Introduction to Monetary Policy

Introduction to Monetary Policy

3.) How Banks make Money

1.) Goals and Types of Monetary Policy

2.) Tools of Monetary Policy

4.) Monetary Policy Limitations

Monetary Policy

AD = C + I + G + (X – M)

- is the use of targeting inflation,

interest rates, and the exchange

rates to shift the AD curve.

Reworded definition: 换句话说

- is the use of changing the supply of

money to sustain economic growth

and smooth 连出 the business cycle.

1.) Goals and Types of Monetary Policy

- An increase in the money supply to

increase AD

Expansionary

Monetary Policy

AD = C + I + G + (X – M)

Inflationary

Monetary Policy

orDefinition with arrows: 换句话说

***Ceteris Paribus

Money Supply Shifts AD right

1.) Goals and Types of Monetary Policy

AD = C + I + G + (X – M)

Contractionary

Monetary Policy

Deflationary

Monetary Policy

or

Money Supply

***Ceteris Paribus

Definition with arrows: 换句话说

Shifts AD left

- An decrease in the money supply to

increase AD

Expansionary Monetary Policy

1.) Goals and Types of Monetary Policy

Time

Long Run

Short Run

Econ

Growth

Use Contractionary

Monetary Policy

Use

Expansionary

Monetary Policy

Monetary Policy - is the use of changing the supply of

money to sustain economic growth

and smooth 连出 the business cycle.

Time

Long Run

Short Run

Business Cycle

Econ

Growth

Monetary Policy - is the use of changing the supply of

money to sustain economic growth

and smooth 连出 the business cycle.

- Basically,

monetary

policy aims to

stabilize

economic

growth,

avoiding a

boom and

bust economic

cycle.

Introduction to Monetary Policy

1.) Goals and Types of Monetary Policy

2.) Tools of Monetary Policy

3.) How Banks make Money

4.) Monetary Policy Limitations

1.) Reserve Requirements (rr)

2.) Interest Rates (ir)

3.) Open Market Operations (omo)

4.) Exchange Rate Controls (Forex controls)

5.) Quantitative Easing (QE)

2.) Tools of Monetary Policy

AD = C + I + G + (X – M)

How the Tools of Monetary Policy work

(PED > 1)

AD = C + I + G + (X – M)

Money Supply

Price

level

GDP

AD

SRAS

PE

LRAS

YN Y1

P1

AD1

***(PED > 1)

1.) Goals and Types of Monetary Policy

- More money mean

more possible

transactions and

investment in the

economy, however can

lead to inflation.

1.) Reserve

Requirements

(rr)

- the minimum fraction of customer deposits that each commercial bank must hold as reserves.

(rather than lend out).

Definition with arrows: 换句话说

***Ceteris Paribus

the (rr)

2.) Tools of Monetary Policy

Money Supply Shifts AD right

Liabilities Assets

$100

Let’s say the (rr) is 10% percent

(rr)

Let’s say people deposit $100 in the bank

The bank can make lots of loans and increase the money supply a lot

10% Cannot be lent out

loans

+ $90

2.) Tools of Monetary Policy – Reserve Requirements

90% Can be lent out

Reserve Requirements - the minimum amount banks have to keep in the bank and can’t lend out.

(rr)

MS AD=

$100

Let’s say the (rr) is 40% percent

(rr)

60% Cannot be lent out

loans

2.) Tools of Monetary Policy – Reserve Requirements

40% Can be lent out

Reserve Requirements - the minimum amount banks have to keep in the bank and can’t lend out.

(rr)

MS AD=

The bank can make lots of loans and increase the money supply by a smaller amount

Liabilities Assets

$100

Let’s say people deposit $100 in the bank

$100 + $40

2.) Interest

Rates (ir)

- The main rate charged to commercial banks from the central bank.

Definition with arrows: 换句话说

***Ceteris Paribus

the (ir) (discount/base rate)

Discount

Rate

What it is called in the US

Base

Rate

What it is called in the UK

2.) Tools of Monetary Policy

Money Supply Shifts AD right

- benchmark rate that some of the world's leading banks charge each other for short-term loans. (inter-bank)

the inter-bank rate

Federal

funds rate

What it is called in the US

LiborWhat it is called in the UK

2.) Tools of Monetary Policy

2.) Interest

Rates (ir)

Definition with arrows: 换句话说

***Ceteris Paribus

Money Supply Shifts AD right

2.) Tools of Monetary Policy – Interest rates

- The central bank rate can control all the other banks rates

Discount Rate or Base rate

- Rate the central bank charges to the commercial banks

- Rate banks charge to each other

Federal Funds Rate or Libor

(only to be used in uncommon times)

(more commonly used rate)

5%

6% 6%

8% 8% 8%

central bank

commercial banks

Bank customers

2.) Tools of Monetary Policy – Interest rates

- The central bank rate can control all the other banks rates

Discount Rate or Base rate

- Rate the central bank charges to the commercial banks

- Rate banks charge to each other

Federal Funds Rate or Libor

(only to be used in uncommon times)

(more commonly used rate)

central bank

commercial banks

Bank customers

Let’s say the central bank lowers it’s rate

2%

3% 3%

5% 5% 5%

Means lowers rates for I in AD so more investment spending MS = AD

3.) Open Market

Operations (OMO)

buying securities

- buying and selling government securities in an attempt to control interbank interest rates.

