Chapter 8 Central Banking and
the Conduct of Monetary
Policy
Requirement
1.Grasp
(1)main component of balance sheet of
the central bank
(2)the process of multiple deposit creation
and simple money multiplier.
(3)money multiplier corresponding to M1
(4)Factors affect money multiplier and
money supply.
(5)tools of monetary policy and their
features.
(6)goals of monetary policy
(7)targets of monetary policy and criteria
for choosing targets
2.main points
(1)Factors affect money multiplier and
money supply.
(2) tools of monetary policy and their
features.
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Key words
Open market operations
Defensive open market operation
Dynamic open market opration
Excess reserve
Required reserve
Monetary base (high powered money)
Multiple deposit creation
Simple deposit multiplier
Money multiplier
Nonborrowed monetary base
Discount window
Lender of last resort
Repurchase agreement
Intermediate targets
Operating target
Philips curve
Taylor rule
Ⅰ Balance sheet of central bank
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1Assets
1.1 Government securities.
1.2 Discount loans.
2. liability
2.1 currency in circulation
2.2 Reserves
Required reserve
Excess reserve
3.monetary base
the monetary base (also called highpowered money)
MB=C+R
Ⅱ Multiple Deposit Creation: A Simple
Model
1.multiple deposit creation
When the central bank supplies the
banking system with a given amount of
additional reserves, deposits increase by a
multiple of this amount, this process called
multiple deposit creation.
2. hypotheses commercial banks have
2.1 only checking account, and don’t have
time deposit and saving deposit account
2.2 There is no excess reserve
somewhere in the banking system.
2.3 There is no cash outflow in the
banking system.
3. Analyze
 3.1 process of Multiple Deposit Creation
Assume that required reserve ratio is 10%,
and $1000 of deposits is deposited at
Bank A.
3.2 deriving the formula for multiple
deposit creation
RR= r×D
D= RR/ r
⊿D= ⊿RR/ r
Variable m is the simple money multiplier
m=⊿D/⊿RR=I/ r
Ⅲ determinant of money supply
 1.the Money Supply Model and the Money
Multiplier
 In deriving a model of the money supply process,
money supply corresponds to M1
m=(1+c)/( r+e+c)
 r=RR/D
 e=ER/D
 c=C/D
 2.Factors That Determine the Money Multiplier
 2.1 required reserve ratio r
 2.2 currency ratio c
 2.3 excess reserves ratio e
 2.3.1 market interest rate.
 2.3.2 deposit outflows
 3.Additional Factors That Determine the
Money Supply
 nonborrowed monetary base :The
monetary base except discount loan
MBn=MB﹣DL
where MBn=nonborrowed monetary base
MB=monetary base
DL=discount loans from the Fed
M=m×(MBn+DL)
discussion
What is the function of central bank?
Ⅳ Tools of Monetary Policy
1.Open market operation
2.discouunt loan
3.reserve requirements
 1. open market operation
 1.1 open market operations
 The central bank exercises control over the
monetary base through its purchases or sale of
government securities in the open market.
 1.2 A purchase of bonds by the central bank is
called an open market purchase, and a sale of
bonds by the central bank is called an open
market sale.
1.3 There are two types of open market
operations:
1.3.1 Dynamic open market operations:
are intended to change the level of
reserves and the monetary base,
1.3.2 Defensive open market operations:
are intended to offset movements in other
factors that affect reserves and the
monetary base,
1.4 influence on money supply
Open market purchase R+C
Open market sale
R+C
 1.5 advantage of open market operation
 1.5.1 Open market operations occur at
the initiative of the central bank
 1.5.2 Open market operations are
flexible and precise
 1.5.3 Open market operations are easily
reversed.
 1.5.4 Open market operations can be
implemented quickly
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1.7 Method of open market purchase and sale
1.7.1 open market purchase
Repurchase agreement
the central bank purchases securities with an
agreement that the seller will repurchase them in a short
period of time, anywhere from 1 to 15 days from the
original date of purchase.
 1.7.2 open market sale
 matched sale–purchase transaction
 (sometimes called a reverserepo): the central bank sells
securities and the buyer agrees to sell them back to the
Fed in the near future.
