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Monetary Policy Tools

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Monetary PolicyChanges in Monetary Policy Tools

in order to affect Aggregate Expenditures

Increase AE

Decrease AE

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Monetary Policy Objectives

Maintain “stable prices” = inflation below 3%.

today:?www.mnb.huMaintain “sustainable economic

growth” = Output Growth at least 3%

Today:?

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GDP - Hungary2007 1.Q.: 102,3%2008 1.Q.: 101,9%

2009 1.Q.: 93,3%2009 4.Q.: 92,8%

2010 1.Q :100,1%2010 2.Q: 100,9%

-16-14-12-10-8-6-4-2024681012

-16-14-12-10-8-6-4-202468

1012

01 Q

101

Q3

02 Q

102

Q3

03 Q

103

Q3

04 Q

104

Q3

05 Q

105

Q3

06 Q

106

Q3

07 Q

107

Q3

08 Q

108

Q3

09 Q

109

Q3

10 Q

1

% (A

nnua

lrate

of gr

owth)

% (A

nnua

lrate

of gr

owth)

Households' consumption Government consumptionGross fixed capital formation Inventories and statistical discrepanciesNet exports GDP growth

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Monetary policy goalsPrice stabilityHigh employmentEconomic growthInterest rate stabilityStability of financial marketsStability in foreign exchange

markets

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Monetary Policy Tools1. Open Market Operations:

Buying or Selling Bonds to the public.

2. Required Reserve Ratio. 3. Changing the Discount Rate.4. Changing Margin Requirements5. Using “Moral Suasion”.

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1. Open Market Operations

Name: from the Bank of England

Refinancing loans only to special institutions

Government papers are on the open market, for everyone

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1. Open Market Operations

To sell open market instruments =

Reduce national bank money

To buy open market instruments=

Create money

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1. Mechanism of Open Market Operations

The entire banking system consists of only five banks

and they hold their reserves at the Fed.

Example r = 20%

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Hungarian required rate of reserves

1994 13% + 6%1995 17% +8.5%2000 11% + 4%2008 2% -

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Banking System DepositsBank 1 has

10,000Bank 2 has

30,000Bank 3 has

40,000Bank 4 has

15,000Bank 5 has

5,000

D=100,000d1= 10,000d2= 30,000d3= 40,000d4= 15,000d5= 5,000

Total deposits in the banking system are $100,000

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Reserves = 20% of Deposits

Bank 1 has 10,000 (0.2) = 2,000 in reserves

Bank 2 has 30,000(0.2) =6,000 in reserves.

Bank 3 has 40,000(0.2) =8,000 in reserves

Bank 4 has 15,000(0.2)=3,000 in reserves

Bank 4 has 5,000(0.2)=1,000 in reserves

All BanksReserves

R=20,000

Total reserves in the banking system are $20,000

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Ms = Deposits + Currency outside banks.

All BanksReserves

R=20,000

All BanksDeposits

D=100,000d1= 10,000d2= 30,000d3= 40,000d4= 15,000d5= 5,000

r = 0.2R=20,000 D=100,000

Ms = 100,000

L= 80,000

80,000 are in loans.

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The Fed’s AccountFederalReserveBank

R=20,000Bank 1= 2,000Bank 2= 6,000Bank 3= 8,000Bank 4= 3,000Bank 5= 1,000

Bonds

Assets Liabilities

The Fed holds Government bonds as part of their Assets.

Bank’s reserves are liabilities to the Fed

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The Fed Buys $100 in Bonds From Mr. Anderson

5000Bonds

Assets Liabilities

100 Bond Mr. Anderson

5100Bonds

Fed pays with a check $100

FED

R=20,000Bank 1= 2,000Bank 2= 6,000Bank 3= 8,000Bank 4= 3,000Bank 5= 1,000

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Mr. Anderson Deposits the Fed’s Check at Bank

1Fed pays with a check

New depositAt bank One$100

All BanksDeposits

D=100,000d1= 10,000d2= 30,000d3= 40,000d4= 15,000d5= 5,000

$100 d1=10,100

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R=20,000Bank 1= 2,000Bank 2= 6,000Bank 3= 8,000Bank 4= 3,000Bank 5= 1,000

A Bond Purchase Increases Bank’s Reserves

5000Bonds

Assets Liabilities

100 Bond Mr. Anderson sells bond

5100Bonds

Bank 1 presents the checkto the Fed for clearing

$100

FED

=2,100

Fed credits Bank One’s reserves

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With $100 in extra reserves…

1r

D D = x D R

10.2

D D = x 100

D D=500

Deposits increase by 500 when reserves increase by 100.This 500 includes a 400 increase in loans.

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When Bank One’s Reserves Increase

Bank One holds now more reserves than required,

Bank One will make more loans To other banks To the public

The loans generated become new deposits at other banks which keep 20% as reserves and loan the rest…

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The Effect of a 100 purchase of bonds by the Fed.

