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CHAPTER THREE
THE CENTRAL BANK (FEDERAL RESERVE), MONETARY POLICY, AND INTEREST
RATE
What is Money?
Money is any thing that is generally accepted as a means of payment for goods and services and a
method of settling debt.
It has three functions in the economy:
 Medium of exchange: It is accepted in exchange for goods and services or pay off debts.
 Store of value: Can be held for sometime and later exchanged for goods and services, It
maintains some or all of its value (or purchasing power) between time it is earned and the
time it is spent.
 Unit of account: It is used as a measure of stating the prices of goods and services, or
comparing between costs and prices received.
Historically, many items (goods) were used as money. The commonly used item was metal. These
historical items had three main characteristics:
 Scarcity: so it can have higher value.
 Durability: so it can be stored.
 Divisibility: so it can be divided into small pieces to state different prices.
Today money consists of:
 Currency(Physical money): Coins and paper notes that people use. It is the money that is
physically exchanged for goods and services.
 Deposit money: Deposits at banks and other financial institutions. These deposits can be
converted into currency and made into spendable form.
The problem with currency is that it is expensive and time consuming, since it is bulky and
requires heavy safeguarding. This gave rise to deposit money which is deposits at banks and other
financial institutions. The ownership of these deposits can be transferred from one person to
another on the “demand” of the deposit owner. This is done by transfering ownership of funds
either electronically or by writing a check to the concerned person instructing the bank. Banks and
financial institutions “clear” and “settle” transfer of funds between people by netting the
difference between their incoming and outgoing checking account transfers and pay the difference
either
 directly to another bank; or
 to a clearing house; or
 to a corresponding bank; or
 to the central bank.
Needless to say, and as will be seen later, that deposit money is the largest component of money
supply, which reflect the importance of banks and financial institutions to the economy.
MEASURING THE SUPPLY OF MONEY:
Money is measured in many ways depending on the liquidity of items included in the definition.
The definition of money consists of:
M1 = currency in circulation + checkable deposits at banks and other financial institutions +
Traveler’s checks.
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This is the narrowest definition of money, it has a vary high degree if liquidity (cash), and is
based on the function of money as a medium of exchange.
M2 = M1 + time and saving deposits at banks and other financial institutions.
It includes M1 and non-checkable deposits and small denomination time deposits (less than
$100,000)
This definition is broader, has less liquidity, and based on function of money as a store of value.
M3 = M2 + large denomination time deposits ($100,000 and more) at financial institutions.
L (all liquid money) which include M3 + all other liquid financial assets (which can be converted
into cash, like bonds and securities etc.)
.
.
Divisia money which weights all types of financial assets according to their “moneyness” and
sums them up.
There are about 12 definitions of money, and the most commonly used are M1 and M2. One
important thing to note is that as one expands the definition of money from M1 to M2 to M3 ….
etc, the use of financial assets in the definition of money increases, while the degree of liquidity
decreases. This indicate the increasing importance of financial institutions and financial markets,
which deal in these financial assets.
The liquidity of an asset is determined by the ease of immediately converting the asset into
money, and whether the asset can be sold at its fair market value. Thus liquidity measures:
 The speed and ease with which an asset can be converted into spendable form with
minimal conversion risk, and
 The riskyness of an asset. Less liquid assets either have greater risk of loss (default or
fluctuation in value) or high conversion costs if they are to be converted to spendable form
quickly.
CONTROL OF MONEY SUPPLY:
The central bank may use any of these tools to control the monetary base, which is the amount of
currency in circulation and reserve balances held by financial institutions.
Changes in Monetary base changes money supply through the Deposit-Expansion process. To
understand how D-E process works, recall that banks are required to keep a certain percentage or
fraction of deposit as reserves. This fraction is known as the Required Reserve Ratio, and could
be measured as:
Required Reserves (RR)
Required Reserve Ratio (RD) = ---------------------------------Deposit (D)
Or
RR
RD = --------D
From which we get, RR = RD * D
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Or;
D = ------- * RR
RD
(1)
(2)
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Now any amount of reserves in excess of the required reserves is known as excess reserve. That
is:
Excess Reserves (ER) = Actual Reserves (AR) – Required Reserves (RR)
Banks can loan out all excess reserves (ER), and thus increase money supply. In fact banks loan
out until ER = 0 , or AR – RR = 0 or until AR = RR. This process of loaning out ER allows banks
to create money and increase money supply trough the Deposit-Expansion multiplier. How does
this happen? From equation (2), we get:
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D = ------- *  RR
(3)
RD
Which is the same as (since banks loan out until AR=RR):
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D = ------- * AR
(4)
RD
That is if Actual Reserves (AR) of the bank change, deposits will change by a multiplied amount
equal to the change in (AR) multiplied by reciprocal of the required reserve ratio i.e. (1/R D). This
reciprocal (1/RD) is known as the deposit expansion multiplier.
Some analysts use Net Free Reserves (NFR) rather than Excess Reserves (ER),where Net Free
Reserves (NFR) is excess reserves over and above borrowed reserves. That is:
Net Free Reserves = Excess Reserves – Borrowed Reserves
NFR = ER - BR
Example: if
Total banks Reserves (actual) = 120
Required reserves
= 110
Borrowed reserves
=2
Then, Excess reserves = ER = AR – RR = 120 – 110 = 10
Net Free Reserves = NFR = ER – BR = 10 – 2 = 8
Therefore:
 The banking system is in a net free position, and
 It has net free reserves of 8 million.
