MONETARY POLICY

8
Topic
The Central Bank: CB

The Federal Reserve System, commonly known as the

Fed, is the central bank of the United States.
A Central Bank (CB) is the public authority that, typically,
regulates a nations depository institutions and controls the
quantity of the nations money. The degree of
independence the central bank has from the government
of the day varies a great deal from one country to another.
The Central Bank: CB

The CBs Goals and Targets

The CB conducts the nations monetary policy, which means that,

among other things, it adjusts the quantity of money in circulation.
The CBs goals are to keep inflation in check, maintain full
employment, moderate the business cycle, and contribute to
achieving long-term growth.
In pursuit of its goals, in the U.S., the Fed pays close attention to
interest rates and sets a target for the federal funds rate that is
consistent with its goals. The federal funds rate is the interest rate
that commercial banks in the U.S. charge each other on overnight
loans of reserves [federal funds]. In Canada, this rate is called the
Overnight lending rate. In Bangladesh, it is called the Call Money
Rate.
Controlling the Quantity of Money

The CBs Policy Tools

In theory, the CB could use three monetary policy tools:
Required reserve ratios
The discount rate
Open market operations
Controlling the Quantity of Money

The CB sets required reserve ratios, which are the

minimum percentages of deposits that depository
institutions must hold as reserves.
The CB does not change these ratios very often.

The discount rate is the interest rate at which the CB

stands ready to lend reserves to depository institutions.

An open market operation is the purchase or sale of

government securities Treasury bills and bonds by
the CB in the open market.
 Controlling the Quantity of Money

How Required Reserve Ratios Work

An increase in the required reserve ratio boosts the reserves that
banks must hold, decreases their lending, and decreases the
quantity of money. However, this is a sudden discontinuous
change, so can be disruptive.
How the Discount Rate Works
An increase in the discount rate raises the cost of borrowing
reserves from the CB and decreases banks reserves, which
decreases their lending and decreases the quantity of money.
But banks try to avoid borrowing from the CB [why?], so discount
rate changes act mainly as a signal.
 Controlling the Quantity of Money

How an Open Market Operation Works

When the CB conducts an open market operation by buying a
government security, it increases banks reserves.
Banks loan the excess reserves.
By making loans, they create money.
The reverse occurs when the CB sells a government security.
Changing the supply of reserves to the banking system changes the
interbank lending/borrowing rate, the interest rate at which banks
lend and borrow reserves among themselves. So in practice, the CB
announces a target rate for the interbank lending rate, and then
uses Open Market Operations to get close to its target.
 The Demand for Money

This Figure illustrates the

demand for money curve.
The demand for money curve
slopes downwarda rise in the
interest rate raises the
opportunity cost of holding
money and brings a decrease in
the quantity of money
demanded, which is shown by a
movement along the demand for
money curve.
The Supply of Money
This Figure shows the supply of
money as a vertical line at the
quantity of money that is largely
determined by the CB. The money
supply is largely but not exclusively
determined by the CB because
both banks and the public are
important players in the money
supply process (as explained in
earlier chapters). For example,
when banks do not lend their entire
excess reserves, the money supply
is not as large as it is when they
do.
Money market equilibrium
determines the interest rate.
Interest Rate Determination

An interest rate is the percentage yield on a financial security such

as a bond or a stock [or savings account].

The price of a bond and the interest rate are inversely related.

If the price of a bond falls, the interest rate on the bond rises.

If the price of a bond rises, the interest rate the bond yields falls.

We can study the forces that determine the interest rate in the
market for money.
 Money Market Equilibrium

This Figure
illustrates the
equilibrium
interest rate.
 Money Market Equilibrium

If the interest rate is

above the equilibrium
interest rate, the
quantity of money that
people are willing to
hold is less than the
quantity supplied.
They try to get rid of
their excess money by
buying financial assets.
This action raises the
price of these assets
and lowers the interest
rate.
 Money Market Equilibrium

If the interest rate is

below the equilibrium
interest rate, the
quantity of money
that people want to
hold exceeds the
quantity supplied.
They try to get more
money by selling
financial assets.
This action lowers the
price of these assets
and raises the
interest rate.
 Money Market Equilibrium

Changing the
Interest Rate
This Figure shows
how the CB
changes the
interest rate.
If the CB conducts
an open market
sale, the money
supply decreases,
the money supply
curve shifts
leftward, and the
interest rate rises.
 Money Market Equilibrium

If the CB
conducts an
open market
purchase, the
money supply
increases, the
money supply
curve shifts
rightward, and
the interest rate
falls.
Transmission Mechanisms

Changes in one market can often ripple outward to affect

other markets. The routes, or channels, that these ripple
effects travel are known as the transmission mechanism.

Monetary policy transmission mechanism: The routes,

or channels, traveled by the ripple effects that the money
market creates and that affect the goods and services
market (represented by the aggregate demand and
aggregate supply curves in the ADAS framework).

In this chapter we discuss two transmission mechanisms:

the Keynesian and the Monetarist.
Transmission Mechanisms

The Money Market in the Keynesian Transmission

Mechanism: Indirect
If the CB increases money supply, the interest rate
decreases. Then, three events follow:
Investment and consumption expenditures increase.
The value of the dollar in terms of foreign currency falls
and net exports increase.
Aggregate demand increases (through a multiplier
effect).
 Transmission Mechanisms

The Keynesian
Transmission
Mechanism: Indirect

This Figure
summarizes these
ripple effects.

The final step

depends on the
shape of the
aggregate supply
curve
Transmission Mechanisms
 Transmission Mechanisms

The Keynesian
Mechanism May
Get Blocked
Interest-Insensitive
Investment
(a) If investment is totally
interest insensitive, a
change in the interest
rate will not change
investment; therefore,
aggregate demand and
Real GDP will not
change.
 Transmission Mechanisms

The Keynesian
Mechanism May
Get Blocked
The Liquidity Trap
(b) If the money market
is in the liquidity trap, an
increase in the money
supply will not lower the
interest rate. It follows
that there will be no
change in investment,
aggregate demand, or
Real GDP.
Transmission Mechanisms
The Keynesian View of Monetary Policy
Transmission Mechanisms

Bond prices, interest rates, and the liquidity trap

Remember that the price of a bond and the interest rate are
inversely related. So, when money supply increases, people
use the extra money supply to buy bonds, price of bonds
increases and interest rate falls.

However, when interest rate is very low, this relationship may

break down. At a low interest rate, the money supply
increases but does not result in an excess supply of money.
Interest rates are very low, and so bond prices are very high.
Would-be buyers believe that bond prices are so high that
they have no place to go but down. So individuals would
rather hold all the additional money supply than use it to buy
bonds.
Transmission Mechanisms

The Monetarist
Transmission
Mechanism: Direct
The monetarist transmission
mechanism is short and
direct. Changes in the money
market directly affect
aggregate demand in the
goods and services market.
For example, an increase in
the money supply leaves
individuals with an excess
supply of money that they
spend on a wide variety of
goods.
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Expansionary Monetary Policy: To reduce unemployment
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Contractionary Monetary Policy: To reduce inflation