Economics
Chapter 4
Bank Credit and Monetary Policy
Banks

Central bank


Special functions in the economy
Commercial banks

Profit making financial institutes
Deposit
Loan
A
B
Deposit withdrawal
+
Interest
Loan payment
+
Interest payment
Money Supply

M1 = Cash held by the public + Demand deposits in LBs

M2 = M1 + Savings and time deposits in LBs
+ NCD issued by LBs which held by the public

M3 = M2 + Deposits & NCD in RBs & DTCs
Money Supply

Mr. A has $1,000 cash

MS = M1 = $1,000




Mr. A saves his $1,000
cash into saving deposit
The bank agrees to lend
$1,000 to Mr. B
(agreement made)
Mr. B cash out his loan
$1,000 from the bank

MS = M2 = $1,000






Mr. B saves his $1,000
into the bank
Cash = $0
Mr. A’s deposit = $1,000
MS = M2 = $2,000


(M1 = Cash = $0)
(M2 = M1 + Deposit in LB from
Mr. A= $1,000)
MS = M2 = $1,000


(M1 = Cash = $1,000)
Cash = $1,000
Mr. A’s deposit = $1,000
MS = M2 = $2,000


Cash = $0
Mr. A & B’s deposit = $2,000
Deposit creation

Through making saving and lending process



Bank gains from difference in interest
Loan  will lead to
 Deposit 
 Money supply  (from $1,000 to $2,000 in above case)
The process is know as


Deposit creation or
Credit creation
The reserve system of banks

In order to protect depositors, banks


Cannot lend out all the deposits
Keep enough cash in case of withdrawal

Cash held by bank = Reserve (儲備)

Reserve ratio = Reserve-to-deposit
Reserve ratio =
𝑹𝒆𝒔𝒆𝒓𝒗𝒆𝒔
𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒑𝒐𝒔𝒊𝒕
x 100%
Calculation of reserve ratio

Bank’s balance sheet


Cash: Assets held by the bank
Deposits: Liabilities that the bank owes the depositors
Assets ($)
Cash reserves
$1,000



Liabilities ($)
Deposits
$1,000
Case 1
With cash reserves equals total deposits
Reserve ratio = ($1000/$1000) x 100%
= 100%
Calculation of reserve ratio
Assets ($)
Cash reserves
($1,000-$500)
Loans
(+$500)




Liabilities ($)
Deposits
$1,000
$500
$500
Case 2
The bank loan out $500
Cash reserves = $1,000-$500 = $500
Reserve ratio = ($500/$1000) x 100%
= 50%
Calculation of reserve ratio
Assets ($)
Cash reserves
($1,000-$1,000)
$0
Loans
(+$1,000)
$1,000




Liabilities ($)
Deposits
$1,000
Case 3
The bank loan out $1,000
Cash reserves = $1,000-$1,000 = $0
Reserve ratio = ($0/$1000) x 100%
= 0%
Calculation of reserve ratio
Assets ($)
Cash reserves
($5,000-$3,000)
$2,000
Loans
(+$3,000)
$3,000
Liabilities ($)
Deposits
$5,000
Try this:
 Given the deposit = $5,000
 The bank loan out $3,000
 Cash reserves = $5,000-$3,000 = $2,000
 Reserve ratio = ($2,000/$5,000) x 100%
= 40%
The minimum reserve requirement

The Gov’t sets a lowest limit to the reserve ratio


To protect public interests
Maintain stability of the financial system

Required reserve ratio (RRR) or
Minimum reserve ratio

In US, RRR=10%,



i.e. for every $100 saving
the bank must keep $10 for cash reserve
and the bank can loan out $90 for profit marking
The fractional reserve system

Fractional reserve system

Banks are required to hold only a portion of their deposits
as reserves.

No need to hold all the deposits as reserve.

Can be loaned out for making profit.
The fractional reserve system and RRR
Country
RRR(%)
Remarks
United Kingdom
None
Canada
None
Australia
None
New Zealand
None
Japan
0.77
Taiwan
7.00
United States
10.00
No reserve required on savings accounts since 1990
20.00
Up from 15%, effective from 2010-12-06 - Ratio is for requirement on
term deposits.
RRR for foreign currency positions increased to 43.00 on 15/6/2010
China
20.00
Ratio is for major Chinese Banks on 2012-05-12;[18] down from a
21.5% high in June 2011.
Small and medium-size banks have a lower rate of 18.50%.
Hong Kong
None
Liquidity ratio ≥ 25% (Banking Ordinance – Sect.102)
Brazil
Member of EU
(e.g. Greece,
Germany, etc.)
Subject to minimum reserve framework of the Eurosystem
(http://www.ecb.int/mopo/implement/mr/html/calc.en.html)
Excess reserve

Additional reserve apart from the required or
Reserve hold by banks which is in excess of the required
reserve.

