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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

  • 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

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

  • 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