All BanksReserves

R=20,100

All BanksDeposits

D=100,500d1= 10,100d2= 30,100d3= 40,100d4= 15,100d5= 5,100

r = 0.2R=20,100D=100,500

Ms = 100,500 and 80,400 of that is loans.

Note that deposits increased in all banks…

L= 80,400

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Three Kinds of ReservesRequired Reserves (RR). The amount

that must be held by law, the required reserve ratio times deposits:

RR = r(D)Actual Reserves (AR). The amount of

reserves actually held by the bank. This could be higher or lower than RR.

Excess Reserves(ER). Any amount held above required reserves.

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Deposits = 10,000Reserves = 2,000

r=20%

New Deposit= 100

New Loan = 80Loans = 8,000

Deposits = 30,000Reserves = 6,000

r=20%

New Deposit= 80

New Loan = 64

Loans = 24,000

Bank One

Bank Two

Hold as reserves=16

The Fed’s Purchase Step by Step

Deposits = 40,000Reserves = 8,000

r=20%

New Deposit= 64

New Loan = 64

Loans = 32,000

Bank Three

Hold as reserves = 12.8

After three steps, deposits have increased by: 100 + 80 + 64 = 244…

Hold as reserves=20

Becomes a new deposit

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At the end of the Money Multiplier Process…

D = 100,000R = 20,000r=20%

L = 80,000

All BanksBefore

All BanksAfter

D = 100,500R = 20,100r=20%

L = 80,400

D R=100; D D=500; D L = 400

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In SummaryWhen the Fed

Buys BondsNew Reserves

become available for banks to loan out

Money is createdThe Money

Supply increases.

D = 100,000R = 20,000r=20%

L = 80,000

DD = DR(1/r) DR = Fed’s Purchase R=20%

DL = DD - DR

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All Short term interest rates change with the fed funds rate

Fed Injects/ erase new reserves to the banking system

1. Open Market OperationsFed

buys/sells bonds from the public or banks Money/Credit

easier/harder to get

Federal Funds Rate Decreases/Increases

Long Term interest rates change

Investment Changes

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2. Reserve ratio1913 FEDTo ensure:

banks’ liquidityTo defend depositors

Now:To serve monetary policyUsually differentiated rates

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2. Reserve ratioInfluence loan interest ratesHow?

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2.Changing the Required Reserve Ratio.

D = 100,000R = 20,000r=20%

L = 80,000

All Banks

r = 10%AR = 20,000RR = 10,000ER = 10,000

New loan = 10,000 New Deposit Hold 10%=1,000New loan = 9,000 New Deposit Hold 10%= 900New loan = 8100 New Deposit Hold 10%=810

DD = DR(1/r) DD = 10,000(1/0.1)

DD = 100,000 D = 200,000

New loan …

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2. Changing the Required Reserve

Ratio.

D = 100,000R = 20,000r=20%

L = 80,000

All BanksBefore

The Fed Decreases r to 10%

D = 200,000R = 20,000

L = 180,000

Reserves did not change.Now 20,000 in reserves must be 10% of total deposits

20,000= (0.1) D D = 20,000/0.1D= 200,000

r=10%

All BanksAfter

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When the Required Reserve Ratio decreases

to 10%

Deposits increase by 100,000.

Reserve Required RatioWhere to find?

www.federalreserve.gov

www.mnb.hu

.

 

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3. The Discount Rate: d

The interest rate charged by the Federal Reserve Bank on

loans to Banks.

d =5%

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Decreasing the Discount Rate d

When funds from the Fed become “cheaper” banks find it less necessary to hold excess reserves…

In case of need, banks can borrow funds from the Fed at low d.

Banks are induced to borrow from the fed rather than keep excess reserves to cover emergencies…

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A decrease in d: two possible scenarios

1. Banks borrow more reserves from the Fed

Reserves in the banking system increase: the Fed injects new reserves which generate new loans and new deposits

2. Decreases Excess Reserves Banks hold on to less excess reserves

and thus make more loans generating new deposits.

The Money Supply Increases

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4. Margin Requirements

The fraction of the stock’s price that must be put up by the person buying the stock:

the Down payment

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Margin RequirementsSelected Years

5019949019585019745019536519707519477019631001945501962751942701960501940

MarginYearMarginYear

WARIn

flatio

n

Recessi

on

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5. Moral Suasion and the Gentlemens Agreements:

The Omen of things to come

“Those found cheating will be suspended from school”

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Fed’s ActionsPublic Statement

“The Fed hopes that banks show more restraint in providing consumer credit, because inflation is a problem”

Official Fed Policy Statements “The Fed will raise interest rates by

25 basis points”Direct Appeals

Letters to bank presidents.

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Thank you!