Excess reserve = Actual reserve – Required reserve

Example
Given RRR = 20% and deposit = $1,000
Required reserve = $1,000 x 20% = $200
If the bank hold reserve = $500
Excess reserve = $500 - $200 = $300
This $300 excess reserve is not required to hold by the gov’t
The bank decides to hold more in case of risk of cash withdrawal
However, maximum loan drops from $800 to $500





Excess reserve

Pros

More protection to depositor


More confidence


Low reserve ratio  If any rumours, easy to have bank run
Cons

Cash reserve makes no interest


Unable to earn from making loans
Less ability to earn


If bad debt, the bank cannot get back the loan
Unfavourable to attract investors
Whether holding excess reserve or not?
Risk vs. Return
Money supply with 100% reserve ratio

In an economy without bank


MS = Cash only
If gov’t issues $1,000 cash, MS = $1,000
Money
Supply
$1,000

Deposit
$0
Having a bank with 100% reserve


$1,000 cash can be saved as deposits
MS = $1,000
Money
Supply
$1,000


Cash
$1,000
Cash
$0
Deposit
$1,000
No loans can be made  No additional deposit
MS remains unchanged
Money supply with 100% reserve ratio

Conclusion
With 100% reserve ratio
 Deposit is kept totally as cash reserve in bank
 Bank has no further money to make loan
 No loan  No additional deposit


With 100%-reserve banking,



MS remains unchanged
the existence of banks does not affect the money supply.
It only changes its composition.
In other words

with reserve ratio < 100%

MS 
A model of deposit creation under a
fractional reserve system

Assumptions **


Minimum reserve ratio < 100%
No excess cash reserve,


Sufficient demand of loan


bank loan out all the reserves in excess of the legal requirement
the public is willing to borrow money from the bank
Public doesn’t hold cash

people deposit their loan into the bank

No cash drain or leakage
A model of deposit creation under a
fractional reserve system
Illustration



Given required reserve ratio = 20%
Assume Mr. A deposits $1,000 cash in a bank
Balance sheet of the bank after the initial deposit :
Assets ($)
Reserves
Liabilities ($)
1000 Deposits
1,000
A model of deposit creation under a
fractional reserve system
Illustration



20% of deposit is reserved = $200
80% of deposit can be loan out = $800
Balance sheet of the bank after the initial deposit (w/ loan):
Assets ($)
Reserves
Loan

Liabilities ($)
200 Deposits
800
Money supply = $1,000
1,000
A model of deposit creation under a
fractional reserve system
Illustration



Suppose Mr. B apply $800 loan from the bank
Then he deposit the $800 into the bank
Balance sheet of the bank after the second deposit:
Assets ($)
Reserves
(+800)
Loan
Liabilities ($)
$1000 Deposit
(+800)
$800
$1,800
A model of deposit creation under a
fractional reserve system
Illustration



20% of deposit is reserved
= $200 + $160 = $360
80% of deposit can be loan out
= $800 + $640 = $1440
Balance sheet of the bank after the second deposit (w/ loan):
Assets ($)
Reserves
Loan

Liabilities ($)
360 Deposits
1,440
Money supply = $1,800
1,800
A model of deposit creation under a
fractional reserve system
Illustration



Suppose Mr. C apply $640 loan from the bank
Then he deposit the $640 into the bank
Balance sheet of the bank after the third deposit:
Assets ($)
Reserves
(+640)
Loan
Liabilities ($)
1,000 Deposit
(+640)
1,440
2,440
A model of deposit creation under a
fractional reserve system
Illustration



20% of deposit is reserved
= $200 + $160 + $128 = $488
80% of deposit can be loan out
= $800 + $640 + $512 = $1,952
Balance sheet of the bank after the third deposit (w/ loan):
Assets ($)
Reserves
Loan

Liabilities ($)
488 Deposit
1,952
Money supply = $2,440
2,440
A model of deposit creation under a
fractional reserve system
Illustration



