MONETARY POLICY

Money and Banking system

• Money is the set of assets in an economy that people regularly use
to buy goods and services from other people.
• The Functions of Money:

➢Medium of exchange

➢Store of value

➢Unit of account

• The Types of Money

USA
JAPAN
Money and Banking system
• The Banking system:

➢Central Bank: an institution designed to oversee the banking system

and regulate the quantity of money in the economy.

❑Vietnam: Ngân hàng nhà nước Việt Nam

❑UK: The Bank of England

❑US: Federal Reserve

➢Commercial Banks: receive deposits and make loans.

❑Create money
The Money Market
Measures of the Money Stock
• The monetary base (high-powered money) M0 (B): the total number of

dollars (issued by the central bank) held by the public as currency C and
by the banks as reserves R
𝐵 =𝐶+𝑅

with
𝑅 = 𝑅𝑟 + 𝑅𝑒
❑𝑅𝑟 : required reserves

❑𝑅𝑒 : excess reserves

The Money Market
Measures of the Money Stock
• M1:

𝑀1 = 𝐶 + 𝐷
➢D: demand deposits

• M2:

𝑀2 = 𝑀1 + 𝐷𝑡
➢Dt: saving deposits

• M3:

•…
The Money Market
Money Supply
• Money supply: the quantity of money available in the economy,

including currency in the hands of the public (C) and demand

deposits (D).
𝑀𝑆 = 𝐶 + 𝐷
The Money Market
Money Supply
• Money creation

➢Case 1:

❑Central bank issues $1 billion.

❑The public holds all as currency (C)

𝑀𝑆 = 𝐶 + 𝐷 = 1 + 0 = 1
The Money Market
Money Supply
• Money creation

➢Case 2:

❑Central bank issues $1 billion.

❑The public deposits all the money into commercial banks.

❑100-percent-reserve banking

𝑀𝑆 = 𝐶 + 𝐷 = 0 + 1 = 1
The Money Market
Money Supply
• Money creation

➢Case 3:

❑Fractional-reserve banking (lend some out, keep some reserves).

❑Suppose:

▪ Reserve ratio: 10%

▪ Loans out: 90%

The Money Market
Money Supply
• Money creation

➢Case 3:

Commercial Bank 1
Assets Liabilities
Reserves 100 million Deposits 1,000 million
Loans 900 million
𝑀𝑆 = 𝐶 + 𝐷 = 900 + 1,000 = 1,900 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠)
The Money Market
Money Supply
• Money creation

➢Case 3:

Commercial Bank 2
Assets Liabilities
Reserves 90 million Deposits 900 million
Loans 810 million
𝑀𝑆 = 𝐶 + 𝐷 = 810 + (1,000 + 900) = 2,710 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠)
The Money Market
Money Supply
• Money creation

➢Case 3:

Commercial Bank 3
Assets Liabilities
Reserves 81 million Deposits 810 million
Loans 729 million
𝑀𝑆 = 𝐶 + 𝐷 = 729 + (1,000 + 900 + 810) = 3,439 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠)
The Money Market
Money Supply
• Money creation

➢Case 3:

Commercial Bank 4
Assets Liabilities
Reserves 72.9 million Deposits 729 million
Loans 656.1 million
𝑀𝑆 = 𝐶 + 𝐷 = 656.1 + (1,000 + 900 + 810 + 729)
= 4,095.1 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠)
 The Money Market
Money Supply
• Money creation

➢Case 3:

D↑ Rr
Commercial Bank 1 1,000 100 900
Commercial Bank 2 900 90 810
… … … …
Commercial Bank n (1-10%)n-1x1,000

MS=10,000 million dollars

 The Money Market
Money Supply
• Money creation

➢Case 3:
D↑ Rr
Commercial Bank 1: D0 rrD0 (1-rr)D0
Commercial Bank 2: (1-rr)D0 rr(1-rr)D0 (1-rr)2D0
................ ......... ........ ...…..
Commercial Bank n: (1-rr) n-1D0
-------------------------------------------------

∆D = D0[1 + (1-rr) + (1-rr) 2 + ... + (1-rr) n-1] = D0/rr

The Money Market
Money Supply
 The Money Market
Money Supply
• The money multiplier (m): the amount of money the banking system generates with each dollar of
reserves

