ECO 120 Lecture Note: Tools and Conduct of Monetary Policy Lecturer: Serpil Kahraman

Money Money plays an important role in “interest rate” and “inflation”. Government budget deficits also can be an influential factor of monetary policy. Budget deficit is the excess of government expenditures over tax revenues for a particular time period. Monetary policy is the management of money and interest rates. Central bank is a responsible for the conduct of monetary policy. Monetary theory relates changes in the quantity of Money to changes in aggregate economy and the price level.

Central Bank’s Monetary Aggregates As you know central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money. A central bank is not a citizens bank that is not provides general banking services. Central Bank affects the interest rate through monetary policy. Interest is the fee borrowers pay to lenders for the use of their funds. Firms and the government borrow funds by issuing bonds, and they pay interest to the firms and households (the lenders) that purchase those bonds. Households and firms that have borrowed from a bank that must pay interest on those loans to the bank. The interest rate is expressed as an annual rate.

Measuring money The narrowest definition of money that the Central Banks report is M1 that corresponds to the definition proposed by the theoretical approach and includes currency, and checking accounts deposits that are extremely liquid because they can be turned into cash quickly. Another problem in the measurement of money is that the data are not always as accurate as we would like.

TOOLS OF MONETARY POLICY Central Banks use of these policy tools has such an important impact on economic activity. Three policy tools that the Central Bank use to manipulate the money supply and interest rates: open market operations which affect the monetary base changes in the discount rate which affect interest rates and the monetary base by influencing the quantity of discount loans and, changes in reserve requirements which affect the money multiplier.

TOOLS OF MONETARY POLICY 1) Open Market Operations: The most important monetary policy tool because they are the primary determinants of changes in interest rates and the monetary base, the main source of fluctuations in the money supply. Open market purchases expand the monetary base, thereby raising the money supply and lowering short-term interest rates and open market shares sharing the monetary base, lowering the money supply and raising short-term interest rates.

Open market operations have several advantages over the other tools of monetary policy: Open market operations occur at the initiative of the Central Bank, which has complete control over their volume. Open market operations are flexible and precise, they can be used to any extend. Open market operations are easily reversed. If a mistake is made in conducting an open market operation, the Fed can immediately reverse it. Open market operations can be implemented quickly; they involve no administrative delays.

TOOLS OF MONETARY POLICY 2) Discount Policy: Discount policy, which primarily involves changes in the discount rate, affects the money supply by affecting the volume of discount loans and the monetary base. A rise in discount loans adds to the monetary base and expands the money supply; a fall in discount loans reduces the monetary base and shrinks the money supply. The Fed facility at which discount loans are made to banks is called the discount window. The Fed can affect the volume of discount loans in two ways: by affecting the discount rate or by affecting the quantity of the loans through its administration of the discount window. The mechanism through which the Fed’s discount rate affects the volume of discount loans is straightforward: A higher discount rate raises the cost of borrowing from the Fed, so banks will take out fewer discount loans; a lower discount rate makes discount loans more attractive to banks, and loan volume will increase.

Discount policy Besides its effect on the monetary base and the money supply, discounting allows the Fed to perform its role as the lender of last resort. The most important advantage of discount policy is that the Fed can use it to perform its role of lender of last resort. However, discount policy does make control of the money supply more difficult because it results in unintended fluctuations in the volume of discount loans and hence in the money supply. So discount policy is less effective than open market operations

Lender of Last Resort In addition to its use as a tool to influence the monetary base and the money supply, discounting is important preventing financial panics. Its most important role was intended to be as the lender of last resort; it was to provide reserve to banks when no one else would in order to prevent bank failures from spinning out of control, thereby preventing bank and financial panics.

TOOLS OF MONETARY POLICY 3) Reserve Requirements: Changes in reserve requirements affect the money supply by causing the money supply multiplier to change. A rise in reserve requirements reduces the amount of deposits that can be supported by a given level of the monetary base and will lead to a contraction of the money supply. Conversely, a decline in reserve requirements leads to an expansion of the money supply because more multiple deposit creation can take place.

Money (deposit) multiplier = 1/ reserve ratio Monetary base = currency in circulations + reserves

TOOLS OF MONETARY POLICY The main advantage of using reserve requirements to control the money supply is that they affect all banks equally and have a powerful tool. Small changes in the money supply could be obtained by extremely small changes in reserve requirements. Disadvantage of using reserve requirements to control the money supply is that raising the requirements can cause immediate liquidity problems for banks with low excess reserves. However it is so expensive to administer changes in reserve requirements, such a strategy is not practical, and hence it is rarely used.

CONDUCT OF MONETARY POLICY: GOALS AND TARGETS Understanding the conduct of monetary policy is important because not only affects the money supply and interest rates but also has a major influence on the level of economic activity and hence on our well-being. GOALS OF MONETARY POLICY Six basic goals are continually mentioned by central banks when they discuss the objectives of monetary policy: high employment, economic growth, price stability, interest rate stability, stability of financial markets, and stability in foreign exchange markets.

The goal of price stability often conflicts with the goals of interest rate stability and high employment in the short run. When the economy is expanding and unemployment is failing, both inflation and interest rates may start to rise. If the central bank tries to prevent a rise in interest rates, this may cause the economy to overheat and stimulate inflation. But if a central bank raises interest rates to prevent inflation, in the short run unemployment may raise.

CENTRAL BANK STRATEGY: USE OF TARGETS The Central Bank’s problem is that it wishes to achieve certain goals, such as price stability with high employment, but it does not influence the goals. It has a set of tools to employ (open market operations, changes in the discount rate and changes in the reserve requirements) that can affect the goals indirectly after a period of time (typically more than a year). If the central bank waits to see what the price level and employment will be one year later, it will be too late to make any corrections to its policy- mistakes will be irreversible. All central banks consequently pursue a different strategy for conducting monetary policy by aiming at variables that lie between its tools and the achievement its goals.