Suppose Mr. D apply $512 loan from the bank
Then he deposit the $512 into the bank
Balance sheet of the bank after the fourth deposit:
Assets ($)
Reserves
(+512)
Loan

Liabilities ($)
1,000 Deposit
(+512)
1,952
Money supply = $2,952
2,952
A model of deposit creation under a
fractional reserve system
The public
Change in deposits
Change in loans
[Deposit x (1-20%)]
1st
$1000
$800
2nd
$800
[$1000 x 0.8]
$640
3rd
$640
[$1000 x 0.82]
$512
4th
$512
[$1000 x 0.83]
$409.6
5th
$409.6
[$1000 x 0.84]
$327.68
6th
$327.68
[$1000 x 0.85]
$262.144
.
.
.
.
.
.
.
.
.
A model of deposit creation under a
fractional reserve system
Total deposits:
The
public
Change in deposits
Total
deposits
1st
$1,000
$1,000
2nd
$1000 x 0.8 = $800
$1,800
3rd
4th
5th
6th
$1000 x 0.82 = $640
$1000 x 0.83 = $512
$1000 x 0.84 = $409.6
$1000 x 0.85 = $327.86
$2,440
$2,952
$3,361.6
$3,689.46
.
.
.
.
.
.
A model of deposit creation under a
fractional reserve system
Total deposits
= $1,000 + $1,000(0.8) + $1,000(0.82) + $1,000(0.83) +…
By geometric progression
1
= $1,000 x
1 −0.8
= $1,000
= $5,000
1
1
x
 [ i.e. Initial deposit x
]
𝑅𝑅𝑅
0.2
A model of deposit creation under a
fractional reserve system
Given that reserve ratio = 20%
 meaning that 80% of deposits can be loaned out
Total loans = Total deposits – required reserve
= $5,000 - $5,000 x 20%
= $5,000 x (1 – 20%)
= $5,000 x 80%
= $4,000
A model of deposit creation under a
fractional reserve system
Illustration


After many deposits and loans
The final status of the bank’s balance sheet:
Assets ($)
Reserves
Loan


Liabilities ($)
1,000 Deposit
4,000
Money supply increase from $1,000 to $5,000
i.e. MS = $4,000
5,000
Deposit creation and the banking multiplier
Given reserve ratio = 20%
Assets ($)
Reserves
Loan
$1,000
$5,000
Liabilities ($)
1,000 Deposit
4,000
Reserves = Deposits x Reserve ratio
Deposits
= Reserves x
1
Reserve ratio
5,000
$5,000 x 20%
1
$1,000 x 0.2
= Reserves x Banking multiplier
$1,000 x 5
= Initial deposit x Banking multiplier
Deposit creation and the bank multiplier
The banking multiplier
Banking multiplier =
1
Reserve ratio
Minimum reserve ratio (RRR) is the lowest reserve ratio
Max banking multiplier =
=
1
Minimum reserve ratio
1
RRR
Deposit-creation ability and the banking multiplier
Deposits = Reserve x
1
Reserve ratio
Max. Deposits = Reserve x
1
Minimum reserve ratio
Example 1:
Given the RRR is 20%. If a person saves $1,000 into the bank
and the bank keeps the required reserves and loans out the
remaining part, what is the maximum increase in deposits?
Solution:
Max. Deposits = Reserve x
= $1,000 x
1
0.2
1
Required reserve ratio
= $5,000
Example 2
Below shows the balance sheet of a bank
Assets ($)
Reserves
Loan
1,000 Deposit
4,000
Suppose there is no excess reserves, calculate
a.
i.
ii.
b.
Liabilities ($)
the required reserve ratio and
The maximum banking multiplier.
Suppose $500 cash is deposited into the bank,
calculate the change in deposit.
5,000
Example 2
Below shows the balance sheet of a bank.
Assets ($)
Reserves
Loan
1,000 Deposit
4,000
5,000
Suppose there is no excess reserves, calculate
a.
b.
Liabilities ($)
$1000
$5000
i.
The required reserve ratio =
x 100% = 20%
ii.
The maximum banking multiplier =
1
20%
=5
Suppose $500 cash is deposited into the bank, calculate the
change in deposit.
The change in deposit = Reserve x
= $500 x
= $2500
1
0.2
1
Minimum reserve ratio
Example 3
Below shows the balance sheet of a banking system.
Assets ($)
Reserves
Loan
Liabilities ($)
700 Deposit
1,800
2,500
Suppose the required reserve ratio is 20% and the public do not
hold cash. Determine whether the following statements are true or
false.
a.
The bank reserve ratio is 20%.
b.
The maximum amount of deposits is $12,500.
c.
The bank hold excess reserves of $100
d.
The bank can increase its loans by at most $1,000.
Example 3
a.
$700
The bank reserve ratio = $2500
x 100% = 28%
(The bank reserve ratio is 20%” is false.)
b.
The maximum amount of deposits
= Reserve x
1
Minimum reserve ratio
= $700 x
1
0.2
= $3500
( The maximum amount of deposits is $12,500” is false)
c.
Excess reserves held by the banks
= Actual reserve - Required reserve
= $700 – ($2,500 x 20%)
= $700 - $500
= $200
( “The bank hold excess reserves of $100” is false.)
Example 3
d.
Since excess reserve = $200
The banks can loan out the excess reserve.
The max. increase in loan
= Additional loan x banking multiplier
= $200 x
1
0.2
= $1000
(‘ The bank can increase its loans by at most $1,000’
is correct.)
Example 4
Fill in the balance sheet below to show the final situation if
$1,000 cash in deposited into the banking system with
required reserve ratio 25% without excess reserve.
Think about:
1
25%
i.
What is the banking multiplier?
ii.
The initial $1,000 deposit dollars is kept and used to support
the final deposit. Then what is the meaning of this $1,000 in
the balance sheet? Reserves
How much is the max deposit can be supported by this $1,000
in the banking system? $1,000 x 4 = $4,000
iii.
=4
Assets ($)
Reserves
Loan
Liabilities ($)
1,000 Deposit
3,000
4,000
Deposit-creation and money supply
MS = Cash held by the public (C) + Deposit (D)
 MS = C + D
Given RRR = 20%
If the public save $1,000 cash into the bank



