Why Study Money and Monetary Policy?

Money is linked to changes in economic variables

that affect all of us and are important to the
health of the economy.
Why does economies expand and contracts or
boom and recession?
Evidence suggests that money plays an important
role in generating business cycles, the upward
and downward movement of aggregate output
produced in the economy.
Money and Inflation
Money and Interest rates
 Cont.
• Because money can affect many economic
variables that are important to the wellbeing
of the economy, politicians and policymakers
throughout the world care about the conduct
of monetary policy, the management of
money and interest rates.
• The organization responsible for the conduct
of a nation’s monetary policy is the central
bank.
 Tools of Monetary Policy

• The Market for Reserves and Inter-bank Rate

Demand curve for reserves
The amount of reserves can be interpreted as (1) required
reserves and (2) excess reserves. Therefore, the quantity of
reserves demanded equals required reserves plus the quantity of
excess reserves demanded.
Excess reserves are insurance against deposit outflows, and
the cost of holding these excess reserves is the interest rate that
could have been earned on lending these reserves out, which is
equivalent to the interbank rate. Thus as the interbank rate
decreases, the opportunity cost of holding excess reserves falls
and, the quantity of reserves demanded rises, ceteris paribus.
 Cont.
• Supply curve for reserves
The supply of reserves has two parts the amount of
reserves that are supplied through open market operations by
the CB (non-borrowed reserves)
and the amount of reserves borrowed from the CB (discount
loans)
The cost of borrowing discount loans from the CB is
the Bank Rate or Discount Rate. if the Interbank rate is below
the discount rate, then banks will not borrow from the CB and
discount loans will be zero because borrowing in the Inter-
bank funds market is cheaper.
Cont.
 Cont.
• id -Discount Rate
• I ff – Interbank Rate( called Federal Fund Rate in US)
• Rn – supply of Reserves
Market equilibrium occurs where the quantity of reserves demanded
equals the quantity supplied, Rs = Rd at point one with I ff*.

When the federal funds rate is above the equilibrium rate at i2 ff ,

there are more reserves supplied than demanded (excess supply)
and so the federal funds rate falls to i*ff as shown by the
downward arrow. On the other hand, when the federal funds rate
is below the equilibrium rate at i1 ff , there are more reserves
demanded than supplied (excess demand) and so the federal
funds rate rises
 Conduct of Monetary Policy
• How tools of monetary policy (open market operations, discount
lending, and reserve requirements) affect the market for reserves
and the equilibrium?
Open market operations
open market purchase leads to greater quantity of reserves
supplied and therefore shifts the supply curve to the right hand
side, lowering the inter-bank funds rate.
Similarly, an open market sale decreases the quantity of
reserves supplied and therefore shifts the supply curve to the left
and causes the inter-Bank funds rate to rise.
Conclusion: an open market purchase causes the inter-bank funds
rate to fall, whereas an open market sale causes the rate to rise.
Cont.
 Changes in Monetary Policy Tools
What are tools of monetary policy?
(i) open market operations
(ii) discount lending
(iii) reserve requirements
Changes through these tools affect the
market for reserves and the equilibrium Inter-
Bank funds rate.
 Cont.
• Open Market Operations.
open market purchase leads to a greater quantity of reserves supplied; this
is true at any given federal funds rate because of the higher amount of
nonborrowed reserves, which rises from R1 n to R2 n. An open market
purchase therefore shifts the supply curve to the right from Rs1 to Rs2 and
moves the equilibrium from point 1 to point 2, lowering the inter-bank
funds rate from i1 ff to i2 ff.

