Monetary Policy

Definitions

Monetary Policy

• The activities conducted by a central bank using the money supply and interest rates to regulate an economy.
• A type of demand-side policy.
  

Central Bank

• A national bank of a country that controls the money supply using monetary policy manages the domestic currency.

Money Supply

• The total amount of money in circulation in an economy.
• It consists of all the coins, notes and bank balances in the economy.
• Money supply doesn't include money that isn't in circulation however, such as money that has been stashed.
• Money deposited in banks is in circulation, however, as it can be lent out to other people.

Bonds

• Bonds are a loan by the government to pay for government spending.
• Bonds are paid by investors and they fund government operations.
• Bonds have interest rates and are often a secure way to store money, making them an appealing purchase.

• The interest rate of bonds increases with the chance that governments will default on the bond.
• More secure bonds tend to have lower interest.

• Bonds are not liquid, and thus if commercial banks spend their money on buying bonds, they will have less money to give out as loans.
• Forcing commercial banks to buy bonds can be used as a contraction policy.
• In a deflationary policy, central banks might reduce interest rates on bonds or force firms to sell them, so that they lend out money to businesses and consumers instead.

Central Bank Functions

• Determines the money supply and interest rate
• Prints money and mints coins
• "Last Resort" lender for commercial banks, the 'bank' of banks
• Open market operations (buying/selling bonds)
• Regulates the banking system (required reserve ratio)

• Central banks have no direct influence on consumers and businesses.
• Instead they apply policies that affect commercial banks, which then affect consumers.
• A central bank can influence commercial banks by changing its interest rate, lending money, and selling bonds

Determining the Money Supply and Interest rate

• There is only a certain amount of money available in an economy, therefore the supply of the money supply is fixed or perfectly inelastic (Sm).
• A nation's central bank can choose to intervene and increase the total money supply in an economy.
• This monetary policy is used to increase both consumption and investment, increasing aggregate demand.

• The relationship between the quantity of money and interest rate is inverse.
• A lower interest rate and increased money supply are designed to stimulate an economy.
• Can be put into a graph with interest rate (%) as the y-axis and quantity of money as the x-axis.
• Demand for money (Dm) is a downward sloping line and the supply for money (Sm) is a vertical line as it is perfectly inelastic.

Getting to Economic Growth Via Lower Interest Rates in Increasing Demand

• Lower interest rates can stimulate both investment (I) and consumption (C) and therefore aggregate demand.

Purposes of the Central Bank

Printing Money and Minting Coins

• The central bank is in charge of printing banknotes and minting coins.
• This gives them the ability to:

Control the money supply
Replace old or illegible banknotes
Regulate counterfeit notes by implementing security features within the notes

The Last Resort Lender for Commercial Banks

• If consumers lose confidence in the banking system, everyone will rush to take out their money (known as a 'run on the bank').
• Banks will not have this money on hand and therefore, run out of money very quickly.
• In this scenario a central bank typically guarantees deposits up to a certain amount.
• Additionally, it may step in and limit withdrawal amounts, close banks, or give loans to banks.

• The central bank can influence the interest loans of commercial banks by changing their interest rates.
• Banks earn interest when they leave money in central banks.
• If the central bank raises interest rates, then it more worthwhile for them to keep their money in the reserve of the central bank.
• They thus raise interest rate to make it worthwhile to lend out money, so that the interest they get from lending money to people is more than the interest rate they get from loaning to the central bank.

Open Market Operations (Buying and Selling Bonds)

• Bonds are a way for the government to raise funds by asking for a 'loan' from individuals and institutions.
• After a predetermined amount of time, the government repays the loan with interest.

• Buying bonds by the central bank/government increases money supply while selling bonds by the central bank/government takes money out of circulation and into the the hands of the government/central bank.

Regulates the Banking System

• The central bank also requires that commercial banks don't take on too much risk. To enforce this, the central bank uses the Required Reserve Ratio, shortened to RRR.
• The RRR is a percentage or portion of deposits that must be kept readily available in reserves.

Goals of Monetary Policy

Low and Stable Inflation

• With the use of an inflation target range, inflation is managed and creates a sense of certainty within an economy.
• Inflation should be low and stable.

Long Term Growth and Stability

• Through careful monitoring of inflation, unemployment and the business cycle, Real GDP has the ability to grow with stability.

