ABSE 204
Monetary Policy
Monetary policy has two basic goals: to promote "stable" prices and to promote
"maximum" output and employment. It is performed by the Central Bank.
Tools of monetary policy
The Central Bank cannot control inflation or influence output and employment
directly. Instead it affects them indirectly, through the following instruments:
-
the minimum reserves ratio
-
the level of the discount rate (interest rate)
-
open market operations
1. Affecting the money supply through the minimum reserves ratio
If the Central Bank wants to encourage economic activity, it can reduce the
minimum reserves ratio (required reserves ratio) for the Commercial Banks. Thus, the
Commercial Banks will be allowed to keep fewer reserves and to give more loans.
The deposit multiplier increases (DM = 1/rr) and money supply can increase, as well.
This can reduce the equilibrium interest rate and the cost of doing business will fall.
Therefore, the reduction of the required reserves ratio is a tool of an expansionary
monetary policy. (Fig. 1)
i
MS
MS1
MD
M/P
Fig. 1. An increase in the Money supply as a result of the reduction in the required
reserves ratio
Unfortunately, this instrument of the Central Bank is not quite effective, because
Commercial Banks might not reduce the level of their reserves if they have
pessimistic expectations bout the ability of the public to pay back the loans. In this
case the reduction in the required reserves ratio will affect only the structure of the
Banks’ reserves – the required reserves will fall, but the Commercial Banks will raise
their excess reserves, keeping the level of the entire reserves unchanged.
If the central Bank wishes to calm down the economic activity due to an
overheating of the economy during the boom, it can raise the level of the required
reserves ratio. Such a move aims to reduce the ability of the Commercial Banks to
give loans. The deposit multiplier will fall and the money supply curve will shift
leftwards. The equilibrium interest rate will increase and the cost of doing business
will increase, as well. Therefore, the increase in the required reserves ratio is a toll of
a restrictive monetary policy. (Fig. 2)
MS1
MS
MD
M/P
Fig. 2. A fall in the money supply as a result of the increase in the required
reserves ratio
The increase in the required reserves ratio is not highly effective either, because
Commercial banks can raise their required reserves at the expense of their excess
reserves and still keep the level of the entire reserves unchanged.
Such a low efficiency of the required reserves ratio as an instrument of the
monetary policy is one of the explanations why the European Central Bank does not
use it in its monetary policy in the Eurozone.
2. The discount rate
The discount rate is the interest rate that the Central Bank charges on its relations
with the commercial banks.
The reduction in the discount rate aims to reduce the cost of banking and to raise
the ability of commercial banks to give loans. Therefore, we can expect that the
money supply will increase and the economic activity will be encouraged. Thus, the
reduction in the discount rate is an instrument of an expansionary monetary policy.
The increase in the discount rate has an opposite effect. It raises the cost of
banking and aims a reduction in money supply, an increase in the interest rates on
loans and restricts economic activity.
The manipulations with the discount rate are not highly effective either, because
the commercial banks might keep following their loan policies, no matter what they
pay to the Central Bank for its services.
3. Open market operations
This instrument of the Central Bank to affect money supply and economic activity
is highly effective.
The central Bank keeps government bonds on its assets. If it wants to encourage
the economic activity, it can buy government bonds at the open financial markets.
This operation simply means an injection of fresh money into the economy. Money
supply increases, and equilibrium interest rate falls.
A restriction of the economic activity is achieved through a sale of government
bonds by the Central Bank. The Central Bank offers less liquid assets (bonds) and
collects money against it. The money supply is reduced and the equilibrium interest
rate rises.1
4. Effectiveness of monetary policy
As we realized, the first two instruments of monetary policy are not very effective,
because the Central Bank does not affect directly money supply and economic
activity. It is up to the Commercial banks whether they will give more and cheaper
loans as a response to an expansionary reduction in the discount rate, or in the
minimum reserves requirements.
As a rule, during a recession expansionary
monetary policy through these instruments is not very effective, because Commercial
banks have pessimistic expectations and do not raise loans significantly.
Open market operations affect money supply directly and for this reason, they are
more effective. Still, the impact of monetary policy on economic activity depends on
two more factors:
a) the elasticity of money demand as regard the interest rate.
If money demand is highly inelastic, a small increase in money supply will
significantly reduce the equilibrium interest rate(Fig. 3 a), and respectively, a
small reduction in money supply will significantly raise the equilibrium interest
rate.
1
As a big player on the financial markets, the Central bank operations affect the
supply and demand of bonds. When it buys bonds, the demand for bonds increases
and the equilibrium interest rate falls. The sales of bonds by the Central Bank shift the
supply curve of bonds rightwards and this raised the equilibrium interest rate.
If money demand is very elastic, a huge increase in money supply will have a
minor effect on equilibrium interest rate (Fig. 3, b)
a)
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b)
MS2
MS2
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MD
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i2
i2
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M/P
M/P
Fig. 3. a) inelastic money demand and huge reduction in the equilibrium interest
rate as a result of monetary expansion; b) highly elastic money demand and a
minor reduction in the equilibrium interest rate as a result of monetary expansion.
b) the elasticity of investment demand as regard interest rate
If investment demand is inelastic as regard interest rate, monetary policy will
not have a significant impact on the economy. A huge reduction in the interest
rate will have a very small impact on economic activity. (Fig. 4)
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I
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i2
I1
I2
I
Fig. 4. Inelastic investment demand and a very small response in investment to a
huge reduction in the interest rate.
Monetary policy is more effective, the more elastic is the investment
demand and the less elastic is the money demand.
Under a recession when investors have pessimistic expectations and
investment demand is highly inelastic, while money demand is very elastic (there
is a huge liquidity preference), monetary policy is not effective.
Usually, monetary policy is more effective as a tool to fight inflation and
during the economic boom.