7/31/2019 8. Monetary Policy (01.11.10)

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Monetary Policy

Johanna Fahy

Week 5

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7/31/2019 8. Monetary Policy (01.11.10)

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Monetary Policy

Central Banks roles:

provide banking services to government andcommercial banks

Supervise and regulate financial institutions

Conduct Monetary Policy

Week 5 Irish Economy Monetary Policy

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Monetary Policy

Monetary Policy attempts to:

Control inflation in an economy

Moderate the business cycle

Provide the foundation for sustainedeconomic growth

How?

Change the money supply

Influence interest rates

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Monetary Policy

Functions of Central Banks (CB) Governments bank (account) Bankers Bank

Lends to Commercial Banks who must keep a % of

reserves with the CB Lender of Last Resort Regulator of Banks

Cash and Capital reserve requirements General banking rules

Maker of Monetary Policy Setting the Goals Setting the Instruments Most countries divide these roles (Goals generally set out

by government)

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Monetary Policy

The Actions of Commercial Banks play amajor role in the Money Supply process

Banks generally only keep a smallpercentage of deposits in reserves and lendout the rest

Say this reserve ratio is 25%...

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Monetary Policy

Say you sell a house for 100K

100K increase in deposits at Bank A25K increase in reserves75K increase in new loans

75K increase in deposits at Bank B19K (around) increase in reserves56K increase in new loans

56K increase in deposits at Bank C14K increase in reserves42K increase in new loans

42K increase in deposits at Bank D11K increase in reserves

31K increase in new loans And so onWeek 5 Irish Economy Monetary Policy

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Monetary Policy

Overall,

Multiplier = 1 / (reserve ratio)

Our example:

Multiplier = 1 / (0.25)= 4

And an initial 100K deposit 400K

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Monetary Policy

Monetary Policy Tools:

1. Open Market Operations

2. Minimum Reserves

3. Standing Facilities

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Monetary Policy

1. Open Market Operations

Buying and selling government bonds on the openmarket to influence the money supply

European Central Bank buys government stock

Seller of bond lodges in bank

Increase in deposits

Increase in lending

Increase in the money supply

Decrease in interest rates (and vice versa)

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The Money Market

Week 4 Irish Economy Money

Quantity of Money

i Ms(1)

i*(2)

Leads to adecreases inthe interestrate

An increase in the MoneySupply

Md(1)

i*(1)

Ms(2)

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Monetary Policy

2. Minimum Reserves

(The percentage of deposits which banks arelegally obligated to lodge at the Central Bank)

Increase in reserve requirement

Lowers the amount of money banks can lend

Less lending throughout the economy

Decrease in money supply Increase in interest rates across the euro area

(and vice versa)

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The Money Market

Week 4 Irish Economy Money

Quantity of Money

i Ms(2)

i*(1)

Leads to aincrease inthe interestrate

An decrease in the MoneySupply

Md(1)

i*(2)

Ms(1)

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Monetary Policy

3. Standing Facilities

Interest rate ECB charges to commercial banks forovernight liquidity

Signals the general direction of interest rates

Increase in discount rate

Discourages banks from borrowing from

ECB restricts lendingDecrease in Money Supply

Increase in interest rates

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The Money Market

Week 4 Irish Economy Money

Quantity of Money

i Ms(2)

i*(1)

Leads to aincrease inthe interestrate

An decrease in the MoneySupply

Md(1)

i*(2)

Ms(1)

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Monetary Policy

The effects of Monetary Policy Consumption: Low interest rate means more loans

and higher consumption. Also less saving morespending.

Investment: Low interest rates means cheaper loansand more investment

Net Exports: Low interest rates in the EU wouldlower the world demand for Euros (less attractive to

invest here) decline in the value of the euro exports cheaper to the world BUT imports now moreexpensive

Prices: Lowering interest rates generally leads tohigher Aggregate Demand higher prices

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Monetary Policy

Monetary Policy Goals High Employment?

High Economic Growth?

Price Stability?

Interest Rate Stability?

Stability in Financial Markets?

Stability in Foreign Exchange Markets?

All are ideal but unfortunately often Conflicting The goal of price stability is often conflicting with the goal of

interest rate stability or high employment in the short-run(probably not in the long-run)

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Monetary Policy

Goals are achieved by monetary targets:

Target the interest rate

Target the Quantity of Money (M1, M2 etc)

Targeting the Quantity of Money can have uncontrollableeffects on the interest rate (very variable)

Most economists agree that since the demand for money isregularly changing (causing large interest rate fluctuations),

the CB should focus solely on targeting the interest rate(which affects the goals more)

Targeting the interest rate is generally practiced by centralbanks as the quantity of money is very difficult to measurefrom day to day

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Monetary Policy

However,

The effects of monetary policy are verydifficult to predict

Often large time lags (1-2 years) beforeeffects are felt forecast need to be VERYgood

Monetarists would argue for a predictableslow and steady growth in the money supply(non-interventionalist)

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Monetary Policy

http://www.ecb.europa.eu/mopo/html/index.en.html

Report Writing on above

http://www.ecb.int/stats/monetary/rates/html/index.en.html#data

Week 5 Irish Economy Monetary Policy

http://www.ecb.europa.eu/mopo/html/index.en.htmlhttp://www.ecb.europa.eu/mopo/html/index.en.htmlhttp://www.ecb.int/stats/monetary/rates/html/index.en.htmlhttp://www.ecb.int/stats/monetary/rates/html/index.en.htmlhttp://www.ecb.int/stats/monetary/rates/html/index.en.htmlhttp://www.ecb.int/stats/monetary/rates/html/index.en.htmlhttp://www.ecb.int/stats/monetary/rates/html/index.en.htmlhttp://www.ecb.europa.eu/mopo/html/index.en.htmlhttp://www.ecb.europa.eu/mopo/html/index.en.htmlhttp://www.ecb.europa.eu/mopo/html/index.en.html