MIDTERMS

• Tools or instruments of monetary policy


  Used to alter the reserves of commercial banks which in turn will affect the lending activities of commercial banks that change the money supply in the economy in the form of checkable deposits
• Multiple-Deposit Expansion


  1. Banking system can lend or create money by a multiple of its excess reserves

  2. Each bank in the system can create money or lend only with its excess reserve
• Assumptions for illustration


  • Reserve ratio is pegged at 20 percent for all commercial banks
  • All banks meet the 20 percent requirement exactly
  • If any bank can increase its loans as a result of acquiring excess reserves, an amount equal to those reserves will be lent to one borrower, who will write a check for the entire amount of the loan and give it to someone else, who will deposit the check to another bank
  • The worst thing possible to happen to each lending bank is a check for the entire amount of the loan is drawn and cleared against it in the favor of another bank
• Individual bank


  Can safely lend an amount equal to its excess reserves
• Banking system


  Can lend by a multiple of its collective excess reserves
• Monetary multiplier


  The relationship between any new excess reserves in the banking system and the magnified creation of new checkable-deposit money by banks as a group
• Calculating maximum new checkable-deposit money


  Excess reserve (E) x Monetary multiplier (m)
• Official policy rate


  The central bank's policy rate that works through the economy via short term interest rates, changes in asset prices, the exchange rate, and expectations of economic agents
• Monetary Transmission Mechanism


  Policy Rate -> Exchange Rate, Expectations, Asset Prices, Market Rates
• Increase in official policy rate

  Commercial banks increase their lending rates to individuals and businesses on both short-term and long-term horizons

  Prices of assets (bonds) or value of capital projects fall due to increase in discount rate

  Household financial wealth decreases leading to a decrease in consumption
• Increase in interest rate

  Makes the country's exchange rate appreciate, turning domestic exports expensive and reducing demand from foreign buyers
• Expectations of economic agents

  They will view the increase in interest rate as creating a slowdown in economic activity and growth, reducing profits and borrowings from individuals and businesses

  Investments and purchasing decisions will be based on their interest rate expectations
• Expansion of the money supply by the entire banking system

  Bank A acquires 100 in reserves, requires 20, has 80 in excess reserves which it can lend out

  Bank B acquires 80 from Bank A, requires 16, has 64 in excess reserves which it can lend out

  This process continues with each subsequent bank, creating a total of 400 in new checkable-deposit money
• Neutral policy rate


  The rate of interest that neither spurs on nor slows down the underlying economy

  Consists of the real trend rate of growth of the underlying economy and the long-run expected inflation
• Money Neutrality Concept
• Tools of Monetary Policy


  • Open-market operations
  • The reserve ratio
  • The discount rates
• Open-market operations


  1. Buying government bonds from commercial banks

  2. Selling government bonds to commercial banks

  3. Buying securities from the public

  4. Selling securities to the public
• Buying securities from commercial banks

  • Commercial banks give up part of their holdings of the government bonds to the Central Bank
  • The Central Bank pays the commercial banks by increasing the reserves of the commercial banks by the amount equal to the purchase
• Buying securities from commercial banks

  Increases the reserves in the banking system, which in turn increases the lending ability of the commercial banks, then increases money supply in the form checkable deposit accounts
• Buying securities from the public

  • Spri-kiting-ting Corp. sells securities to the CB and gets payment in check drawn by the CB against itself
  • Spri-kiting-ting Corp. deposits the CB check payment in its account with the Kurokong Bank
  • Kurokong Bank sends the check payment of the CB to the CB headquarters for collection
• Buying securities from the public

  • Increases the lending ability of the Kurokong bank and of the commercial banking system
  • Increased the money supply through the increased amounts of checkable deposits
• Selling Securities to commercial banks

  1. Central Bank give up the securities purchased by the commercial banks

  2. The commercial banks pay for those securities by drawing check against their reserve deposits in the Central Bank

  3. The Central Banks collects by reducing the commercial banks reserve deposits effectively reducing banks' lending ability
• Selling Securities to the Public

  1. Central Bank sells securities to Spriki-ting-ting Corp. which pays with a check drawn on the Kurokong bank

  2. The Central Bank clears the check against the reserve deposit of Kurokong bank that reduced its reserve deposit which in turn reducing its lending ability

  3. Kurokong bank returns the cancelled check to Spriki-ting-ting corp. and reduce Spriki-ting-ting checkable deposits accordingly
• Reserve Ratio


  • Tools of Monetary Policy and Banks' lending activities
  • Tools or instruments of monetary policy are used to alter the reserves of commercial banks which in turn will affect the lending activities of commercial banks that change the money supply in the economy in the form of checkable deposits
• Multiple-Deposit Expansion


  Banking system can lend or create money by a multiple of its excess reserves, this is done though each bank lend in the system can create money or lend only with its excess reserve
• • Reserve ratio is peg at 20 percent for all commercial banks
  • All banks meet the 20 percent requirement exactly: no excess reserve that means all were loaned up fully in terms of the reserve requirement
  • If any bank can increase its loans as a result of acquiring excess reserves, an amount equal to those reserves will be lent to one borrower, who will write a check for the entire amount of the loan and give it to someone else, who will deposit the check to another bank
• Buying securities from commercial banks

  Increases the reserves of commercial banks
• Monetary multiplier


  • Maximum checkable-deposit creation is the relationship between any new excess reserves in the banking system and the magnified creation of new checkable-deposit money by banks as a group
  • The money multiplier (m) is the reciprocal of reserve ratio (R)
  • Monetary multiplier (m) = 1/required reserve ratio
• Reserve ratio = commercial bank's required reserves / commercial bank's checkable-deposit liabilities
• Increase of reserve ratio


  The bank might sell bonds held and add the proceeds to its reserve, both transactions would reduce money supply
• Decrease of reserve ratio

  Convert the required reserves into excess reserve and improve the ability of banks to create new money by lending that increase money supply
• Discount Rate


  • Central Bank is known as a "lender of last resort"
  • Commercial banks experience unexpected and immediate needs for additional needs, and the central bank do make short-term loan to commercial banks
  • When commercial bank borrows, it gives a promissory note (IOU) drawn against itself and secured by acceptable collateral usually government securities
  • Central bank too charges interest rate on loans they grant to commercial banks, called Discount rate
• Commercial banks borrowing from the CB

  • The central bank increases the reserves of the borrowing commercial bank
  • The new reserves acquired by borrowing becomes excess reserves by the borrowing commercial bank that enhances the commercial banks' ability to extend credit
• Central bank raises discount rate


  Restricts the money supply
• Central bank decreases discount rate


  Increases money supply
• Term Auction Facility


  1. Central bank auction reserves to commercial banks

  2. Commercial banks submit bids that includes how much they wish to borrow and the interest rate they are willing to pay

  3. The central bank arranges the submitted bids of the commercial banks from highest to lowest by interest rate

  4. The pool of reserves goes to those banks that offer the highest interest rate

  5. The rate all the auction winners pay is the same, that is the rate offered by the lowest bidder whose bid is accepted
• Term Auction Facility


  Allows the central bank to alter money supply by either increasing or decreasing the amounts of reserves it auctions
• Tools or instruments of monetary policy are used to alter the reserves of commercial banks which in turn will affect the lending activities of commercial banks that change the money supply in the economy in the form of checkable deposits
• Tools of Monetary Policy


  • Open-market operations
  • The reserve ratio
  • The discount rates
• Open-market Operations


  1. Buying securities from commercial banks

  2. Buying securities from the public

  3. Selling Securities to commercial banks

  4. Selling Securities to the Public