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
      

• 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

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

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  • 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:

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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

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• 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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