Lecture 9

Monetary policy

Reading:
Sloman and
Garratt,
chapter 13
ECN1014 Prepared by:
Dr. Bawani Lelchumanan &
INTRODUCTORY Dr. Chong Poh Ling (DEF,
SBS)
ECONOMICS
INSTRUME Reading:
NTS OF Sloman and
Garratt,
MONETAR Chapter 13

Y POLICY
The central bank can manipulate the amount of liquid
assets of the banking system, thereby influencing the
amount of credits banks can create and eventually,
total money supply.
This can be done by using the following instruments:
 Open market operations (OMO)
 Changing the minimum reserve ratio
 Changing the discount rate
A change in money supply will eventually influence the
rate of interest and national income or output.
OPEN MARKET OPERATIONS

Open-market operations involve the sale or purchase

of government securities by the central bank.
By doing so, the central bank can influence whether
individuals wish to hold idle deposits in current
accounts (in banks) or government securities.
By changing the level of deposits or reserves in the
banking system, the lending capacity of commercial
banks changes as well, thus affecting the level of
money supply.
By selling government securities to the commercial
banks or the public, the central bank decreases money
supply.
 People withdraw from their accounts in commercial
banks as they purchase government securities, thus
reducing the level of deposits in the banking system.
 With a reduced level of deposits, commercial banks’
reserves with the central bank would fall as well, thus
reducing the banks’ lending capacity.
 As less loans are created, money supply is reduced
accordingly.
By buying government securities from the commercial
banks or the public, the central bank increases money
supply.
 Money is credited to people’s accounts in commercial
banks, thus raising the level of deposits in the
banking system.
 With a higher level of deposits, commercial banks’
reserves with the central bank would rises as well,
thus raising the banks’ lending capacity.
 As more loans are created, money supply is raised
accordingly.
CHANGING THE
MINIMUM RESERVE
RATIO
The statutory minimum reserve ratio specifies the
minimum amount of reserves that banks must
hold against deposits that must not be loaned out.
By changing the reserve requirement, the central
bank can alter the lending capacity of the
banking system.
By raising the minimum reserve requirement, money
supply decreases.
 More reserves must be held with the central bank,
thus reducing the lending capacity of commercial
banks.
 As less loans are created, money supply is reduced
accordingly.
By reducing the minimum reserve requirement, money
supply increases.
 Less reserves are held with the central bank, thus
raising the lending capacity of commercial banks.
 As more loans are created, money supply is raised
accordingly.
CHANGING THE
DISCOUNT RATE
Commercial banks may sometimes have too few
reserves (either because of making too many loans or
facing too many withdrawals) to meet the minimum
reserve requirements imposed by the central bank.
They can boost their reserves by obtaining straight
loans from the central bank.
In turn, the central bank charges the commercial banks
an interest (i.e. discount rate) for using this facility.
By raising or keeping the discount rate above the
market interest rate, the central bank decreases
money supply.

 A higher discount rate reduces the incentives

for commercial banks to borrow from the central
bank.
 Reserves in the banking system would be
reduced or remain low, thus reducing
commercial banks’ lending capacity.
 As less loans are created, money supply is
reduced accordingly.
By reducing or keeping the discount rate below the
market interest rate, the central bank increases
money supply.

 A lower discount rate raises the incentives for

commercial banks to borrow from the central
bank.
 Reserves in the banking system would be raised,
thus expanding commercial banks’ lending
capacity.
 As more loans are created, money supply is
raised accordingly.
 MONETARY
POLICY:
INTEREST- Reading:

RATE Sloman and

Garratt,
TRANSMISSIO Chapter 13

N
MECHANISM
MONETARY POLICY AND
ECONOMIC STABILISATION
The Keynesian school believes that monetary policy can,
and should be, conducted such that macroeconomic
stabilisation can be achieved.
Monetary policy can potentially alter macroeconomic
outcomes by managing the level of money supply.
A change in the money supply will lead to…
 …a change in the monetary equilibrium and hence the
rate of interest, which in turn will lead to…
 …a change in investment expenditure and…
 …a change in the macroeconomic equilibrium.
 Monetary Equilibrium, Investment Expenditure and
Macroeconomic Equilibrium

Monetary +Macroeconomic
Equilibrium Investment Equilibrium

Price Level
Interest Rate

Interest Rate
MS1
AS

r1 r1
P1
LP I
AD1
O Q1 Quantity O I1 Investment O Y1 National
of Money Output
EXPANSIONARY
MONETARY POLICY
Suppose the economy is in recession, producing less
than its full-employment potential.
The central bank can use monetary policy to restore
aggregate demand by expanding money supply
through:
 Purchasing government securities
 Reducing the reserve requirement
 Reducing the discount rate
Impact of monetary expansion on the monetary
equilibrium
 A monetary expansion would increase banks’
lending capacity.
 An increase in money supply would reduce the rate
of interest.