The same reasoning implies that an open market sale decreases the
quantity of reserves supplied, shifts the supply curve to the left and causes
the inter-bank funds rate to rise.
The result is that an open market purchase causes the federal funds rate to
fall, whereas an open market sale causes the federal funds rate to rise.
 Cont.
Discount Lending
The effect of a discount rate change depends on whether the demand curve
intersects the supply curve in its vertical section versus its flat section.
In this case, when the discount rate is lowered by the Fed from
i1d to i2d, the vertical section of the supply curve where there is
no discount lending just shortens, as in Rs2, while the intersection
of the supply and demand curve remains at the same point. Thus,
in this case there is no change in the equilibrium inter-bank funds
rate, which remains at i1 ff. Because this is the typical situation—
since the Fed now usually keeps the discount rate above its target
for the inter-bank funds rate—the conclusion is that most
changes in the discount rate have no effect on the inter-bank funds
rate.
what happens if the intersection occurs at
the vertical section
Cont.
 Cont.
• if the demand curve intersects the supply curve on its
flat section, so there is some discount lending, changes
in the discount rate do affect the Inter-Bank funds rate.
In this case, initially discount lending is positive and the
equilibrium inter-bank funds rate equals the discount
rate, i1 ff i1 d. When the discount rate is lowered by the
Fed from i1d to i2d , the horizontal section of the supply
curve Rs2 falls, moving the equilibrium from point 1 to
point 2, and the equilibrium inter-bank funds rate falls
from i1 ff to i2ff
(i2d)
 Cont.
Reserve Requirements.
When the required reserve ratio increases, required
reserves increase and hence the quantity of reserves
demanded increases for any given interest rate.
Thus a rise in the required reserve ratio shifts the
demand curve to the right from Rd1 to Rd 2, moves
the equilibrium from point 1 to point 2, and in turn
raises the interbank funds rate from i 1 ff to i 2 ff .
• The result is that when the Fed raises reserve
requirements, the Inter-Bank funds rate rises.
Cont.
 Cont.
• Similarly, a decline in the required reserve
ratio lowers the quantity of reserves
demanded, shifts the demand curve to the
left, and causes the Inter- Bank funds rate to
fall. When the Fed decreases reserve
requirements, it leads to a fall in the Inter-
Bank funds rate.
 Open Market Operations

• Open market operations are the most important

monetary policy tool, because they are the primary
determinants of changes in interest rates and the
monetary base (MB). MB is the main source of
fluctuations in the money supply.
• Open market purchases expand reserves and the
monetary base, thereby raising the money supply and
lowering short-term interest rates.
• Open market sales shrink reserves and the monetary
base, lowering the money supply and raising short-term
interest rates.
 Cont.
• There are two types of open market operations:
(i) Dynamic open market operations
are intended to change the level of reserves
and the monetary base
(ii) Defensive open market operations
• are intended to offset movements in other
factors that affect reserves and the monetary base.
• The decision-making authority for open market
operations is the Monetary Board which sets a target
for interest rate.
 REPO
• In a repurchase agreement (REPO) the CB
purchases securities with an agreement that
the seller will repurchase them in a short
period of time (from 1 to 15 days).
• A repo is actually a temporary open market
purchase and is an especially desirable way of
conducting a defensive open market purchase
that will be reversed shortly.
 Reveres Repo
• When the CB wants to conduct a temporary
open market sale, it engages in a matched
sale–purchase transaction (a reverse repo) in
which the CB sells securities and the buyer
agrees to sell them back to the CB in the near
future.
 Advantages of
Open Market Operations

• 1. Open market operations occur at the

initiative of the CB, which has complete
control over their volume. This control is not
found, for example, in discount operations, in
which the Fed can encourage or discourage
banks to take out discount loans by altering
the discount rate but cannot directly control
the volume of discount loans.
 Cont.
• 2. Open market operations are flexible and precise;
they can be used to any extent. No matter how
small a change in reserves or the monetary base is
desired, open market operations can achieve it
with a small purchase or sale of securities.
• On the other hand, if the desired change in
reserves or the base is very large, the open market
operations tool is strong enough to do the job
through a very large purchase or sale of securities.
 Cont.
• 3. Open market operations are easily reversed.
If a mistake is made in conducting an open
market operation, the CB can immediately
reverse it. If the CB decides that the Interest
rate is too low because it has made too many
open market purchases, it can immediately
make a correction by conducting open market
sales.
 Cont.
• 4. Open market operations can be
implemented quickly; they involve no
administrative delays.
When the CB decides that it wants to change
the monetary base or reserves, it just places
orders with securities dealers, and the trades
are executed immediately.
 Operation of the
Discount Window

• The CB’s discount loans to banks are of three types.