Reducing Business Cycle Fluctuations

• Business Cycle Fluctuations can heavily impact an economy.
• Central Banks have the ability to limit the severity of these fluctuations using monetary policy.

External Balance

• External balance is achieved when imports are equal to experts.
• Changes to the money supply and interest rates have the ability to affect the external balance and trade.

Creation of Money (HL)

• Commercial banks have the ability to create money through loans and credit.
• Banks are only required to keep the reserve requirement amount.
• The remaining amount of deposits may be loaned out.

• If a bank gets a deposit, then they have to keep a certain percentage, based on the required reserve ratio (RRR).
• They can give out the rest as loans.
• When giving out loans, they also have to keep the percentage as the RRR, and can create the rest digitally or as assets that are expected to be paid back, but aren't actually owned by the bank.

Example

• Jin Woo deposits 100,000 Korean Won at his bank.
• The required reserve ratio (RRR) is set by the central bank at 10%.
• The bank must keep 10,000 Won on hand but can loan out the remaining 90,000 KRW.
• Yu Jin, a restaurant owner, loans 90,000 KRW to buy supplies for their restaurant.

• By doing this, a commercial bank has turned 100,000 Won in circulation to 190,000 KRW using credit creation.

• This process is a chain reaction.
• Jin Woo deposits money and makes credit available.
• Then Yu Jin deposits the money from her loan and the rest is credit available.
• Then someone else can receive a loan from Yu Jin's deposit.
  
• A reduction in the required reserve ratio, leads to an increase in money supply, causing the
• Sm curve to shift right.
• An increase in the RRR shifts the Sm curve to the left.
  

Money Creation Calculations

• A credit multiplier is used to determine how much money is created when there are many variables.
  
• Credit multiplier = the reciprocal of the reserve requirement ratio.
• For example: 10/100 RRR = 100/10 credit multiplier.
  
• Total deposits = initial deposit * credit multiplier
• Total credit creation = total deposits - initial credit creation

Monetary Policy Tools

• Important even though Central Banks are mostly independent, its activities are part of government monetary policy.
  

Expansionary Monetary Policy

• Buying bonds
• Lowering reserve requirement (RRR)
• Lowering lending rates
• Quantitative easing

Contractionary Monetary Policy

• Selling bonds
• Raising the reserve requirement (RRR)
• Raising interest rates
• Quantitative tightening

Money Supply and Interest Rate

Supply for Money

• The total amount of money in circulation. The supply of money is influenced by monetary policy.

Demand for Money

• The willingness and ability of firms and consumers to use money at a given interest rate.
• The curve is downward sloping.

What influences the demand for Money?

Transactions Motive

• Individuals demand money for physical goods and services.

Precautionary Motive

• Individuals demand money as a precaution for unexpected costs such as medical bills.

Speculative Motive

• Individuals demand money because they want to hold it due to low confidence regarding the future.

Nominal vs Real Interest Rate

Nominal Interest Rate

• The interest rate quoted by banks that does not include inflation adjustments.

Real Interest Rate

• An interest rate with inflation take into account.

Approximate Formula

• real interest rate = nominal interest rate - inflation rate

Proper Formula

• (1 + nominal interest rate)/(1 + inflation rate) = 1 + real interest rate
• Answers and values for interest and inflation rate are in decimal form.
• This means that x% interest rate would equal x/100 for the formula.

Effectiveness of Monetary Policy

Challenges With Monetary Policy

Time Lags

• Policies may be delayed, as it may take a number of months before there is a noticeable effect on demand.

Dependent on Business and Consumer Confidence

• When low consumer and business confidence, relatively ineffective.

Ineffective at Low Interest Rates

• Limited impact when interest rates are already low as interest rates cannot (normally) go below 0%.

Conflict with other government objectives.

• In most industrialized countries the central bank is an independent body with the primary responsibility of maintaining a low and stable rate of inflation in the economy.
• Other government objectives such as low unemployment and stable currency exchange rates.

Strengths of Monetary Policy

Flexible

• Relatively quick to put in place and small changes possible allowing for specific outcomes such as a target of 2% inflation.

Reversible

• Any changes with unintended consequences can be quickly reversed.

No Political Intervention

• As the central bank is usually an independent body, it can implement policies quicker.

An absence of "crowding out"

• Policies do not require the government to take on debt and thus cannot lead to crowding out.