𝐶 𝐷
𝑀𝑆 𝐶 + 𝐷 𝐷 + 𝐷 𝑐𝑟 + 1
𝑚= = = =
𝐵 𝐶+𝑅 𝐶 𝑅 𝑐𝑟 + 𝑟𝑟
+
𝐷 𝐷
𝐶
➢ 𝑐𝑟 = : currency-deposit ratio
𝐷
𝑅
➢ 𝑟𝑟 = : reserve-deposit ratio
𝐷

𝑟𝑟 = 𝑟𝑟𝑟 + 𝑟𝑟𝑒
❑ 𝑟𝑟𝑟 : required reserve deposit ratio
❑ 𝑟𝑟𝑒 : excess reserve deposit ratio
The Money Market
Money Supply
• The money multiplier (m): the amount of money the banking system

generates with each dollar of reserves

𝑐𝑟 + 1
𝑚=
𝑐𝑟 + 𝑟𝑟
➢𝑟𝑟 ↑→?

➢𝑟𝑟 ↓→?

➢𝑐𝑟 ↑→?

➢𝑐𝑟 ↓→?
The Money Market
Money Supply
• 3 variables that cause the money supply to change:

➢Monetary base

➢Reserve-deposit ratio

➢Currency-deposit ratio
 The Money Market
Money Supply
• Central Bank’s tools of Monetary Control (influences the money supply):

➢Open-market operations (OMO): the purchase and sale of government bonds by the central
bank.
❑Central bank buys bonds from the public: B ↑→ 𝑀𝑆 ↑
❑Central bank sells bonds to the public: 𝐵 ↓→ 𝑀𝑆 ↓

➢Discount rate: the interest rate on the loans that the central bank makes to banks.
❑A higher discount rate: 𝐵 ↓→ 𝑀𝑆 ↓
❑A lower discount rate: 𝐵 ↑→ 𝑀𝑆 ↑

➢Required reserve-deposit ratio

❑𝑟𝑟𝑟 ↑→ 𝑚 ↓→ 𝑀𝑆 ↓

❑𝑟𝑟𝑟 ↓→ 𝑚 ↑→ 𝑀𝑆 ↑
The Money Market
Money Supply
• Nominal money supply: MS

• Real money supply: MS/P

i
MS/P

MS/P
28
The Money Market
Money Demand
• The demand for money reflects how much wealth people want to

hold in liquid form.

• Motives:

➢Transactions

➢Precautionary

➢Speculative
The Money Market
Money Demand
• Variables that affect the demand for money:

➢P

❑𝑃 ↑→?

❑𝑃 ↓→?

➢Y

❑𝑌 ↑→?

❑𝑌 ↓→?

➢i: the opportunity cost of holding money

❑𝑖 ↑→?

❑𝑖 ↓→?
The Money Market
Money Demand
• The money demand function:

𝐿 = 𝑘. 𝑌 − ℎ. 𝑖
(k, h > 0)
➢L: real money demand

➢k: the higher the level of income Y, the greater the demand for real
money balances.
➢h: the higher the nominal interest rate i, the lower the demand for real
money balances.
 The Money Market
Money Demand
• L = k.Y – h.i → i = (- 1/h) L + (k/h)Y

i
A
i1
B
i2

L
0 L1 L2 L
The Money Market
Money Demand

i
Y↑

L L’

L
33
Money Market
Money Market Equilibrium
i

MS/P
i1
i0 E
i2
L
0 L1 L2 L
MS/P

34
Money Market
Money Market Equilibrium

i
MS/P
E2
i2

i1 E1
Y↑

L (Y1) L (Y2)

0 MS/P Real balance

35
Money Market
Money Market Equilibrium
i
MS/P
MS/P↑

i1 E1

i2 E2
L
0 MS/P L

36
Money Market
Investment and Interest rate
• Investment and Interest rate
𝑖
𝐼 = 𝐼0 − 𝐼𝑚 .𝑖

➢𝐼0 : autonomous investment

𝑖
➢𝐼𝑚 : the lower interest rate reduces the cost of borrowing and the
return to saving → I ↑

➢E.g. 𝐼 = 1200 − 250𝑖

Monetary Policy
Expansionary Monetary Policy
• Increase money supply, reduce
interest rates
• Use when: recession
• Tools:
• Decrease reserve requirements
• Decrease the discount rate
• Buy government bonds from the public
𝑀𝑆
𝑀𝑆 ↑→ ↑→ 𝑖 ↓→ 𝐼 ↑→ 𝐴𝐸 ↑→ 𝑌 ↑
𝑃 𝑃
Contractionary Monetary Policy
• Decrease money supply, increase
interest rates
• Use when: high inflation
• Tools:
• Increase reserve requirements
• Increase the discount rate
• Sell government bonds to the public
𝑀𝑆
𝑀𝑆 ↓→ ↓→ 𝑖 ↑→ 𝐼 ↓→ 𝐴𝐸 ↓→ 𝑌 ↓
Monetary Policy
Disadvantages
• Time lags

