Chapter 8
Monetary
Policy
After studying this chapter, you should be able to
understand:
Goals of monetary policy
Tools of monetary policy
Cause chain effect between monetary policy and
changes in GDP
Relative importance of monetary tools
Strengths and weaknesses of monetary policy
Issues in monetary policy
Monetary policy is the process by
which the monetary authority
controls the supply of money, often
targeting a rate of interest.
The responsibility for the conduct of monetary policy lies
firmly with the Central Bank.
Monetary policy has a very powerful impact on the
economy!
The Chairman of the Federal
Reserve, Jerome Powell, is
sometimes called the second most
powerful person in the U.S!
Ben Bernanke JanetYallen Jerome Powell
(2006 – 2014) (2014-2018) (since Feb 5, 2018)
1) Keep prices
What are the stable
basic goals of 2) Achieve full
monetary employment
policy? 3) Steady real GDP
growth
An expansionary A restrictive monetary
monetary policy policy decreases
increases supply of supply of money, or
money, or lower the increase the interest
interest rate. rate.
It is used to fight It is used to fight
unemployment inflation during
during recession. economic boom.
An increase in the money supply will:
A. lower interest rates and lower the equilibrium
GDP.
B. lower interest rates and increase the equilibrium
GDP.
C. increase interest rates and increase the
equilibrium GDP.
D. increase interest rates and lower the equilibrium
GDP.
The four major monetary policy tools:
Open market
operation
operations
Changing
required
reserve ratio
Changing
Term discount rate
Auction
Facility
There are trillions of
dollars worth of
What is open government bonds in
existence.
market
Open market
operations? operations refer to the
central bank buying and
selling of government
bonds.
Open-market operations refer to:
A. purchases of stocks in the NewYork Stock
Exchange.
B. the purchase or sale of government
securities by the Fed.
C. central bank lending to commercial banks.
D. the specifying of loan maximums on stock
purchases.
The required reserve ratio (RR)
is the fraction of reserves
What is required to be kept in the central
bank relative to their customer
required deposits.
reserve It is meant as a monetary tool
for the central bank to control
ratio? the lending activities of banks.
Changing the RR has two effects.
1) It affects the size of excess reserves because:
Excess Reserves = Actual Reserves - Required Reserves
2) It affects the size of monetary multiplier because:
Money multiplier = 1/Required Reserves.
For example, if ratio is raised from 10% to 20%, the
multiplier falls from 10 to 5.
Raising the RR shrinks Lowering the RR
the excess reserves. expands the excess
Loss of excess reserves reserves.
shrinks banks’ lending Gain in excess reserves
ability . increases banks’ lending
Together with lower ability.
money multiplier, money Together with higher
supply will decrease. money multiplier, money
supply will increase.
Discount rate is the
What is interest rate that the
central bank charges
discount to commercial banks
that borrow short
rate? term funds directly
from the central
bank.
Why would banks borrow money
from Central Bank?
Banks are required to have a certain amount of cash
on hand each night, known as the reserves
requirement.
However, sometimes banks loan out too much that
day. Central bank lends them to make sure they meet
their reserves requirement.
Central bank only lend out money to banks as
the lender of last resort!
By raising or lowering the discount rate, the
central bank can influence bank’s lending habit!
Raising the discount Lowering the
rate discourages discount rate
banks from borrowing encourages banks to
from the central bank, borrow from the
making banks more central bank, turning
prudent in lending. banks more aggressive
in lending.
Lowering the discount rate has the effect of:
A. Changing required into excess reserves
B. Changing excess into required reserves
C. Making it less expensive for commercial banks
to borrow from the central banks
D. Forcing commercial banks to call in outstanding
loans from their best customers
The Federal The Fed holds two
auctions each month
Reserve uses its since December of
term auction 2007 in response to
facility to make mortgage debt crisis.
excess reserves Banks bid for the right
available to to borrow reserves for
banks. 28 days.
These loans of reserves borrowed by auction-
winning banks have the same effect on reserves as
the borrowing of reserves at the discount rate.
Increasing the amount Reducing the amount
of reserves auctioned of reserves auctioned
under the term auction under the term auction
facility will increase facility will decrease
banks’ excess reserves banks’ excess reserves
and increasing lending and decreasing lending
ability. ability.
Qualitative methods
1) Moral suasion (tactic used by
the central bank to influence
and pressure, but not force,
banks into adhering
to policy).
2) Changing loan tenure.
3) Changing loan down
payment.