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

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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
  • 

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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

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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

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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)

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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
  • 
• 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
  • 

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