Modern Banking - Monetary policy

What is the purpose of conventional monetary policy?

refers to the usual tools a central bank uses to control money and interest rates to maintain economic stability.

• reserve requirements

• target federal funds rate range

• interest rate on excess reserves

• discount rate

What are reserve requirements?

What it is: The minimum amount of money that banks must keep (can’t lend out).

Why it matters: It controls how much money banks can create through lending.

What is the target federal funds rate range?

What it is: The interest rate banks charge each other for overnight loans.

Why it matters: It influences other interest rates in the economy (like on loans and savings).

What is the interest rate on excess reserves (IOER)?

What it is: The interest the Fed pays banks for money they keep at the Fed beyond the required minimum.

Why it matters: It encourages banks either to lend or to hold money, affecting the money supply.

What is the discount rate?

What it is: The interest rate the Fed charges banks when they borrow money directly from it.

Why it matters: It helps banks manage short-term cash needs and acts as a backup option (a safety net).

What is the monetary base?

is the starting amount of money in the system, controlled directly by central banks, but the actual money supply can grow due to the money multiplier.

How does the money multiplier work?

allows banks to lend out a portion of deposits, creating more money in the system without printing more physical cash.

Money = money multiplier x monetary base

what reduces the multiplier effect?

• cash withdrawals

• excess reserves

why do banks lend to each other overnight?

-              Banks aim to have a certain amount of reserves by the end of each day.

-              Due to customer transactions, some banks may have too much (excess), while others have too little (shortfall).

-              Those with too much lend to those with too little — this is the overnight lending market.

what are the unconventional monetary poolicy?

backup tools used when interest rates are already very low and economy still needs help (recession or crises)

• forward guidance

• quantitative easing

• target asset purchase

what is forward guidance?

The central bank tells people what it plans to do in the future. Why? It helps people and markets make decisions now (e.g., borrow or invest)

what is quantitative easing?

The central bank creates money to buy lots of financial assets, like government bonds.

-              This adds more money to the banking system, even when interest rates can't go any lower.

-              Goal: Make loans cheaper, boost investment, and help the economy grow.

what is target asset purchase?

The central bank chooses specific types of assets to buy (not just government bonds).

-              This helps influence prices or interest rates in certain parts of the economy (like housing or business loans).

-              Goal: Directly support struggling areas or encourage activity where needed.

what is a fractional reserve banking system?

banks hold only a portion of deposits as reserves and lend the rest, creating money via the money multiplier.