- ( libor –UK) - ( federal funds rate – US)

2.) Tools of Monetary Policy

Definition with arrows: 换句话说

***Ceteris Paribus

Money Supply Shifts AD right

2.) Tools of Monetary Policy - OMO- buying and selling government securities

in an attempt to control interbank interest rates.

MS AD=

Central bank goes out into the market and buys bonds and securities…

in exchange for liquid money.

central bank

Investors are commercial banks New money can now

be lend out or used for consumption.

4.) Exchange

Rate controls(FOREX controls)

increase Depreciation

- Managing the use of the countries money between countries.

2.) Tools of Monetary Policy

Definition with arrows: 换句话说

***Ceteris Paribus

Money Supply Shifts AD right

Marvel Land

DC Land

Marvel Land MoneyDC land Money

(Country B)(Country A)

FOREX graph example

D from B D from A

S from BS from A

A money = more valuable

B/AA/B

B money = less valuable

Appreciationin other country

Depreciationin this country

NX AD==Depreciation

5.) Quantitative

Easing (QE)

buying securities

- Buying and selling more types of securities.- used by central banks to stimulate the

economy when standard monetary policy has become ineffective.

2.) Tools of Monetary Policy

Definition with arrows: 换句话说

***Ceteris Paribus

Money Supply Shifts AD right

2.) Tools of Monetary Policy - QE- The same idea and OMO, but now the

bank just buys even more different types of securities.

MS AD=

Central bank goes out into the market and buys bonds and securities…

in exchange for liquid money.

central bank

Investors are commercial banks New money can now

be lend out or used for consumption.

Introduction to Monetary Policy

3.) How Banks Create Money

1.) Goals and Types of Monetary Policy

2.) Tools of Monetary Policy

4.) Monetary Policy Limitations

- banks keep a fraction of deposits as reservesand use the rest to make loans.

The central bank of a country establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.

The reserve ratio, (rr)= fraction of deposits that banks hold as reserves

= total reserves as a percentage of total deposits

fractional reserve banking system,

部分准备

金银行制度

Excess reserves are bank reserves over and above its required reserves.

3.) How Banks Create Money

Liabilities Assets

$100

Reserves (rr)

deposit

10% Cannot be lent out

loans

+ $90

90% Can be lent out

3.) How Banks Create MoneyT-account: a simplified accounting statement

that shows a bank’s assets & liabilities.

Example: Banks’ liabilities include deposits,

assets include loans & reserves.

In this example, notice that

(rr) = $10/$100 = 10%.

$100

An Example with 3 different situations:

Suppose $100 of currency is in circulation.

To determine banks’ impact on money supply, we calculate the money supply in 3 different cases:

Case 1. No banking system

Case 2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans

Case 3. Fractional reserve banking system

3.) How Banks Create Money

CASE 1: No banking system

Public holds the $100 as currency.

Money supply = $100.

3.) How Banks Create Money

No banks…no increase in the money supply…

Liabilities Assets

$100

Reserves (rr)

deposit

100% Cannot be lent out

$100

3.) How Banks Create Money

CASE 2: 100% reserve banking system

Public deposits the $100 at First National Bank (FNB).

Money supply =

currency + deposits =

$0 + $100 = $100

In a 100% reserve banking system, banks do not affect size of money supply.

Banks can’t make loans…

no increase in the money supply…

Liabilities Assets

$100

Reserves (rr)

deposit

$10 Cannot be lent out

$100 +90

3.) How Banks Create Money

CASE 3: Fractional reserve banking system

Suppose rr = 10%. Banks loans all but 10% of the deposit:

loans $90 Can be lent out

Liabilities Assets

$100

Reserves (rr)

deposits

$9 Cannot be lent out

$100 +90

3.) How Banks Create Money

Suppose rr = 10%. Banks loans all but 10% of the deposit:

Loans + Reserves

$81 Can be lent out

CASE 3: (Continued..) Fractional reserve banking system

Assets

$90

deposits

+81

LiabilitiesLoans + Reserves

$90

Liabilities Assets

$100

deposits

$8.10Cannot be lent out

$100 +90

3.) How Banks Create Money

Suppose rr = 10%. Banks loans all but 10% of the deposit:

Loans + Reserves

$72.90 Can be lent out

CASE 3: (Continued..) Fractional reserve banking system

Assets

$90

deposits

$90 +81

LiabilitiesLoans + Reserves

Assets

$81

deposits

+72.90

LiabilitiesLoans + Reserves

$81

The process continues, and money is created with each new loan...

Original deposit =

1-bank lending =

2-bank lending =

3-bank lending = ...

$ 100.00

$ 90.00

$ 81.00

$ 72.90...

Total money supply = $ 1000.00

3.) How Banks Create Money

In this example $100 or reserves generates $1000of money

Known as the Money Multiplier

CASE 3: Fractional reserve banking system

部分准备金银行制度

***A fractional reserve banking system

creates money, but not wealth.

