CHAPTER-15 (ARNOLD):

MONETARY POLICY:

COURSE TEACHER:
D R . TA M G I D A H M E D C H O W D H U R Y
A S S O C I AT E P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER
After completing this chapter, students will be able to answer:
• What is Central Bank and how they control money supply
• The way of controlling money in the economy
• Demand, supply and money market equilibrium
• Transmission system in the money market
• Use of monetary policy during inflation and unemployment
• The role of commercial banks in the monetary system
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 nation’s depository institutions and controls the
quantity of the nation’s 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 CB’s Goals and Targets
 The CB conducts the nation’s monetary policy, which means that, among other things,
it adjusts the quantity of money in circulation.
 The CB’s 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 CB’s 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.
HOW CENTRAL BANK INFLUENCES MONEY SUPPLY
• This money supply model depends on three variables:
1. The monetary base (B): Total currency held by people (C) and reserves of banks (R)
2. The reserve-deposit ration (required reserve, rr): Fraction of deposit that banks hold
3. Currency-deposit ratio (cr): Amount of currency people holds as fraction of their demand deposits (D).
Now, we Know, M (Money supply) = C + D
B=C+R
Dividing first equation by second to see the relation between M and B:
M/B = (C + D) / (C + R)
Dividing numerator and denominator of right hand side by D:
M/B = (C /D+ D/D) / (C/D + R/D)
M/B = (cr+ 1) / (cr + rr) or M = [(cr+ 1) / (cr + rr) ] * B
M = m * B (m is called money multiplier)
Example, Assume B is $800 billion, rr is 0.1 (10%), and cr is 0.8 (80%). Money multiplier would be
m = (0.8 + 1)/(0.8 + 0.1) = 2.0
Thus, total money supply in the economy is: M = 2.0 * $800 billion = $1600 billion.
INFLUENCE ON MONEY SUPPLY
• Consider several cases:
• Assume that monetary base is $800 billion

Cases Money multiplier (m) Total money supply (M)

rr = 0.1, cr = 0.8 (0.8 + 1)/(0.8 + 0.1) = 2.0 2.0 * $800 billion = $1600 billion
rr = 0.15, cr =0.8 (0.8 + 1)/(0.8 + 0.15) = 1.89 1.89 * $800 billion = $1512 billion
rr = 0.1, cr = 0.9 (0.9+ 1)/(0.9+ 0.1) = 1.9 1.9 * $800 billion = $1520 billion

• Interpretations:
- Higher the required reserve (rr), lower will be the money supply and vice versa.
- Higher the currency deposit ratio (cr), lower will be the money supply and vice versa.
- Higher the monetary base (B), more will be the money supply.
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 downward—a 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 – Money market equilibrium determines the
vertical line at the quantity of money that is interest rate.
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.
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 AD–AS 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 • Interest-Insensitive
May Get Blocked 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 • The Liquidity Trap
May Get Blocked • (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
ROLE OF COMMERCIAL BANKS IN MONETARY
SYSTEM
• Required Reserve (RR): The deposits that banks have received but have not lent out are called
required reserve.
• First type of bank: 100-percent-Researve Banking

Bank’s Balance Sheet

__________________________
AssetsLiabilities
__________________________
Reserve $1000 Deposit $1000
Outcome: If banks hold 100 percent of deposits in reserve, the banking system doesn’t affect the
money supply.
ROLE OF COMMERCIAL BANKS IN MONETARY
SYSTEM (CONT......)
• Second type of bank: Fractional reserve banking
Assume, a customer has deposited $1000 in the bank. The RR is 20% (or 0.20) of the deposit.
First Bank’s Balance Sheet
__________________________
AssetsLiabilities
__________________________
Reserve $200 Deposit $1000
Loans $ 800

Second Bank’s Balance Sheet

__________________________
AssetsLiabilities
__________________________
Reserve $160 Deposit $800
Loans $ 640
MONEY CREATION IN FRACTIONAL RESERVE
SYSTEM
• Based on the example given in the last slide:
Original deposit = $1000
First Bank’s Lending = (1-rr) * $1000
Second Bank’s Lending = (1-rr)2 * $1000
Third Bank’s Lending = (1-rr)3 * $1000
_________________________________
Total money supply = [ 1+ (1-rr) + (1-rr)2 + (1-rr)3 + ....] * $1000
= (1/rr) * $1000
In this case, total money creation would be : (1/0.20) * $1000 = $5000
Note: Currently RR in Bangladesh is around 18.5%