(i) primary credit
(ii) secondary credit
(iii) seasonal credit.
• Primary credit is the discount lending that plays the
most important role in monetary policy. Healthy banks are
allowed to borrow all they want from the primary credit
facility, and it is therefore referred to as a standing lending
facility. The facility is intended to be a backup source of
liquidity for sound banks so that the inter-bank funds rate
never rises too far above the target.
Cont.
 Cont.
• Suppose that initially, the demand and supply
curve for reserves intersect at point 1 so that the
federal funds rate is at its target level, iTff. Now
the increase in required reserves shifts the
demand curve to Rd2 and the equilibrium moves
to point 2. The result is that discount lending
increases from zero to DL2 and the federal funds
rate rises to id and can rise no further. The
primary credit facility has thus put a ceiling on the
federal funds rate of id.
 Cont.
• Secondary credit is given to banks that are in
financial trouble and are experiencing severe
liquidity problems. The interest rate on
secondary credit is above the discount rate.
This interest rate on these loans is set at a
higher, penalty rate to reflect the less-sound
condition of these borrowers.
 Cont.
• Seasonal credit is given to meet the needs of a
limited number of small banks in vacation and
agricultural areas that have a seasonal pattern
of deposits. The interest rate charged on
seasonal credit is tied to the average of the
federal funds rate and certificate of deposit
rates.
 Lender of Last Resort

• In addition to its use as a tool to influence reserves, the

monetary base, and the money supply, discounting is
important in preventing financial panics. This is one of
the most important role of CB to prevent bank failures
from spinning out of control, it was to provide reserves
to banks when no one else would, thereby preventing
bank and financial panics.
Discounting is a particularly effective way to provide
reserves to the banking system during a banking crisis
because reserves are immediately channeled to the
banks that need them most.
 Cont.
• Advantages and Disadvantages of Discount Policy
The most important advantage of discount policy is that the
CB can use it to perform its role of lender of last resort.
In the past, discount policy was used as a tool of monetary
policy, with the discount rate changed in order to affect
interest rates and the monetary market. However, because
the decisions to take out discount loans are made by banks
and are therefore not completely controlled by the CB, while
open market operations are completely controlled by the CB,
the use of discount policy to conduct monetary policy has
little advantage.
 Reserve Requirements

• A rise in reserve requirements reduces the amount of

deposits that can be supported by a given level of the
monetary base and will lead to a contraction of the
money supply.
• A rise in reserve requirements also increases the
demand for reserves and raises the federal funds rate.
• A decline in reserve requirements leads to an
expansion of the money supply and a fall in the inter-
bank funds rate. The CB has had the authority to vary
reserve requirements.
 Cont.
• Advantages and Disadvantages of Reserve
• Requirement Changes
• The main advantage of using reserve
requirements to control the money supply and
interest rates is that they affect all banks equally
and have a powerful effect on the money supply.
However, small changes in the money supply and
interest rates are hard to engineer by varying
reserve requirements. Therefore to fine-tune the
money supply using reserve requirements is costly.
 Cont.
• Another disadvantage of using reserve
requirements to control the money supply and
interest rates is that raising the requirements
can cause immediate liquidity problems for
banks with low excess reserves.
• Continually fluctuating reserve requirements
would also create more uncertainty for banks
and make their liquidity management more
difficult.
 Why Have Reserve Requirements Been Declining Worldwide?

In recent times, central banks in many countries in the

world have been reducing or eliminating their reserve
requirements.
• reserve requirements act as a tax on banks. Because
central banks typically do not pay interest on reserves
The cost imposed on banks from reserve
requirements means that banks, in effect, have a
higher cost of funds than intermediaries not subject to
reserve requirements making them less competitive.
• .
 Cont.
• Central banks have thus been reducing reserve
requirements to make banks more
competitive and stronger.