Session 7

Macroeconomics
Session 7
16-1
Monetary Policy
“Monetary policy refers to the use of monetary instruments

under the control of the central bank to regulate magnitudes
such as interest rates, money supply and availability of
credit with a view to achieving the ultimate objective of
economic policy.”
16-2
Goals of Monetary Policy
• Price Stability
• Economic Growth
16-3
High Powered Money and Money Supply
• High powered money (monetary base) consists of :

• Currency with the Public
• Important reserves of commercial banks
• Money Supply in an economy consists of:

• Currency with the Public
• Bank Deposits
16-4
Money Stock Determination
• The CB has direct control over high powered money (H)
• Money supply (M) is linked to H via the money multiplier, mm  Figure shows
this relationship:
• Top of figure is the money stock
• Bottom of figure is the stock of high-powered money = monetary base
• Money multiplier (mm) is the ratio of the stock of money to the stock of high
powered money  mm > 1
• The larger deposits are, as a fraction of M, the larger the multiplier
[Insert Figure 16-2 here]
16-5
• Money supply consists of currency, CU, plus deposits:
M  CU  D (1)
• High powered money consists of currency plus reserves:
H  CU  reserves (2)
• Summarize the behavior of the public, the banks, and the
central bank in the money supply process by three
variables:
• Currency-deposit ratio: cu  CU
D
• Reserve ratio: re  reserves
D
• Stock of high powered money: H
16-6
• We can rewrite equations (1) M  CU  Dand (2)
H  CU  reserves as:
M  (cu  1) D and H  ( cu  re ) D
since cu  CU and re  reserves

D D
This allows us to express the money supply in terms of its principal
determinants, re, cu, and H:
1  cu
M H  mm  H (3)
re  cu
where mm is the money multiplier, given by: 1  cu
mm 
re  cu
16-7
• Some observations of the money multiplier:
1  cu
mm 
re  cu
 The money multiplier is larger the smaller the reserve ratio, re

 The money multiplier is larger the smaller the currency-deposit
ratio, cu
 The smaller is cu, the smaller the proportion of H that is being
used as currency AND the larger the proportion that is available to
be reserves
16-8
The Currency Deposit Ratio
 Thepayment habits of the public determine how much
currency is held relative to deposits
 The currency deposit ratio is affected by the cost and
convenience of obtaining cash
 Currency deposit ratio falls with costs
 Ex. If there is a cash machine nearby, individuals will on average

carry less cash with them because the costs of running out are
lower
 The currency deposit ratio has a strong seasonal pattern
 Highest around Christmas
16-9
The Reserve Ratio
• The CB sets the required reserve ratio
• Looking at the money multiplier shown in equation (3), it

is easy to see that the CB can increase the money supply
by reducing the required reserve ratio:
1  cu
M H  mm  H
re  cu
16-10
Quantitative Instruments of MP
1. Open Market Operations (Long Term)
2. Repo and Reverse Repo Rate (Short term)
3. CRR/SLR
16-11
Expansionary Monetary Policy
• Open Market Operation –
• Purchase govt. securities > payment deposited in buyer bank’s
reserve accounts (increase in monetary base) > more money
available to CBs to lend > CBs attract borrowers with lowering
interest rates > cheap credit attracts investors to borrow and
invest (money supply increases) > production increases >
employment increases > income and spending increases
16-12
Contractionary Monetary Policy
• Open Market Operations –
• Sells govt securities to CBs> payment debited from CBs reserve
deposits (decrease in monetary base) > less amount left with
CBs to lend > interest rate rises > individuals and businesses are
discouraged from borrowings (money supply decreases) >
higher interest rates encourages people to save more > Spending
in the economy falls > inflation and economic growth slows
down
16-13
Liquidity Adjustment Facility
• Repo rate
• Repo rate is the rate at which the central bank of a country lends money to
commercial banks in the event of any shortfall of funds.
• Repo is a form of short-term, interest-bearing and collateral-backed
borrowing.
• Reverse Repo Rate

• The rate at which commercial banks park their excess money with Reserve
Bank of India for a short-term period.
• Reverse repo rate deals with liquidity in the economy
16-14
Other instruments of Monetary Policy
• CRR – Cash Reserve Ratio
• Cash reserves to be maintained by CBs as percentage of their
Net Demand and Time Liabilities.
• Affects profitability of banks and money supply in the economy
• SLR – Statutory Liquidity Ratio

• Maintain liquid assets in the form of gold, cash, and approved
securities.
• Affects availability of money for credit with CBs.
16-15
Control of the Money Stock and Control
of the Interest Rate
• The Fed cannot simultaneously set [Insert Figure 16-4 here]
the interest rate AND the stock of
money at any given target levels that
it may choose
• Suppose that the Fed wants to set the
interest rate at i* and the money stock
at M*, with the demand for money at
LL
• The Fed can move the money supply
around, but not LL
• It can only set combinations of i
and M that lie along LL
• At interest rate i*, can have M0/P
• At the target money supply, M*/P,

can have interest rate of i0
• Cannot achieve BOTH targets
16-16
Fiscal Policy Multiplier
16-17
Fiscal Multiplier – RBI Monetary Policy
Report (April 2019)
16-18

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Macroeconomics

“Monetary policy refers to the use of monetary instruments

• High powered money (monetary base) consists of :

• Money Supply in an economy consists of:

[Insert Figure 16-2 here]

since cu  CU and re  reserves

 The money multiplier is larger the smaller the reserve ratio, re

 Ex. If there is a cash machine nearby, individuals will on average

• Looking at the money multiplier shown in equation (3), it

2. Repo and Reverse Repo Rate (Short term)

• Reverse Repo Rate

• SLR – Statutory Liquidity Ratio

• At the target money supply, M*/P,

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