Monetary Policy. Macroeconomics II,

Transcription

1 Monetary Policy Macroeconomics II,

2 Monetary policy..can be categorised along 3 characteristics: Goals Intermediate targets Instruments

3 Monetary policy goals Goals address the Central Bank s agenda in general terms, like the target inflation (recall from our discussion of DAD/DAS model) The goal of the ECB: The primary objective of the ECB s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. The goal of the Fed: The statutory objectives for monetary policy are maximum employment, stable prices, and moderate long-term interest rates

4 Intermediate targets Intermediate Targets are the variables that the central bank can more directly control. They help the CB achieve its goals Among the targets might be the interest rate target (recall the Taylor rule) or the money supply target. Let s stop here for a minute. In the convential textbook analysis, it is quite often assumed that the central bank targets the money supply Yet, in the modern policymaking, this assumption is often not true. The central bank targets the nominal interest rate and the money supply is adjusted to reach this target How does the central bank affect the money supply?

5 Instruments How does the CB affect the money supply, to reach its target? The CB affects the money supply through the use of its instruments Instruments refer to the policy options the central bank has to control the supply of money These are: The deposit & the lending rate (the discount rate) Open market operations (these are also related to interest rates) Reserve requirements

6 Money creation process In order to understand how the central bank, (by using its instruments) can adjust the money supply to reach its goals...it is worthwhile to review the money creation process..and then we will return to bank s instruments and we will try to understand how they work

7 What is the money supply? The money supply equals currency plus demand (checking account) deposits: M = C + D Note that Tthe money supply includes demand deposits This money supply is often called M1 There are also other money aggregates like M2 or M3, which are broader than M1 The exact definitions of M1, M2, M3 depend on the country. M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds. M3 includes M2 plus longer-term time deposits and money market funds with more than 24-hour maturity.

8 The money creation process. Initially. Initially C = $1000, D = $0, M = $1000. Now suppose households deposit the $1000 at Firstbank. FIRSTBANK S balance sheet Assets Liabilities reserves $1000 deposits $1000 After the deposit, C = $0, D = $1000, M = $ % of reserves Money supply 1000 slide 8

9 Fractional-reserve banking Thus, in a fractional-reserve banking system, banks create money. FIRSTBANK S balance sheet Assets Liabilities reserves $200 loans $800 deposits $1000 The money supply now equals $1800: The depositor still has $1000 in demand deposits, but now the borrower holds $800, which is turned into a new deposit.

10 Fractional-reserve B\banking Suppose the borrower deposits the $800 in Secondbank. SECONDBANK S balance sheet Assets Liabilities reserves $800 $160 loans $0 $640 deposits $800 But then Secondbank will loan 80% of this deposit and its balance sheet will look like this:

11 Fractional-reserve banking If this $640 is eventually deposited in Thirdbank, then Thirdbank will keep 20% of it in reserve, and loan the rest out: THIRDBANK S balance sheet Assets Liabilities reserves $640 $128 loans $0 $512 deposits $640 and so on..

12 Concusion: the money supply is a multiplicative of the monetary base: Original deposit = $ Firstbank lending = $ Secondbank lending = $ Thirdbank lending = $ other lending Total money supply = (1/rr ) $1000 where rr = ratio of reserves to deposits Money supply is much bigger than reserves! Each dollar (euro, zloty) of reserves creates much bigger money supply.

13 Reserves, loans and deposits

14 The amount of reserves is not a constraint! Commercial banks can increase the amount of outstanding loans (if they choose to do so) The Central Bank is always ready to supply more reserves on demand. How does work? THIRDBANK S balance sheet Assets Liabilities reserves $128 $640 loans $512 $0 Additional loan: $100 deposits $640 a credit from CB: $ 100 For example, the commerical bank can borrow reserves from the central bank And the whole multiplier process multiplies the additional 100, as previously shown

15 Modern monetary policy Important: the Central Bank supplies reserves on demand Hence, the quantity of reserves does not constraint the amount of loans if commercial banks want to increase the quantity of outstanding loans, they can always obtain more reserves The multiplier process shows the relationship between reserves and money supply, but reserves are not fixed the central bank stands ready to supply them, according to the demand from commercial banks

16 Summary so far Money supply = deposits plus currency A fractional reserve banking system creates money, but it doesn t create wealth: bank loans give borrowers some new money and an equal amount of new debt. When a bank makes a loan, simultaneously a deposit is created, thereby creating new money Reserves are supplied on demand by the central bank

17 Summary so far Important (so let s repeat it once again) In modern banking, commercial banks are not restricted by the amount of reserves they can get reserves practically on demand from the central bank If the bank wants to increase the amount of loans, it can always get the required amount of reserves from the central bank. So how does the central bank affects (or controls) the money supply?

18 Modern monetary policy The central bank affects money supply not by limiting the amount of reserves, but by affecting their price that is the interest rate! The central bank, by using its instruments (interest rates!) affects the price of reserves and hence influences (but does not fully control) both the supply and demand for loans and hence the money supply

19 Central Bank s interest rate and money supply Pożyczki 19

20 Instruments of the CB The CB affects the money supply through its instruments Instruments refer to the policy options the Central Bank has to control the supply of money These are: The deposit & the lending rate (the discount rate) Open market operations (these are also related to interest rates) Reserve requirements (but in practice are not used to control the money supply)

21 Instruments of the ECB The key interest rates for the euro area set by the Governing Council are: The interest rate on the main refinancing operations (MROs), which normally provide the bulk of liquidity to the banking system. The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem. The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem.

22 Open market operations are often the main liquidity providing operations Open market operations are transactions in which the central bank engages with commercial banks on its own initiative. The CB purchases from (sells to) commercial banks securities to give (or take from the commercial banks) liquidity

23 Credit-deposit operations Credit-deposit operations are conducted by the CB with commercial banks on their initiative The commercial banks can borrow liquidity (on a short-term basis) from the central bank to meet the reserve requirements (the so called discount window ) The CB charges them the discount rate Lending at the discount rate complements open market operations in achieving the target interest rate and serves as a backup source of liquidity for commercial banks. Commerical banks can also put excess liquidity on deposit at the Central Bank These deposits carry a deposit rate

24 ECB interest rates ange_rates/key_ecb_interest_rates/html/index.en. html

25 Reserve requirements Reserve requirements are the portions of deposits that banks must hold in cash, either in their vaults or on deposit at CB. Nowadays, CB rarely change reserve requirements, hence they do not play a significant role in regulating the money supply

26 Interest rates and money supply An increase in CB interest rates increases the price of reserves, hence limits the demand for reserves Higher price of reserves imply higher market interest rates, what limits the consumers demand for loans Hence the amount of loans decline and money supply decreases

27 Non-standard monetary policy measures Big liquidity injections, used during the recent crisis by ECB or by the Fed The CB buys non-standard assets from commercial banks or engages in long-term operations See, for example: /html/index.en.html