuals, banks lower the average risk
of making loans.
4. Make Payments
A banks deposits are money because they can be transferred from one person or business
to another at low cost. Banks provide the payments system that enables these transfers of
ownership to occur.