Currency in circulation:  $1,000 [i.e. C = - $1,000]
1
Deposits: $5,000 [i.e. D = $1,000 x 0.2 = $5,000]
MS
= C + D
= -$1,000 + $5,000
= $4,000
HKCEE 2009/Paper 1/Q.6
Study the following balance sheet of a banking system.
Assets ($)
Liabilities ($)
Reserves
Loan
300 Deposit
700
1,000
Suppose the legal reserve ratio is 20%.
a.
Calculate the excess reserve of the banking system. (2 marks)
Excess reserve = $300 – ($1000 x 20%)
= $100
b.
Suppose all excess reserve is loaned out. Calculate the maximum possible amount
of total deposits in the banking system. (2 marks)
Max. deposits
1
= $300 x 20%
= $1500
c.
Hence, calculate the change in money supply. (2 marks)
Change in money supply = Change in cash (held by the public) + Change in deposit
= $0 + ($1500 - $1000)
= $500
Monetary base ( 貨幣基礎 / 銀根 )
MS = Cash held by the public + Total Deposit
Total Deposit = Initial deposit x Banking multiplier
= Reserves x Banking multiplier
= Reserves x
MS
1
RRR
= Cash held by the public + Initial deposits x
Monetary base
1
RRR
Example
Given RRR = 20%, Cash held by the public = $500 and
Initial deposit = $1000.
Find i. Monetary base & ii. Money supply
Solution:
i. Monetary base
ii. Money supply
= Cash held by the public + Initial deposits
= $500 + $1000
= $1500
= Cash held by the public + Deposits
= Cash held by the public + Reserves x
= $500 + $1000 x 1/0.2
= $5,500
1
RRR
HKDSE Practice Paper 2/Q.14
The following table shows the balance sheet of the banking system of an economy:
Assets ($million)
Reserves
Loan
Liabilities ($million)
1000 Deposit
3000
4000
Suppose the public in this economy always holds $500 million cash and the
banking system never holds excess reserves.
a.
Calculate the monetary base and money supply of the economy. (2 marks)
b.
Suppose the central bank lowers the minimum reserve ratio of the banking
system by 5%.
i.
Explain whether the monetary base of the economy changes. (2 marks)
ii.
Calculate the new money supply. Show your working. (4 marks)
HKDSE Practice Paper 2/Q.14
The following table shows the balance sheet of the banking system of an economy:
Assets ($million)
Reserves
Loan
Liabilities ($million)
1000 Deposit
3000
a.
Monetary base = $1 000 million + $500 million = $1 500 million (1)
Money supply = $4 000 million + $500 million = $4 500 million (1)
b.
(i) No, because (1)
the policy affects neither the amount of reserves nor
the cash held by the general public. (1)
(ii)
Before the policy change, the minimum reserve ratio
= $4 000million / $1 000million = 0.25 (1)
The new minimum reserve ratio = 0.25 – 0.05 = 0.2 (1)
The banks will lend out the excess reserves.
New deposits = $1 000 million x
1
0.2
= $5 000 million (1)
New money supply = $500 million + $5 000 million = $5 500 million (1)
4000
No. of banks and the form of loans
do not affect deposit creation