• Money demand and interest rate

• The response of investment to changes in interest rate

• The Multiplier
Exercise 1
• Short answer: What happens to MS, if:

a. People prefer holding cash to deposits.

b. The central bank buys government bonds from commercial banks.

c. Commercial banks borrow from the central bank’s discount window.

d. The central bank decreases the required reserve-deposit ratio.

e. Commercial banks pay back loans to the central bank.

f. The central bank increases the required reserve-deposit ratio.

g. The central bank lowers the discount rate.

Exercise 2

• Suppose the banking system has a total reserve of $100 billion, the

required reserve-deposit ratio is 10%, banks do not hold excess

reserves, and the public does not hold cash.

a. Calculate the money multiplier and the money supply.

b. If the central bank increases the required reserve-deposit ratio

to 20%, how do reserve and money supply change?

Exercise 3

• The central bank decreases the required reserve-deposit ratio from

20% to 10%, the currency-deposit ratio is 10% and the monetary

base B = 20,000. How much does the money supply increase?
Exercise 4
• Consider a hypothetical economy in which the required reserve-deposit ratio is
10%, commercial banks’ reserves are in accordance with the central bank’s
regulations and there is no currency outside the banking system.
a. If the central bank sells $1 billion worth of government bonds, what
happens to the monetary base and the money supply?
b. Suppose the central bank decreases the required reserve-deposit ratio to
5%, commercial banks decide to hold excess reserves of 5%. How does
this affect the money multiplier and the money supply?
Exercise 5

• The central bank buys $10,000 billion worth of government bonds

from commercial banks.

a. How much does the money supply change if the reserve-

deposit ratio is 20% and the currency-deposit ratio is 19%?

b. If the reserve-deposit ratio is 15%, how much government

bonds does the central bank buy to get the above result?
 Exercise 6
• Consider an economy with 2,000 bills of 100,000 VND

a. If the public holds all as currency, how much is the money supply?
b. If the public holds all as demand deposits, with a 100-percent-reserve banking, how
much is the money supply?
c. If the public holds equal amounts of currency and demand deposits, with a 100-
percent-reserve banking, how much is the money supply?
d. If the public holds all as demand deposits, and the reserve-deposit ratio is 10%, how
much is the money supply?
e. If the public holds equal amounts of currency and demand deposits, and the reserve-
deposit ratio is 10%, how much is the money supply?
Exercise 7
• Consider the following T Account of the banking system (in billion VND)

Assets Liabilities
Reserves 500 Deposits 3,000
Bonds 2,500

• Suppose the currency-deposit ratio is 4.

a. Calculate the money multiplier

b. Calculate the monetary base
c. Calculate the money supply
Exercise 7
• Then, suppose the central bank buys 2,500 billion VND worth of
government bonds from commercial banks and commercial banks loan
out all the excess reserves.
d. Calculate the monetary base
e. Calculate the money supply
f. Currency, demand deposits?
g. Reserves?
h. How much do commercial banks loan out?
Exercise 8
• Explain how the following activities affect the money supply, the money
demand, and interest rates.
a. The central bank buys government bonds from the public.
b. The popularity of credit cards reduces the amount of currency the
public wants to hold.
c. The central bank decides to decrease the required reserve-deposit
ratio from 5% to 3%.
d. Households decide to hold more cash for spending on Tet’s holiday.
 Exercise 9
• Consider an economy with:

𝐶 = 400 + 0,75𝑌𝑑
𝐼 = 800 + 0,15𝑌 − 80𝑖
𝐺 = 900 𝑇 = 200 + 0,2𝑌
𝑋 = 400 𝑀 = 50 + 0,15𝑌

𝑀𝑆
𝑌𝑝 = 5500 = 400 𝐿 = 800 − 100𝑖
𝑃
a. Calculate the equilibrium output. How are the government budget and the balance of trade?
b. To achieve 𝑌𝑝 , how should OMO be used, if 𝑐𝑟 = 60%, rr = 20%
c. To achieve 𝑌𝑝 , how should the tax policy be implemented?