If borrowed reserves is 12 million, then NFR = 10 – 12 = -2
So, the banking system is in a net borrowed reserves position, and it has a net borrowed reserves
equal to 2.
The central bank controls the monetary base by affecting banks reserves through the use of its
monetary policy tools:
Use of Open Market Operations:
Recall that:
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D = ------- * AR
RD
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If the central bank increase banks reserves by buying government securities worth BD200 million,
and reserve requirement ratio (RD) was equal to 10%, then deposits will change by:
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D = ------- *(200) =BD2000
10%
That is, an increase of actual reserves of 200, have increased deposits by BD2000 thus increasing
the supply of money (recall that M1=C+D, currency + deposits).
What happen if the central bank sells government securities through open market operations
(OMO)?
If D = 1000, RD = 10%
So, RR = AR = 100
Now if central bank sells government securities worth 20, then
Δ RR = Δ AR = -20
So,
1
1
1
Δ D =-------- X Δ AR = -------- X –20 = -------- X –20 = -200
RD
10%
0.1
Finally, Deposits = 1000 – 200 = 800
So, as a result of selling securities in the OMO, deposits decreases and so does supply of money.
Use of Discount Rate:
Discount rate is rate changed by central bank. So if discount rate decreases, cost of borrowing
decreases, and banks make loans, and supply of money increases.
The opposite turn if the central bank increases its discount rate.
Use of Reserve Requirements Ratio (RD):
Central bank may change RD, and thus changes bank deposit and reserves.
Example:
D = 1000 , RD = 10% , then RR = 1000 X 10% = 100
Now if RD is decreased to 5%, then
1
1
D = -------- X AR = -------- X 100 = 2000
RD
0.05
So, a decrease in RD increases deposit and money supply.
If however, RD is increased to 15%, then:
1
1
D = -------- X AR = -------- X 100 = 666.67
RD
0.15
Deposits decreases as the result of increasing Required Reserves Ratio (RD), and money supply
decreases.
Monetary Expansion with Cash Drain:
We noted that as central bank changes reserves (by changing discount rate, or RR or by selling &
buying government securities), deposit expand through a multiplier affect, which is (1/ R D). If
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however the public holds some cash balances with them, they make cash drain and thus reduce the
amount available for the banks to make loans.
If the public holds a certain fraction (or %) of deposits (c) in form of cash holdings, then their
cash holding is equal to this fraction multiplied by deposits. That is: CH = c X D. This cash
holdings by the public reduces bank’s ability to expand deposits, and thus reduces the multiplier
effect. In this case the multiplier is equal to (1/ (RD +c)):
1
So, Δ D = -------- Δ AR
RD +c
1
That is: deposit expansion multiplier is --------------RD + c
If RD = 10%, C = 15% then,
1
1
1
1
------------- = ----------------- = --------------- = --------- = 4%
RD + C
10% + 15%
0.1 + 0.15
0.25
Note that if c=0, deposit multiplier is equal to 10 (1/ RD =1/10%=10), which is now reduced to
4%. So RD decreases if public holdings of cash balances increases.
Note that the money expansion multiplier in the existence of cash drain is given by
1+c
-----------; which in our example is equal to:
RD+ c
1 + 15%
1 + 0.15
1.15
= ---------------- = --------------- = ------------ = 4.6
10%+15%
0.15 +0.1
0.25
The Central Bank and the economy:
What are the effects of the central bank on the economy and how does the central bank affect the
economy? Or what are the short and long-run impacts of monetary policy?
In fact the longer-run impact of monetary policy is to change consumption and investment
spending. This is because changes in monetary policy affect consumption expenditure, investment
expenditure, government expenditure, and net exports.
These in turn affect Aggregate Expenditure (AE), which affect real GDP and the price level.
That is to say that monetary policy has immediate impacts, intermediate effect, and longer-run
impacts.
Change in monetary policy is felt immediately on the bank’s net reserves, which is transmitted in
the longer-run to affect the whole economy through changes in money supply and interest rates.
Consider for example the impact of:
 an increase in reserve (by the use of OMO), or
 a decrease in reserve ratio (change of reserve requirements), or
 a decrease in discount rate (change in discount rate)
This will lead to increase in Net Excess Reserve (ER) of the banking system immediately, which
in turn will increase bank’s:
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►assets
►loans
►investment
Each of these impacts has additional impacts as follows:
 increase in banks assets  lead to increase in money supply.
 increase in loans  increase credit availability, and
 decrease interest rates.
 Increase in investment  decrease interest rate, and
 increase the prices of securities.
The increase in money supply and decrease in interest rate (resulting in the above step), will in
turn:
►increase consumption expenditure (C).
►increase expenditure on plant, equipment, housing, etc or increase
investment (I).
►increase government expenditure (G).
► increase exports (X).
► decrease import (M).
►decrease in foreign exchange.
So, aggregate expenditure (AE) is increased, and AD shift to the right (upward), and thus both
real GDP (YR) and price (P) will increases.
Note that the central bank can adversely affect GDP and price level if it undertakes the opposite
monetary policy.
When central bank increases money supply this is known as an easier monetary policy.
When central bank decreases money supply, it is said to be following a tight monetary policy.