In reality, many banks
Do not affect deposit creation



Loan from Bank A  Deposit to Bank B
Loan from Bank B  Deposit to Bank C
…
The
Change in deposits
Change in loans
public

[Deposit x (1-20%)]
1st
$1000
$800
2nd
$800
$640
3rd
$640
$512
4th
$512
$409.6
5th
$409.6
$327.68
6th
$327.86
$262.144
.
.
.
For details, read p.110
Deposit as
a whole is
not affected
Realistic assumption

Assumptions of maximum deposit creation
1.
2.
3.
4.

Banks adopts fractional reserve system
No excess reserves held by banks
Sufficient demand of loans
No cash drain / leakage
In real world:




Only assumption 1 is true.
 Assumption 2. Reason: for risk management
 Assumption 3. Reason: interest rate   loans 
 Assumption 4. Reason: the public need cash
Violations of assumption


Violation of assumption 2: Excess reserve
 Banks usually hold excess reserve to reduce risk
  Actual reserve ratio   Banking multiplier 
Violation of assumption 3: Insufficient demand of loan


High reserves  Less amount for loan
 Banks’ profit  interest rate   Demand of loan 
Violation of assumption 4: Cash leakage





The public holds cash
 less loan get back to the banks as deposit
 Deposit 
 Loan
 Deposit creation can’t be maximized
Conclusion:
Model of deposit creation
Assumption
Able to have
deposit creation?
Able to maximize
deposit?
Fractional reserve system

-
No excess reserves
-

Sufficient loans
-

No cash leakage
-

Necessary condition for deposit creation
Necessary conditions for maximizing deposit
Reserve shortage

What happen if Mr. A withdraws $100 from
the bank?
Assets ($)
Reserves
Loan

Liabilities ($)
1,000 Deposit
4,000
5,000
Total deposit = $5,000 - $100 = $4,900
Assets ($)
Reserves
(-100)
Loan
Liabilities ($)
900 Deposit
(-100)
4,000
4,900
Reserve shortage
Assets ($)
Reserves
(-100)
Loan

Liabilities ($)
900 Deposit
(-100)
4,000
After withdrawal,
Reserve ratio =



4,900
$900
$4900
x 100% = 18.37%
However, required reserve ratio (RRR) = 20%
Not accepted by the law:
Actual reserve ratio < RRR
 necessary to increase reserves to fulfill the
minimum reserve requirement
Reserve shortage
Assets ($)
Reserves
(-100)
Loan




Liabilities ($)
900 Deposit
(-100)
4,000
4,900
If deposit = $4,900 & RRR = 20%
Required reserves = $4,900 x 20% = $980
However, after $100 withdrawal
Actual reserves = $900
Reserve shortage:
Actual reserves < Required reserves
Amount of reserve shortage
= $980 - $900
= $80
Deposit contraction(存款收縮)

Reserve shortage = $80, what can the banks do?

Recall loans

The bank recalls loans from Mr. B = $80



Since bank holds 20% reserves & loans out 80% of deposit
For every $1 withdrawal, the bank has to recall $0.8 of loans to
maintain sufficient reserves
Effect

Mr. B doesn’t have cash


When a bank recalls loans, he needs to withdraw $80 from his
deposit
Another round of reserve shortage occurs
Deposit contraction(存款收縮)

Reserve shortage:

Reserves
Loan

Assets ($)
Liabilities ($)
900 Deposit
4,000
Recall loans from Mr. B
Assets ($)
Reserves
(+80)
Loan

(-80)