The Credit multiplier = 1/rr.

In our example,

rr = 10%

money multiplier = 1/rr = 10

$100 of reserves creates $1000 of money

Credit multiplier

or

Money multiplier

- the amount of money the banking system generates with each dollar of reserves.

3.) How Banks Create Money

Introduction to Monetary Policy

3.) How Banks Create Money

1.) Goals and Types of Monetary Policy

2.) Tools of Monetary Policy

4.) Monetary Policy Limitations

At some point it stops being effective.

4.) Monetary Policy Limitations

A common expression about it is called,

“pushing on a string”

Liquidity Trap

4.) Monetary Policy Limitations

- injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective.

Money Supply Shifts AD rightLower

interest rates

*** Only leads to

more inflation

Liquidity TrapDiscount Rate or Base rate

Federal Funds Rate or Libor

central bank

commercial banks

Bank customers

Once the rate gets to 0% it’s not working to stimulate any more growth. 0%

0% 0%

0% 0% 0%

Reached the end of this tool and I in AD is not increasing with the lower rates.

Now what?

4.) Monetary Policy Limitations – Liquidity Trap

4.) Monetary Policy Limitations

Monetary policy can’t really help this problem.

Price

level

GDP

AD

SRAS

PE

LRAS

YN

SRAS1

Y1

P1

2.) Cost-Push

Negative supply shock

4.) Monetary Policy Limitations

The bad kind of inflation because it involves lower output.

Monetary policy can’t really help this problem, it only adds to inflation.

{

Price

level

GDPY

AS

Aggregate Supply is: Aggregate Supply is:

Classical zone

Economy’s resources already are fully used so only prices increase.

Intermediate zone Increase in GDP can lead to an increase of inflation too.

Keynesian zone

So an increase in GDP wouldn’t mean an increase in inflation.

4.) Monetary Policy Limitations

Where you are on this curve matters how

effective the policies can be.

Price

level

GDPY

Aggregate Supply is:

Classical zone

Economy’s resources already are fully used so only prices increase

Intermediate zone Increase in GDP can lead to an increase of inflation too.

Keynesian zone

So an increase in GDP wouldn’t mean an increase in inflation.

4.) Monetary Policy Limitations

AD AD1

Can be very effective here...

AS

Price

level

GDPY

Aggregate Supply is:

Classical zone

Economy’s resources already are fully used so only prices increase.

Intermediate zone Increase in GDP can lead to an increase of inflation too.

Keynesian zone

So an increase in GDP wouldn’t mean an increase in inflation.

4.) Monetary Policy Limitations

AD

AD1

Can be effective here, but watch out for

inflation.

AS

Price

level

GDPY

Aggregate Supply is:

Classical zone

Economy’s resources already are fully used so only prices increase.

Intermediate zone Increase in GDP can lead to an increase of inflation too.

Keynesian zone

So an increase in GDP wouldn’t mean an increase in inflation.

4.) Monetary Policy Limitations

AD

AD1

ASNo longer effective now, you just have

inflation.

So to summarize…

AD = C + I + G + (X – M)

Money Supply

Price

level

GDP

AD

SRAS

PE

LRAS

YN Y1

P1

AD1

***(PED > 1)

1.) Goals and Types of Monetary Policy

- More money mean

more possible

transactions and

investment in the

economy, however can

lead to inflation.

1.) Reserve Requirements (rr)

2.) Interest Rates (ir)

3.) Open Market Operations (omo)

4.) Exchange Rate Controls (Forex controls)

5.) Quantitative Easing (QE)

2.) Tools of Monetary Policy

AD = C + I + G + (X – M)

How the Tools of Monetary Policy work

(PED > 1)

- banks keep a fraction of deposits as reservesand use the rest to make loans.

The central bank of a country establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.

The reserve ratio, (rr)= fraction of deposits that banks hold as reserves

= total reserves as a percentage of total deposits

fractional reserve banking system,

部分准备

金银行制度

Excess reserves are bank reserves over and above its required reserves.

3.) How Banks Create Money

The Credit multiplier = 1/rr.

In our example,

rr = 10%

money multiplier = 1/rr = 10

$100 of reserves creates $1000 of money

Credit multiplier

or

Money multiplier

- the amount of money the banking system generates with each dollar of reserves.

3.) How Banks Create Money

4.) Monetary Policy Limitations

Price

level

GDPY

AS

Aggregate Supply is:

Classical zone

Economy’s resources already are fully used so only prices increase.

Intermediate zone Increase in GDP can lead to an increase of inflation too.

Keynesian zone

So an increase in GDP wouldn’t mean an increase in inflation.

4.) Monetary Policy Limitations

AD

AD1

Price

level

GDPY

AS

Aggregate Supply is:

Classical zone

Economy’s resources already are fully used so only prices increase.

Intermediate zone Increase in GDP can lead to an increase of inflation too.

Keynesian zone

So an increase in GDP wouldn’t mean an increase in inflation.

4.) Monetary Policy Limitations

AD

AD1

The endThank you