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Unit 4.6: Financial Sector

Monetary Policy

  • Monetary policy::
    • A central bank’s policies of influencing nominal interest rates to help achieve macroeconomic objectives:
    • Price stability
    • Full employment
  • Interest rate changes impact the price level, real output, and unemployment through shifts of AD

Monetary policy’s target interest rate

  • When banks are unable to meets the reserve requirement, they can:
    • Call in loans
    • Sell assets
    • Borrow from the central bank (pay discount rate)
    • Borrow from other commercial banks (pay policy rate)
  • Policy rate::
    • Overnight interbank lending rate
    • Called the federal funds rate in the US
  • Central banks often set a target range for the policy rate to guide monetary policy
  • Expansionary monetary policy::
    • When the central bank decreases nominal interest rates in the short run to help get an economy out of a recessionary gap
    • Lower interest rate => less expensive to borrow => more interest-sensitive spending (investment and consumption) => increase in AD \n
  • Contractionary monetary policy::
    • When the central bank increases nominal interest rates in the short run to get an economy out of an inflationary gap
    • Higher interest rates => more expensive to borrow => less interest-sensitive spending (investment and consumption) => decrease in AD

Monetary policy lags

  • Recognition lag::
    • It takes central banks time to collect and analyze the data needed to recognize problems in the economy
  • Impact (or operational) lag::
    • It takes time for the economy to adjust after the policy action is taken

Limited reserves

  • In a limited reserves framework, interest rate changes are brought about through shifts of the money supply
  • Limited reserves framework::
    • A banking system in which:
    • Reserves are not overly abundant
    • There is a nonzero reserve requirement
    • Commercial banks hold required reserves and possibly also excess reserves
    • Monetary policy works by changing the supply of excess reserves and therefore the supply of money
    • Changing the money supply results in changes to the nominal interest rate

Limited Reserves monetary policy tools

  • a) Required reserve ratio::

    • The percentage of demand (checkable) deposits banks must hold in their reserves
    • If it decreases
    • Banks have more excess reserves to lend
    • MS (money supply) increases (nominal interest rate falls or NIR)
    • If it increases
    • Banks have less excess reserves to lend
    • MS decreases (nominal interest rate rises)

  • b) Discount rate::

    • The interest rate commercial banks must pay to borrow from the central bank
    • Decreases:
    • Banks encouraged to lend more
    • MS increases (nominal interest rate falls)
    • Increases:
    • Banks encouraged to lend less
    • MS decreases (nominal interest rate rises)

  • c) Open market operations (OMO)::

    • Central bank buying and selling of government bonds (securities)
    • Central bank buys bonds (OM purchase)
    • Banks’ excess reserves increases
    • MS increases (NIR falls)
    • Central bank sells bonds (OM sale)
    • Banks’ excess reserves decreases
    • MS decreases (NIR rises)

The money multiplier

  • OMO causes changes in reserves, so the monetary base changes
  • In limited reserves environments, the effect of an OMO on the MS is greater than the effect on the monetary base because of the money multiplier
  • An increase in excess reserves (OMO purchases) leads banks to make more loans, which leads to more deposits, which creates more excess reserves, which allows for more loans
  • A decrease in excess (OMO sale) works the opposite way
  • Maximum possible value of money multiplier:
    • Money multiplier = 1 / required reserve ratio
    • Based on assumptions:
    • Banks hold no excess reserves
    • Borrowers spend their entire loans
    • Customers hold no cash
  • Maximum possible change to MS as a result of an OMO:
    • Change to MS = OMO amount * money multiplier
  • Open market operations effects
    • Liabilities don’t change, but money is moved around in the assets section
    • change a bank’s excess reserves by the entire amount of the purchase (increase) or sale (decrease)
      • Required reserve ratio doesn’t apply to OMO
    • change a bank’s bond holding amount by the entire amount of the purchase (decrease) or sale (increase)

Ample Reserves

  • Tied to central bank of the US (federal reserve)
  • In a limited reserves framework, interest rate changes are brought about through changes to administered interest rates
  • Ample reserves framework::
    • A banking system in which:
    • Reserves are abundant
    • The required reserve ratio is zero
    • ^^Changing the MS no longer leads to changes in nominal interest rates^^
    • Different monetary policy tools are needed
  • The money market graph is not used to model an ample reserves banking system, ^^the reserve market model^^ is
    • Policy rate (federal funds rate in the US) is important in the model used for this framework
    • Policy rate is set at the intersection of SR (supply of reserves) and DR (demand for reserves)
    • In ample reserves, SR intersects the lower horizontal portion of DR
    • Buying bonds is used to maintain ample reserves (not a monetary policy tool in this case)
    • The monetary base increases, but there is no impact on interest rates
    • Reserve market model:

Ample Reserves monetary policy tools (used by Fed)

  • a) Administered interest rates, including:
    • Interest on reserves (IOR)::
    • The interest rate commercial banks earn on the funds in their reserve balances accounts with the Fed
    • Fed’s primary monetary policy tool
    • increases to IOR move up the lower bound (lower horizontal area on DR) on the reserve market model graph
      • Decreases to IOR move the lower bound down
    • Discount rate::
    • Same definition as under limited reserves, but the central bank is the Fed in the US
    • increases to discount rate move up the upper bound (higher horizontal area on DR) on the reserve market model graph
      • Decreases to discount rate move the upper bound down
  • Expansionary policy
    • A decrease in these administered interest rates leads to a decrease in the policy rate then a decrease in other nominal interest rates
    • Interest-sensitive spending and AD will increase
    • effect of expansionary monetary policy on reserve market model
  • Contractionary policy
    • An increase in these administered interest rates leads to an increase in the policy rate then an increase in other nominal interest rates
    • Interest-sensitive spending and AD will decrease
    • effect of contractionary monetary policy on reserve market model