4,900
Liabilities ($)
980 Deposit
4,900
3,920
Mr. B’s withdrawal
Assets ($)
Reserves
(-80)
Loan
Liabilities ($)
900 Deposit
(-80)
3,920
4,820
Deposit contraction(存款收縮)
Withdrawal
Change in deposits
Change in loans
1st
- $100
- $80
2nd
- $80
- $64
3rd
- $64
- $51.2
4th
- $51.2
- $40.96
5th
- $40.96
- $32.768
6th
- $32.768
- $26.2144
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.
.
.
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Deposit contraction

Initial withdrawal



2nd round withdrawal



Mr. A withdraws $100 from a bank
To keep enough reserves, the bank recalls $80 from Mr. B
Mr. B withdraws $80 from a bank to repay his debt
To keep enough reserves, the bank recalls $64 from Mr. C
3rd round withdrawal


Mr. C withdraws $64 from a bank to repay his debt
To keep enough reserves, the bank recalls $51.2 from Mr. D
Deposit contraction and the banking multiplier
Deposits = Reserve x
1
Reserve ratio
Max. Deposits = Reserve x
Deposits = Reserve x
= - $100 x
= - $500
1
20%
1
Minimum reserve ratio
1
Reserve ratio
Deposit contraction
Before withdrawal:
Assets ($)
Reserves
Loan
Liabilities ($)
1,000 Deposit
4,000
5,000
After withdrawal:
Max. change of loans = Change in deposits – Change in reserves
= - $500 – [-$500 x 20%]
= - $500 x (1 – RRR)
= - $500 x (1 – 20%)
= - $400
Assets ($)
Reserves
(-100)
Loan
(-400)
Liabilities ($)
900 Deposit
(-500)
3,600
4,500
Example
Below is the balance sheet of the banking system. Suppose the
bank has no excess reserves:
Assets ($)
Reserves
Loan
Liabilities ($)
400 Deposit
1,600
2,000
If a depositor withdraws $100 cash from the bank, what is the
maximum change in the deposits?
Answers:
Reserve ratio =
$400
$2000
x 100% = 20%
Change in deposits = Reserve x
= - $100 x
= - $500
1
20%
1
Reserve ratio
Assets ($)
Reserves
Loan
Liabilities ($)
300 Deposit
1,200
1,500
Monetary policy
Borrow $$ to buy
car now?
( Yes / No )
Consumption
Apply mortgage to
buy a house now?
( Yes / No )
Investment
Interest
rate
Borrow $$ from the
bank to expand
production?
( Yes / No )
Production
Monetary policy ( 貨幣政策 )

The central bank’s control of
1.
the money supply or
2.
the interest rate
to achieve certain economic objectives

MS = Cash held by the public + Deposits


How to control the amount of cash in public?
How to influence deposits?
I. Monetary policy tools
1.
Issuing banknotes



Cash held by the public 
 Money supply 
Cash 
 Deposit 
 Reserves 
 Loans
 Deposit creation
 Money supply 
Most likely for MS increasing
I. Monetary policy tools
2.
Minimum reserve requirement


RRR 
 Cash reserves in banks 
 Ability to make loans 
 Deposits creation 
 Money supply 
RRR 
 Cash reserves in banks 
 Ability to make loans
 Deposits creation
 Money supply 
I. Monetary policy tools
3.
Open market operation

Controlled by central banks



Reserves and deposits at the central bank
Operation with commercial banks
Buying and selling gov’t bonds
I. Monetary policy tools
3.
Open market operation
Open market purchase
a.






Assume ABC Company (the public) holds gov’t bond
Central bank buys bonds (worth $1million) by paying cheque
to ABC Co.
ABC Co. deposits the cheque into commercial bank
Central bank pays Bank A $1million for cheque clearing
Deposit: Increase by $1 million
Through deposit creation, MS 
$1million
Central bank
Bank A
Cheque
Deposit
ABC Co.
[holding Gov’t
bonds]
Illustration
After the open market purchase:
Assets ($)
Reserves
Liabilities ($)
+1,000,000 Deposits
+1,000,000
In short, both reserves and deposits increase by $1 million.
Given the RRR=20%
Total Deposits = Initial deposits x Banking multiplier
= $1,000,000 x
= $5,000,000
 Ms = Cash + Deposits
= $0 + $5,000,000
= $5,000,000
1
20%
I. Monetary policy tools
3.
Open market operation
Open market sale
b.