Impact of monetary expansion on investment

expenditures
 A lower rate of interest discourages saving and
reduces the cost of borrowing, thus raising
investment expenditures (and other consumption
expenditures on credit).
Impact of monetary expansion on the macroeconomic
equilibrium

 As people increase investment and consumption,

aggregate demand increases.
 Aggregate price level increases.
 National output increases in tandem with a fall in
unemployment.
 Impact of Expansionary Monetary Policy

Monetary Investment Macroeconomic

Equilibrium Equilibrium

Price Level
Interest Rate

Interest Rate
MS1 MS2
AS

r1 r1 P2
P1 AD2
r2 LP r2 I
AD1
O Q1 Q2 Quantity O I1 I2 Investment O Y1 Y2 National
of Money Output

MS ® r I AD ® P ® Y
RESTRICTIVE
MONETARY POLICY
Suppose the economy is overheating, where excessive
aggregate demand may put too much pressure on
productive capacity.
The central bank can use monetary policy to restrain
aggregate demand by reducing money supply through:
 Selling government securities
 Raising the minimum reserve requirement
 Raising the discount rate
Impact of monetary restraint on the monetary equilibrium
 A monetary restraint would reduce banks’ lending
capacity.
 A decrease in money supply would raise the rate of
interest.

Impact of monetary restraint on investment expenditures

 A higher rate of interest encourages saving and raises
the cost of borrowing, thus reducing investment
expenditures (and other consumption expenditures on
credit).
Impact of monetary restraint on the macroeconomic
equilibrium
 As people reduce investment and consumption,
aggregate demand decreases.
 Aggregate price level decreases.
 National output decreases in tandem with a rise in
unemployment.
 Impact of Restrictive Monetary Policy

Monetary Investment Macroeconomic

Equilibrium Equilibrium

Price Level
Interest Rate

Interest Rate
MS2 MS1
AS

r2 r2 P1
P2 AD1
r1 LP r1 I
AD2
O Q2 Q1 Quantity O I2 I1 Investment O Y2 Y1 National
of Money Output

MS ® r I AD ® P ® Y
 MONETARY
POLICY IN
TOUGH TIME: Reading:

QUANTITATIV Sloman and

Garratt,
E EASING Chapter 13

AND
DEFLATION
 EXPANSIONARY MONETARY
POLICY: WHY INEFFECTIVE?
Liquidity trap: as liquidity preference approaches perfect
elasticity, further increases in money supply cannot drive the
rate of interest any lower, thus failing to encourage borrowing
and spending.
 The public is unwilling to borrow (due to excessive
pessimism, high level of indebtedness, and uncertainties)
 The bank is unwilling to lend (due to the fear of default)
 Deflationary expectation (people prefer to postpone
spending if they expect prices to fall further in the future)
Unstable political or macroeconomic factors which are
beyond the central bank’s control.
HOW QUANTITATIVE
EASING WORKS
QE is a very aggressive form of open market operations,
where central banks inject a huge amount of money
supply by buying up a range of financial assets from the
banking sector.
This will increase the cash reserves (i.e. liquid assets)
of commercial banks, thus encouraging them to extend
more credit for investment and consumption.
Through more lending and borrowing, it is hoped that
eventually economic recovery will take off.
THE OBJECTIVE OF
QUANTITATIVE EASING
During the financial crisis in late-2000s, central
banks in some developed countries were cutting
interest rates aggressively to ward off a deep
economic slump.
However, economic recovery failed to take off
although interest rates had been cut to sub-zero.
Unconventional Quantitative Easing (QE) had to be
experimented when traditional loose monetary policy
failed to stimulate recovery.
Central banks experimenting QE:
 Federal Reserve
 Bank of England
 European Central Bank
 Bank of Japan
 Differences between open market operations and QE
can be summarised as follows:

Open Market Operations Quantitative Easing

• The purchase of financial assets
is restricted to short-term
government securities.
• The focus is on lowering short-
term interest rates.
• The purchase of financial assets
includes long-term government
securities and mortgage-
backed securities.
• The focus is on lowering long-
term interest rates as well.

*A mortgage-backed security (MBS) is a type of instrument which is secured

by a mortgage. The mortgages are aggregated and sold to a group of individuals
(a government agency or investment bank) that securitizes, or packages, the
loans together into a security that investors can buy.
HAS QUANTITATIVE
EASING WORKED?
QE would be ineffective if there is liquidity trap.
A liquidity trap is an adverse economic situation that can
occur when consumers and investors hoard cash rather
than spending or investing it even when interest rates are
low, stymying efforts by economic policymakers to
stimulate economic growth.