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Monopoly power over money

Central banks have a huge influence over the financial system. In this, the
fifth of our schools briefs on the world of finance, we explain how they
conduct monetary policy
The Economist, Nov 18th 1999 | from PRINT EDITION
Central banks matter to the financial system for two main reasons. First, they set short-term
interest rates. These affect the cost of borrowing throughout the economy, from money
markets to mortgage rates..
The reason the Fed can set interest rates is that it has a monopoly on supplying bank reserves.
Banks are required to hold a fraction of the money deposited with them in a reserve account
at the Fed (see chart 1). They usually hold more, for precautionary reasons. The interest rate
at which banks demand for reserves matches the Feds supply is known as the federal funds
rate; this is also the rate at which banks lend reserves to each other overnight. The Fed
controls it by changing the supply of reserves through sales and purchases of government
securities, known as open-market operations.
when the Fed wants to lower the rate, it buys securities, which increases banksreserves
and it bids down interest rates
The Fed can also influence the federal funds rate indirectly, by changing the discount rate
the rate at which it will lend reserves to banks, or altering banks reserve requirements, the
fraction of their deposits that they are required to hold as reserves. ..
Changes in the federal funds rate ripple through financial markets and the economy. They
have knock-on effects on the interest rates at which banks lend to households and firms, and
hence the amount of credit in the economy. And they influence long-term market interest
rates too
Most central banks set monetary policy with the aim of keeping inflation low. The European
Central Bank (ECB) has the statutory goal of price stability; the Fed also has a duty to
support employment and economic growth
many central banks used at one time to finance governments budget deficits. When
government spending exceeds tax revenues, the difference is financed by selling government
bonds. If these are sold to the public, then the net effect on the money supply is zero. But if
they are purchased by the central bank, the money-supply rise that accompanies the deficit is
not offset: this is known as printing money or monetising the deficit

MACRO AGGREGATES, USA, 2006-2011


Real GDP
GDP Growth rate
Consumption(Growth

2006
12958
.5
2.9

2007
13206.
4
1.9
2.3

2008
13161.
9
-0.4
-0.6

2009
12759
.9
-3.5
-1.9

2010
13064
.0
3.0
2.0

2011
13299
.1
1.7
2.2

2.5

-1.4

-5.1

-15.2

2.0

3.7

110
4.97
4.79

90.6
5.02
4.63

38.6
1.92
3.76

53.60
0.16
3.26

53.30
0.18
3.21

0.10
2.79

5.59

5.56

5.63

5.31

4.94

4.64

3.24
-1.9

2.85
-1.2

3.85
-3.2

-0.34
-10.1

1.64
-9.0

3.16
-8.7

rate)

Investment (Growth
rate)
Consumer Confidence
Fed fund rate
Ten year Govt. Bond
(yield)
Ten Year Corporate
bond yield(AAA)
Inflation (CPI)
Fiscal Deficit

Answer the following questions:


1. What caused recession in the US during 2008-09? Explain using IS-LM model.
2. Were monetary and fiscal policies used to fight against recession? Explain using data
and their intended effects on aggregate demand using IS-LM model.
3. Was the US economy dominated by monetary policy or fiscal policy during the
recovery (i.e., in 2010-11). Explain using IS-LM model.
Monetary policy after the crash

Controlling interest
The third of our series of articles on the financial crisis looks at the unconventional
methods central bankers have adopted to stimulate growth in its wake
Sept 21st , 2013
BEFORE the financial crisis life was simple for central bankers. They had a clear mission:
temper booms and busts to maintain low and stable inflation. And they had a seemingly
effective means to achieve that: nudge a key short-term interest rate up to discourage
borrowing (and thus check inflation), or down to foster looser credit (and thus spur growth
and employment)
2

The recession that accompanied the credit crunch in the autumn of 2008 delivered a massive
blow to demand. In response central banks in the rich world slashed their benchmark interest
rates. By early 2009 many were close to zero, approaching what economists call the zero
lower bound. Even so, growth remained elusive... Central banks in the developed economies
faced a frightening collapse in output and soaring unemployment without recourse to the tool
that had been the mainstay of monetary policy-making for a generation.
Central banks were not entirely unprepared for this challenge. In the 1990s the Japanese
economy had slumped following an asset-price crash. Facing weak growth and deflation the
Bank of Japan had slashed rates to near-zero before embarking on a series of experiments
with unconventional monetary tools

Unconventional policy falls into two broad categories: asset purchases and forward
guidance. Asset purchases are a natural extension of central banks more typical activities.
Americas Federal Reserve, for instance, has long bought Treasury bills and other bonds with
short maturities to increase the money supply and reduce short-term interest rates. After its
benchmark rate fell close to zero the Fed began buying longer-term securities, including tenyear Treasury bonds and mortgage-backed securities.
Printing money to buy assets is known as quantitative easing (QE) because central banks
often announce purchase plans in terms of a desired increase in the quantity of bank
reserves The central banks of America, Britain and Japan have all engaged in QE since the
crisis struck, buying up a vast stock of financial assets (see chart 2).

Economists reckon QE works in a few ways. Central bankers emphasise the portfoliobalance effect...
From theory to practice
Studies of quantitative easing generally find that it has indeed reduced long-term interest
rates. One rule of thumb has it that $600 billion in purchases brings down long-run rates by
0.15-0.2 percentage points, equivalent in impact to a cut of 0.75 percentage points in the
Feds benchmark short-term interest rate. Lower rates are estimated to have raised real output
in Britain and America 2-3% higher than it would have been without QE, even though
borrowing costs remained stubbornly high for British banks

MACRO AGGREGATES, INDIA, 2008-2010


2003-08
Real GDP (Rs Billion)
GDP Growth rate
Private Final Consumption
Expenditure (Growth rate)
Government Final
Consumption Expenditure
(Growth Rate)
Gross Capital Formation
Investment (Growth rate)
Exports
Imports
Repo Rate (%)

2008-09

2009-10

44163.50

47908.47

8.8
7.5

3.9
7.2

8.48
7.4

5.8

10.4

13.9

18.5

-1.6

12.7

17.8
20.1
-

14.6
22.7
9 (October
2008)
9 (October
2008)
25(April
2009)
6.43
7.06
8.99
8.00

-4.7
-2.1
4.75(April 2009)

8.00

6.50

11.50
5.9

11.00
6.46

--

Cash Reserve Ratio


SLR
Base Money
Call Money Rate
M1
Deposit Rate (1-3 Yrs
Maturity)
Deposit Rate (1-5 years
Maturity)
Lending Rate
Centres Fiscal Deficit (%
of GDP)

5(April 2009)
24 (April 2009)
16.97
3.25
18.23
6.00