2. Discount Policy
2.1 discount window:
The central bank facility at which discount
loans are made to banks is called the
discount window.
 2.2 mechanism of discount window
2.3 advantages and disadvantage of
discount policy
2.3.1 advantages

lender of last resort
2.3.2 disadvantage of discount policy
 (1)announcement effect
 (2) adjustment of discount rate may lead
to unintended fluctuations in the volume of
discount loan and money supply
 (3)discount loan can not be controlled
completely by the central bank
 (4)cannot be easily reversed compared
with open market operation
 3.reserve requirements
 3.1 mechanism
 3.2 advantages and disadvantages of reserve
requirement
 3.2.1 advantages
 3.2.2disadvantages
 3.2.2.1 small changes in the money supply
and interest rates are hard to engineer by
varying reserve requirements.
 3.2.2.2 raising the requirements can cause
immediate liquidity problems for banks with low
excess reserves.
changes in reserve requirement ratio of U.S.
20%
15%
10%
5%
0%
reserve requirement
ratio
25%
adjustments of reserve requirement ratio by PBC
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198
dates
discussion
Why “reserve requirement ” is the most
frequently used monetary policy tools in
China?
Ⅴ conduct of monetary policy : goals and
target
1.Goals of monetary policy
1.1 high employment
1.2economic growth
1.3price stability
1.4 interest rate stability
1.5stability in foreign exchange markets
1.6 stability in financial markets
2. Target of monetary policy
 2.1intermediate target : variables which
have a direct effect on goals of monetary
policy.
such as the monetary aggregates (M1, M2,
or M3) or interest rates (short- or long-term)

2.2 operating targets( alternatively
instrument targets)
Variables which are more responsive to its
policy tools.
such as reserve aggregates (reserves,
non-borrowed reserves, monetary base, or
nonborrowed base) or interest rates
(interbank offered rate or Treasury bill rate),
Tools of
monetar
y policy
operatin
g
target
Intermedia
te
Target
Goal of
Monetar
y policy
2.3 Choosing the Targets
Measurability
Controllability
Predictable Effect on Goals
Summary
 1.the balance sheet of the central bank
composed by the asset and liability. Discount
loans and government securities belong to the
asset of the central bank and reserves and
currency in circulation are the liability of central
bank. increase of discount loan will make the
reserves of central bank increase and increase
of government securities hold by central bank
will make the reserves and currency in
circulation rise.
2.When the central bank supplies the
banking system with a given amount of
additional reserves, deposits increase by a
multiple of this amount, we call this
process as multiple deposit creation.
Simple money multiplier m=⊿D/⊿RR=1/ r,
money multiplier corresponding to money
supply M1,m=(1+c)/(r+e+c), in which
r=RR/D,e=ER/D,c=C/D.
 3.money supply MS=m×MB, MB is monetary
base, MB=reserves+ currency in circulation,
factors affect money supply are: required
reserve ratio r ,currency ratio c, excess reserves
ratio e, market interest rate, deposit outflows,
discount loan and nonborrowed monetary base.
 4.Open marker operation, discount loans and
reserve requirement are tools of monetary policy.
Among them, open market operation is most
commonly used tools and the others two can not
be used frequently.
 5. All central banks consequently pursue a
different strategy for conducting monetary policy
by aiming at variables that lie between its tools
and the achievement of its goals. variables
which have a direct effect on goals of monetary
policy are intermediate target of monetary policy,
such as the monetary aggregates (M1, M2, or
M3) or interest rates (short- or long-term).
Operation targets are variables which are more
responsive to monetary policy tools, such as
reserve aggregates (reserves, non-borrowed
reserves, monetary base, or nonborrowed base)
or interest rates (inter bank offered rate or
Treasury bill rate)
Reference book
1. Frederic S. Mishkin , “money strategy",
Massachusetts institution of technology,
2007
2. Akhand Akhtar Hossain, “Central
Banking and Monetary Policy in the Asiapacific”, Edward Elgar publishing
limited,2009