CHAPTER 29

Monetary
Policy
The
Economic Problem

©1999 Addison Wesley Longman Slide 29.1

 Control of the Money Supply

• There are four ways in which the central

bank affect the money supply . These are
• 1. Open market operations .
• 2. Reserve requirements.
• 3. Discount rate .
• 4. Selective credit control .

©1999 Addison Wesley Longman Slide 29.2

 1. Open Market Operations
• The Process of buying and selling government
bonds in the financial market is called “Open
market operations“. This process can be
divided into to cases:
• A. Open Market Purchase.
• B. Open Market Sale.

©1999 Addison Wesley Longman Slide 29.3

 Open Market Purchase
1. The central bank buys government bonds from firms
or households.
2. The central bank pays for these bonds with check
drawn on itself and payable to the seller.
3. The seller deposits the check in a commercial bank.
4. The commercial bank present the check to the central
bank for payment.
5. The central bank make a book entry increasing the
deposit of the commercial bank at the central bank and
thus, adds to the commercial bank’s reserves.

©1999 Addison Wesley Longman Slide 29.4

The effect of purchasing bonds by the central bank

• 1. Creates excess reserves to commercial

banks .
• 2. This enables commercial banks to create
more loans .
• 3. The increase in loans will create more
deposits by the banking system , and that will
increase the money supply.

©1999 Addison Wesley Longman Slide 29.5

 Open Market Sale

• The central bank sells government bonds and

receive a check drawn on commercial banks.
The value of the check will be deducted from
the deposit of the commercial bank.
• This decreases the reserves available to
commercial banks which will decrease the
loans made by commercial banks.
• This decreases the deposit created by banks
which in turn decreases the money supply .

©1999 Addison Wesley Longman Slide 29.6

 2. Reserve Requirements

• An increase in the required reserve ratio

forces the banks with no excess reserves to
decrease its loans, which in turn, decreases
the deposits and that will decrease the
money supply.

©1999 Addison Wesley Longman Slide 29.7

 3. Discount Rate
• It is the interest rate at which the central bank
will lend funds to commercial banks whose
reserves are temporarily below the required
level.
• These loans help banks to meet their reserve
requirements when open market sales by the
central bank cause a sudden fall of commercial
banks reserves.

©1999 Addison Wesley Longman Slide 29.8

• A fall in the discount rate encourages more borrowing
by commercial banks and that increases the reserves of
the banks , which in turn, increases loans and deposits
in the banking system. This will lead to an increase the
money supply.
• When the discount rate increases, commercial banks
are likely to increase their reserves so as to avoid the
costs associated with an unexpected cash drain.
• Changes in the discount rate provide a signal of the
central bank intention.

©1999 Addison Wesley Longman Slide 29.9

 4. Selective Credit Control
• Examples: margin requirements, mortgage
controls, and maximum interest rates.
• Margin Requirement:
• It is the fraction of the price of stock that must be
put in cash by the purchaser and the balance can
be borrowed from the brokerage firm.
• If the central bank would like to increase the
money supply, it will reduce the margin
requirement and the opposite is also true.

©1999 Addison Wesley Longman Slide 29.10

 Policy Variables and Policy Instruments

• The central bank conduct the monetary

policy to influence the real GDP and the
price level (the central bank’s twin policy
variables).
• These ultimate objectives of the central bank
(Y, P) are called “Policy Variables“.

©1999 Addison Wesley Longman Slide 29.11

 Policy Instruments
• To achieve its objective, the central bank
uses certain variables or tools. These
variables are called Policy Instruments.
• Open-market operations are the primary
policy instrument used by central banks to
change the reserves in the banking system.
• Variables that are neither policy variables
nor policy instruments, but play a key role
in the execution of monetary policy are
called Intermediate Targets.

©1999 Addison Wesley Longman Slide 29.12

 Policy Variables
• Short Run: Nominal National Income:
The short-run effects of a shift in the AD curve
are divided between the price level and real
output in a manner determined by the slope of the
SRAS curve. And thus, monetary policy is not
capable of pushing the price level (P) and real
GDP (Y) toward independently determined
targets simultaneously.
• For this reason, central banks often focus on
nominal national income (PY) as a target in the
short run.
©1999 Addison Wesley Longman Slide 29.13
• Long Run: The Price Level:
Since money is neutral in the long run, this led
many central banks to focus on the price level
(the inflation rate) as the long run target for
monetary policy.

©1999 Addison Wesley Longman Slide 29.14

 Intermediate Targets
• There are two Intermediate targets available for the
central bank:
1. Money supply 2. Interest rate
• For a given liquidity preference function, the
central bank can not control both of these targets
independently. Therefore, the central bank needs
to choose to control either the money supply or
the interest rate.
• It doesn’t matter whether the central bank
chooses to target the interest rate or the money
supply.
©1999 Addison Wesley Longman Slide 29.15
• Example: if the central bank wishes to remove
an inflationary gap, it doesn’t matter whether
to force the interest rates up or to contract the
money supply, because doing one accomplishes
the other:
• “the central bank sells government securities
and thus drives their prices down, which will
lead to an increase in the interest rate. This
open-market sale will contract the money
supply”.
©1999 Addison Wesley Longman Slide 29.16
• On the other hand, driving the interest rate
down by an open market purchase of
government securities will tend to expand the
money supply.
• In the 1970’s, many central banks began to
focus on the money supply as their intermediate
target.

©1999 Addison Wesley Longman Slide 29.17

 Figure 29-2
Alternative Intermediate Targets

©1999 Addison Wesley Longman Slide 29.18

 Controlling Money Supply

• If the central bank chooses

money supply as the
intermediate target, then it
must accept the fluctuation in
the interest rate.

©1999 Addison Wesley Longman Slide 29.19

 Controlling the interest rate

• If the central bank would like to

control interest rate, then it
must accept the fluctuation in
the money supply.

©1999 Addison Wesley Longman Slide 29.20

 Intermediate Targets When the Demand for
Money Shifts
• Suppose that there is a downward shift in the LP
function and also a fall in the money supply. If
the central bank focuses only on the money
supply (and didn’t recognize the reduction in
money demand), it will conclude that the
monetary policy had tightened.
• But if it focused on the fall in the interest rate
(and ignored the reduction in money supply), it
would conclude that monetary policy had
loosened.
©1999 Addison Wesley Longman Slide 29.21
• But what really happened in figure 29-3 is that the
combination of demand and supply of money shifts
led to a reduction in the interest rate. This is because
the money supply fell by less that the money
demand.
• The smaller reduction in the money supply in this
case would be viewed as an expansionary monetary
policy.

©1999 Addison Wesley Longman Slide 29.22

 Figure 29-3
Intermediate Targets When the Demand for Money Shifts

©1999 Addison Wesley Longman Slide 29.23