Chapter 10: Monetary Policy

Bank Negara Malaysia

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Learning Outcomes
On completion of the chapter, the student will be
able to:
Define monetary policy
Explain the tools of monetary policy used and
how they affect the money supply
Distinguish between easy money policy
(expansionary monetary policy) and tight money
policy (contractionary monetary policy)

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What is Monetary
Policy?
A central bank’s deliberate
changing of the money supply
(by manipulating size of excess reserves
held by banks) to influence interest
rates and thus the total level of
spending in the economy.
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 GOALS OF MONETARY POLICY

…to assist the economy in

achieving a full-employment,
non-inflationary (price
stability) level of total output

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Tools of Monetary Policy
Three tools of monetary policy used
by the BNM to alter the reserves of
commercial banks include:
1.       Open-market operations
2.       The reserve ratio
3.       The discount rate

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 A Quick Recap…
Monetary tools (OMO, the reserve ratio
and the discount rate) ∆ER∆CD
∆MS ∆interest rate  ∆ AD (i.e.,
C and Ig) ∆P and ∆Real GDP

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 1. Open-Market Operations (OMOs) by BNM

Bond markets are ‘open’ to all buyers & sellers of corporate &
govt. bonds (securities).

Bond

a certificate that you can buy from a government or company that

promises to pay you interest on the money you have given and the
principal at maturity.

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 1. Open-Market Operations (OMOs) by BNM

 OMOs are the BNM’s most important instrument for

influencing the money supply.

 Buying securities (open market purchase): The BNM can

purchase govt. bonds either from commercial banks or
from the public. In both cases the reserves of the
commercial banks ↑ ↑banks’ lending ability MS ↑

 Selling securities (Open-market sale): When the BNM sells

govt. bonds, commercial banks’ reserves are reduced.

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 1. Open-Market Operations (OMOs)
 Example:
- Assume reserve ratio = 20%.
- The BNM’s purchase of a RM1000 bond from
the public creates a RM1000 new Checkable
deposit  RM800 (excess deposits) & RM200
(required reserves to back up the RM1000
new CD)
- The banks expand the MS by RM4000
(RM800 x 1/0.2) through making loans.
- Total increase in MS = RM5000.
In short, when BNM buys bonds bank reserves↑ &
the MS ↑ by a multiple of these reserves via monetary
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multiplier.
 BANK NEGARA MALAYSIA
PURCHASE OF BONDS
New reserves RM200
Purchase of a RM800 Required
RM1000 bond Excess
Reserves reserves
from the public...

RM1000
RM4000 Initial
Bank System Lending Deposit

Total Increase in Money Supply (RM5000)

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 Open Market Operations
Monetary Base = the currency in the hands of the public +
reserves in the banking system

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 2. The Reserve Ratio
 The BNM can manipulate   the reserve ratio in
order to influence the ability of commercial banks
to lend.
 Raising the reserve ratio: If the BNM raised the
reserve ratio, it would increase the amount of
required reserves banks must keep.
As a consequence:
- banks would lose excess reserves,
diminishing their ability to create money by
lending, or
- banks may find their reserves deficient and
are forced to contract checkable deposits
and therefore the money supply. 12
 2. The Reserve Ratio
r ER  loans   new CD created through lending

 Raising the reserve ratio forces banks to reduce
the amount of checkable deposits (CD) they can
create through lending.

 Lowering the reserve ratio: If the BNM lowered

the reserve ratio, required reserves would decline
and excess reserves would increase. As a result,
the banks’ lending (money-creating) ability would
increase. In other words the reserve ratio
transforms required reserves into excess reserves
and enhances the ability of banks to create new
money by lending.
r  ER loans   new CD created through lending
 13
 3. The Discount Rate
Collateral = property or something valuable that you promise to
give to someone if you cannot pay back money that you borrow.
 Occasionally, commercial banks have
unexpected and immediate needs for
additional funds. In such cases, BNM will make
short-term loans to commercial banks.
 When a commercial bank borrows, it gives the
BNM a promissory note (IOU) drawn against
itself and secured by acceptable collateral –
typically govt. securities.
 The interest rate that the BNM charge on
discount loan is called the discount rate.
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 3. The Discount Rate
 In providing discount loan, the BNM increase the reserves
of the borrowing commercial bank. Since no required
reserves need to be kept against loans from the BNM, all
new reserves acquired by borrowing from the BNM are
excess reserves (ER). Discount loan = ER
 In short, borrowing from the BNM by commercial banks
increases the reserves of the commercial banks and
enhances their ability to extend credit.
 A lowering of the discount rate encourages commercial
banks to obtain additional reserves by borrowing from the
BNM. When the commercial banks lend new reserves, the
money supply increases.
 An increase in the discount rate discourages commercial
banks from obtaining additional reserves through
borrowing from the BNM. So the BNM may raise the
discount rate whenever it wants to restrict the money
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supply.
 Easy Money and Tight
Money
Easy Money Policy (Expansionary
Monetary Policy)
 Suppose the economy faces recession and
unemployment. The BNM decides that an increase
in supply of money is needed to increase aggregate
demand so as to employ idle resources. To increase
the supply of money, the BNM must increase the
excess reserves of commercial banks through:
1. Buy securities
2. Lower the reserve ratio
3. Lower the discount rate
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 Easy Money Policy (Expansionary
Monetary Policy)

 These actions are called an easy money policy.

 Purpose of easy money policy is:
to make bank loans less expensive
and more available and thereby
increase aggregate demand,
output and employment.

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Tight Money Policy
(Contractionary/ Restrictive monetary
policy)
 Suppose the economy faces inflation problem. Then
the BNM should try to reduce aggregate demand by
limiting the supply of money. That means reducing
the reserves of commercial banks through:
1. Sell securities
2. Increase the reserve ratio
3. Raise the discount rate
 These actions are called a tight money policy.
 The objective is to tighten the supply of money in
order to reduce spending and control inflation.

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Which Tool Does the BNM Prefer to Use?
 The BNM can use open market operations, the
required-reserve ratio, or the discount rate to
influence the money supply.
 The BNM prefers to use Open Market Operations.
– Open market operations are flexible
– Open market operations can be reversed
– Open market operations can be implemented
quickly
 Reserve Ratio  rarely  as this could destabilize
bank’s lending & profit positions.
 Discount Rate  little direct effect since there is a
very small portion of bank reserves that are
borrowed from BNM 19
BNM Monetary Tools & their
Effects on the Money Supply

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