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Chapter 15Chapter 15

The Monetary The Monetary PolicyPolicy

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What is monetary policy?What is monetary policy?

Conducted by the federal reserve or the Conducted by the federal reserve or the central bankcentral bank

Goal: price stability, full employment, Goal: price stability, full employment, economic growth, stable exchange rate…economic growth, stable exchange rate…

Functions of the CB:Functions of the CB: Supervise commercial banks, conduct of Supervise commercial banks, conduct of

monetary policy, bank of the state, monetary policy, bank of the state, controlling money supply, lender of last controlling money supply, lender of last resort… resort…

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Tools of monetary policyTools of monetary policy

1. 1. Open market operationsOpen market operations::The process of buying and selling The process of buying and selling

government bonds. government bonds. A- Open market purchase: buying A- Open market purchase: buying

government bonds, used to face government bonds, used to face inflationary gap (AD>AS)inflationary gap (AD>AS)

- Money supply falls, purchasing power - Money supply falls, purchasing power declines, (AD )declines, (AD )

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B- Open market sale: selling B- Open market sale: selling government bonds, used to face government bonds, used to face contractionary gap (AD<AS)contractionary gap (AD<AS)

- Money supply increases, purchasing - Money supply increases, purchasing power increases, (AD )power increases, (AD )

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2. 2. the reserve ratiothe reserve ratio::

Used to influence the ability of Used to influence the ability of commercial banks to lend.commercial banks to lend.

Remember: more loans means more Remember: more loans means more moneymoney

Thus, changing reserve ratio affect Thus, changing reserve ratio affect reserve requirement of the reserve requirement of the commercial bankcommercial bank

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a. a. Contractionary monetary policyContractionary monetary policy: : Raising reserve ratio: reduces Raising reserve ratio: reduces ability of banks to lend money, ability of banks to lend money, reduces Ms, reduces ADreduces Ms, reduces AD

b. b. Expansionary monetary policyExpansionary monetary policy: : reducing reserve ratio: increases reducing reserve ratio: increases the ability of banks to lend money, the ability of banks to lend money, increases Ms, increases ADincreases Ms, increases AD

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3. The Discount Rate3. The Discount Rate

The central bank is the “lender of last The central bank is the “lender of last resort”. resort”.

Commercial banks have immediate Commercial banks have immediate and unexpected needs for additional and unexpected needs for additional cashcash

The CB provides short-term loans to The CB provides short-term loans to commercial bankscommercial banks

The interest rate charged is called the The interest rate charged is called the discount rate. discount rate.

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Expansionary monetary Expansionary monetary policypolicy

When the CB reduces the discount When the CB reduces the discount rate, commercial banks are rate, commercial banks are encouraged to borrow moreencouraged to borrow more

This increases the ability of banks to This increases the ability of banks to lendlend

Increase MsIncrease Ms Increase ADIncrease AD

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Contractionary monetary Contractionary monetary policypolicy

When the CB increases the discount When the CB increases the discount rate, commercial banks are rate, commercial banks are discouraged to borrow morediscouraged to borrow more

This reduces the ability of banks to This reduces the ability of banks to lendlend

reduces Msreduces Ms reduces ADreduces AD

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Tools of Monetary Policy Tools of Monetary Policy

1- Open market purchase: sell and 1- Open market purchase: sell and buy government bondsbuy government bonds

2- Reserve requirement: increase or 2- Reserve requirement: increase or decrease required reserve ratiodecrease required reserve ratio

3- The discount rate: increase or 3- The discount rate: increase or decrease discount ratedecrease discount rate

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Expansionary monetary Expansionary monetary policypolicy

Open Market Sale. Open Market Sale.

Decreases reserve ratioDecreases reserve ratio

Decreases discount rate Decreases discount rate

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Contractionary monetary Contractionary monetary policypolicy

Open Market purchase. Open Market purchase.

increases reserve ratioincreases reserve ratio

increases discount rateincreases discount rate

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THANK YOU, AND GOOD LUCK!THANK YOU, AND GOOD LUCK!