Gov’t sell bonds to the public
ABC Company bank buys bonds (worth $1million) by paying
cheque to the central bank
Central bank withdraws $1million for ABC’s account
Deposit: decrease by $1 million
Through deposit contraction, MS 
$1million
$1million
Central bank
Bank A
Deposit
ABC Co.
[holding Gov’t
bonds]
I. Monetary policy tools
4.
Discount rate
Interest rate (Cost) of loan from the central bank to
commercial banks
 If discount rate 
 Cost of loan 
 Commercial banks: less incentive to borrow
 Loan out 
 Deposit 
 Reserve 
 Ability of deposit creation 
 Ms
 Conclusion: Discount rate  Reserves and Ms

I. Monetary policy tools
4.
Discount rate
If discount rate 
 Cost of loan 
 Commercial banks: more incentive to borrow
 Loan out 
 Deposit 
 Reserve 
 Ability of deposit creation 
 Ms 
 Conclusion: Discount rate  Reserves and Ms 

Conclusion: Monetary policy tools
Open market
operations
Discount
rate
Monetary
policy
tools
Minimum
reserve ratio
Issuance of
banknotes
Commercial banks’
deposits at the
central bank
Reserves
Deposits
Money
Supply
Cash
held by the public
II. Controlling of interest rate
Effects on interest rate
If Gov’t sell bonds,
 Ms 
(i.e. capital in the market flow towards the central bank)
 Deposit 
 Reserve 
Interest rate (%)
MS2
 Loanable fund in the market 
MS1
 Interest rate 
r2
r1
Md
0
Q2
Q1
Quantity
of money
II. Controlling of interest rate

By controlling Ms,



the gov’t indirectly controls interest rate
affect the incentive of loan making
Relationship:

Ms   interest rate 

Ms   interest rate 
Types of monetary policy

Carry out by the central bank


Expansionary monetary policy
Contractionary monetary policy
Monetary policy
Types
Expansionary
Contractionary
Central bank controls
Money supply 
Interest rate 
Money supply 
Interest rate 
Open market operation
Buy bonds
Sell bonds
Discount rate


Minimum reserve ratio


Issuance of banknotes


Tools
Effects of monetary policy
Expansionary monetary policy ( Ms  , r  )
 Banks have more to loan out
 More people are willing to borrow




Consumption 
Investment 
GDP 
 Gov’t uses expansionary monetary policy to booth
the economic growth

E.g. the US Gov’t adopted QE (Quantitative ease) in 2008
& QE2 policies in 2010
Effects of monetary policy
Expansionary monetary policy ( Ms  , r  )
 Pros

GDP 



Employment 


Consumption 
Investment 
Investment   Firms will hire more labour
Cons

Inflation

Consumption   Demand of goods   Price
Effects of monetary policy
Contractionary monetary policy ( Ms , r  )
 Banks have less to loan out
 With high interest rate, less people make loan




Consumption 
Investment 
GDP 
 Gov’t uses contractionary monetary policy to
prevent overheated economy
Effects of monetary policy
Contractionary monetary policy ( Ms  , r )
 Pros

Avoid economic overheat


Avoid inflation


Investment   Production 
Consumption   Demand of goods   Price 
Cons

Unemployment 

Investment 
 Firms will not hire or even lay off excess labour
Monetary policy in Hong Kong


Easy to be affected by foreign economies
No HK bonds buying or selling

Linked exchange rate system


Aim at keeping exchange rate: HKD7.8 = USD 1
Operation:
Linked exchange rate [ HKD7.8 = USD1 ]
Exchange rate
HKMA’s action
Result
-
HKD exchange rate
[ HKD7.5 = USD1 ]
HKD exchange rate 
[ HKD8 = USD1 ]
Sell HK Dollar
Buy HK Dollar
to lower the price of HKD
Maintain HKD7.8 = USD1
Ms 
-
to raise the price of HKD
Maintain HKD7.8 = USD1
Ms 
Monetary policy in Hong Kong

Conclusion

Issuance of banknotes
- usually around Chinese New Year

Minimum reserve ratio
- Liquidity ratio ≥ 25%

Discount rate
- Replaced by HIBOR (Hong Kong Inter-bank offered rate)

Open market operation
-
Replaced by the “Linked Exchange Rate System”
Chance to be attacked by global speculators, lost the
function of controlling money supply