Monetary Policy

Johanna Fahy

Week 5

Monetary Policy
Central Banks roles:
provide banking services to government and commercial banks Supervise and regulate financial institutions Conduct Monetary Policy

Week 5 Irish Economy

Monetary Policy

Monetary Policy
Monetary Policy attempts to:
Control inflation in an economy Moderate the business cycle Provide the foundation for sustained economic growth

How?
Change the money supply Influence interest rates
Week 5 Irish Economy

Monetary Policy

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)
Week 5 Irish Economy Monetary Policy

Monetary Policy
The Actions of Commercial Banks play a major role in the Money Supply process
Banks generally only keep a small percentage of deposits in reserves and lend out the rest Say this reserve ratio is 25%...

Week 5 Irish Economy

Monetary Policy

Monetary Policy
Say you sell a house for 100K 100K increase in deposits at Bank A
25K increase in reserves 75K increase in new loans

75K increase in deposits at Bank B

19K (around) increase in reserves 56K increase in new loans

56K increase in deposits at Bank C

14K increase in reserves 42K increase in new loans

42K increase in deposits at Bank D

11K increase in reserves 31K increase in new loans And so on

Week 5 Irish Economy

Monetary Policy

Monetary Policy
Overall, Multiplier = 1 / (reserve ratio)

Our example:
Multiplier = 1 / (0.25) =4

And an initial 100K deposit 400K

Week 5 Irish Economy Monetary Policy

Monetary Policy
Monetary Policy Tools:
1. Open Market Operations 2. Minimum Reserves 3. Standing Facilities

Week 5 Irish Economy

Monetary Policy

Monetary Policy
1. Open Market Operations
Buying and selling government bonds on the open market 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)
Week 5 Irish Economy Monetary Policy

The Money Market

i
i*(1) Leads to a decreases in the interest i*(2) rate Ms(1) Ms(2)

An increase in the Money Supply

Md(1)

Quantity of Money Week 4 Irish Economy Money

Monetary Policy
2. Minimum Reserves (The percentage of deposits which banks are legally 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)
Week 5 Irish Economy

Monetary Policy

The Money Market

i
i*(2) Leads to a increase in the interest rate Ms(2) Ms(1)

An decrease in the Money Supply

i*(1)

Md(1)

Quantity of Money Week 4 Irish Economy Money

Monetary Policy
3. Standing Facilities
Interest rate ECB charges to commercial banks for overnight liquidity Signals the general direction of interest rates

Increase in discount rate Discourages banks from borrowing from ECB restricts lending Decrease in Money Supply Increase in interest rates
Week 5 Irish Economy Monetary Policy

The Money Market

i
i*(2) Leads to a increase in the interest rate Ms(2) Ms(1)

An decrease in the Money Supply

i*(1)

Md(1)

Quantity of Money Week 4 Irish Economy Money

Monetary Policy
The effects of Monetary Policy
Consumption: Low interest rate means more loans and higher consumption. Also less saving more spending. Investment: Low interest rates means cheaper loans and more investment Net Exports: Low interest rates in the EU would lower 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 more expensive Prices: Lowering interest rates generally leads to higher Aggregate Demand higher prices
Week 5 Irish Economy Monetary Policy

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)
Week 5 Irish Economy Monetary Policy

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 uncontrollable effects on the interest rate (very variable) Most economists agree that since the demand for money is regularly 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 central banks as the quantity of money is very difficult to measure from day to day
Week 5 Irish Economy Monetary Policy

Monetary Policy
However,
The effects of monetary policy are very difficult to predict Often large time lags (1-2 years) before effects are felt forecast need to be VERY good Monetarists would argue for a predictable slow and steady growth in the money supply (non-interventionalist)
Week 5 Irish Economy Monetary Policy

Monetary Policy
http://www.ecb.europa.eu/mopo/html/index. en.html Report Writing on above http://www.ecb.int/stats/monetary/rates/htm l/index.en.html#data

Week 5 Irish Economy

Monetary Policy