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ECO 120
Lecture Note:
Tools and Conduct of Monetary Policy
Lecturer: Serpil Kahraman
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Money
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Money plays an important role in “interest rate” and “inflation”.
Government budget deficits also can be an influential factor of
monetary policy. Budget deficit is the excess of government
expenditures over tax revenues for a particular time period.
Monetary policy is the management of money and interest rates. Central
bank is a responsible for the conduct of monetary policy.
Monetary theory relates changes in the quantity of Money to
changes in aggregate economy and the price level.
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Central Bank’s Monetary Aggregates
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As you know central bank is a bank’s bank and a public
authority that regulates a nation’s depository
institutions and controls the quantity of money. A
central bank is not a citizens bank that is not provides
general banking services. Central Bank affects the
interest rate through monetary policy. Interest is the
fee borrowers pay to lenders for the use of their funds.
Firms and the government borrow funds by issuing
bonds, and they pay interest to the firms and
households (the lenders) that purchase those bonds.
Households and firms that have borrowed from a bank
that must pay interest on those loans to the bank. The
interest rate is expressed as an annual rate.
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Measuring money
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The narrowest definition of money that the Central Banks report is M1 that
corresponds to the definition proposed by the theoretical approach and
includes currency, and checking accounts deposits that are extremely liquid
because they can be turned into cash quickly. Another problem in the
measurement of money is that the data are not always as accurate as we would
like.
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TOOLS OF MONETARY POLICY
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Central Banks use of these policy tools has such an
important impact on economic activity. Three policy
tools that the Central Bank use to manipulate the
money supply and interest rates:
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open market operations which affect the monetary base
changes in the discount rate which affect interest rates and
the monetary base by influencing the quantity of discount
loans and,
changes in reserve requirements which affect the money
multiplier.
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TOOLS OF MONETARY POLICY
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1) Open Market Operations: The most important
monetary policy tool because they are the primary
determinants of changes in interest rates and the
monetary base, the main source of fluctuations in the
money supply. Open market purchases expand the
monetary base, thereby raising the money supply and
lowering short-term interest rates and open market
shares sharing the monetary base, lowering the money
supply and raising short-term interest rates.
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Open market operations have several advantages
over the other tools of monetary policy:
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Open market operations occur at the initiative of the
Central Bank, which has complete control over their
volume.
Open market operations are flexible and precise, they
can be used to any extend.
Open market operations are easily reversed. If a
mistake is made in conducting an open market
operation, the Fed can immediately reverse it.
Open market operations can be implemented quickly;
they involve no administrative delays.
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TOOLS OF MONETARY POLICY
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2) Discount Policy: Discount policy, which primarily involves
changes in the discount rate, affects the money supply by
affecting the volume of discount loans and the monetary base. A
rise in discount loans adds to the monetary base and expands the
money supply; a fall in discount loans reduces the monetary base
and shrinks the money supply. The Fed facility at which discount
loans are made to banks is called the discount window. The
Fed can affect the volume of discount loans in two ways: by
affecting the discount rate or by affecting the quantity of the
loans through its administration of the discount window. The
mechanism through which the Fed’s discount rate affects the
volume of discount loans is straightforward: A higher discount
rate raises the cost of borrowing from the Fed, so banks will take
out fewer discount loans; a lower discount rate makes discount
loans more attractive to banks, and loan volume will increase.
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Discount policy
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Besides its effect on the monetary base and the money
supply, discounting allows the Fed to perform its role
as the lender of last resort. The most important
advantage of discount policy is that the Fed can use it
to perform its role of lender of last resort. However,
discount policy does make control of the money supply
more difficult because it results in unintended
fluctuations in the volume of discount loans and hence
in the money supply. So discount policy is less
effective than open market operations
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Lender of Last Resort
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In addition to its use as a tool to influence the
monetary base and the money supply,
discounting is important preventing financial
panics. Its most important role was intended to
be as the lender of last resort; it was to provide
reserve to banks when no one else would in
order to prevent bank failures from spinning out
of control, thereby preventing bank and
financial panics.
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TOOLS OF MONETARY POLICY
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3) Reserve Requirements: Changes in reserve
requirements affect the money supply by causing
the money supply multiplier to change. 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. Conversely, a
decline in reserve requirements leads to an
expansion of the money supply because more
multiple deposit creation can take place.
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Money (deposit) multiplier = 1/ reserve ratio
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Monetary base = currency in circulations +
reserves
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TOOLS OF MONETARY POLICY
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The main advantage of using reserve requirements to
control the money supply is that they affect all banks
equally and have a powerful tool. Small changes in the
money supply could be obtained by extremely small
changes in reserve requirements. Disadvantage of using
reserve requirements to control the money supply is
that raising the requirements can cause immediate
liquidity problems for banks with low excess reserves.
However it is so expensive to administer changes in
reserve requirements, such a strategy is not practical,
and hence it is rarely used.
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CONDUCT OF MONETARY POLICY:
GOALS AND TARGETS
Understanding the conduct of monetary policy is
important because not only affects the money supply
and interest rates but also has a major influence on the
level of economic activity and hence on our well-being.
GOALS OF MONETARY POLICY
 Six basic goals are continually mentioned by central
banks when they discuss the objectives of monetary
policy: high employment, economic growth, price
stability, interest rate stability, stability of financial
markets, and stability in foreign exchange markets.
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The goal of price stability often conflicts with
the goals of interest rate stability and high
employment in the short run. When the
economy is expanding and unemployment is
failing, both inflation and interest rates may start
to rise. If the central bank tries to prevent a rise
in interest rates, this may cause the economy to
overheat and stimulate inflation. But if a central
bank raises interest rates to prevent inflation, in
the short run unemployment may raise.
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CENTRAL BANK STRATEGY: USE OF
TARGETS
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The Central Bank’s problem is that it wishes to achieve
certain goals, such as price stability with high employment, but it
does not influence the goals. It has a set of tools to employ
(open market operations, changes in the discount rate and
changes in the reserve requirements) that can affect the goals
indirectly after a period of time (typically more than a year). If
the central bank waits to see what the price level and
employment will be one year later, it will be too late to make any
corrections to its policy- mistakes will be irreversible. All central
banks consequently pursue a different strategy for conducting
monetary policy by aiming at variables that lie between its tools
and the achievement its goals.
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