Monetary Policy Overview

Central Bank Overview

• Central bank oversees a nation's monetary system and policy
• Regulates money supply and sets interest rates
• Central banks enact monetary policy to balance the economy by easing or tightening the money supply and credit availability
• Sets banking industry requirements, such as the amount of cash reserves banks must hold.
• Acts as a lender of last resort to troubled financial institutions and governments

What is Monetary Policy?

• Refers to financial policies adopted by the monetary authority (like the Federal Reserve) to achieve the country's economic goals.
• Refers to actions taken by a central bank to manage the country's money supply and interest rates with the aim of promoting economic growth and stability.

Roles and Functions of a Central Bank

• Dictates monetary policy
• Controls inflation, unemployment, and economic growth
• Influences currency exchange rates
• Adjusts interest rates (e.g., discount rate)
• Adjusts reserve requirements
• Conducts open market operations (buying/selling government securities)
• Regulates the financial system
• Provides banking services
• Serves as a lender of last resort
• Monitors economic data

Monetary Policy Objectives & Instruments

• Main objectives: low and stable inflation, balanced and sustainable economic growth, manage inflation, unemployment, and maintain currency exchange rates.
• Tools: interest rate adjustments, change reserve requirements, open market operations

Monetary Policy Objectives & Instruments: Tools

• Interest Rate Adjustment: The central bank influences interest rates by changing the discount rate (base rate)—the interest rate the central bank charges banks for short-term loans.
  • Increasing the rate raises borrowing costs, decreasing money supply.
  • Decreasing the rate lowers borrowing costs, increasing money supply.

Monetary Policy Objectives & Instruments: Change Reserve Requirements

• Central banks set minimum reserve amounts held by commercial banks.
• Increasing the reserve requirement reduces the money supply by decreasing funds available for loans to clients.
• Interest is paid on reserves (IOR/IORR).

Monetary Policy Objectives & Instruments: Open Market Operations

• Central banks purchase or sell government securities to affect the money supply.
• Purchasing bonds increases the money supply by giving banks more funds to lend.

Capital Requirement and Capital Adequacy

• Standardized regulations for banks and other depository institutions
• Determine how much liquid capital banks must hold relative to their assets.
• Minimum capital requirements vary based on the number of branches.
• Capital Adequacy Ratio (CAR) measures a bank's ability to meet obligations if depositors or borrowers cannot repay. (Capital to Risk-weighted assets)
• Used to protect depositors and promote financial system stability and efficiency

Reserve Requirement & Discount Rate Policy

• Reserve requirements are the percentage of deposits a commercial bank must hold in cash to cover potential withdrawals..
• Example: A 5% reserve requirement on $200,000,000 in deposits = $10,000,000 reserved.
• Discount rate policy used to manage money circulation by adjusting interest rates (raising or lowering) to control the money supply.

Expansionary and Contractionary Monetary Policy

• Expansionary: Increases the money supply to stimulate spending during recessions.
  • Lower interest rates to increase lending and spending (loose monetary policy)
• Contractionary: Reduces the money supply to control inflation.
  • Higher interest rates to decrease lending and spending (tight monetary policy)

The Monetary Transmission Mechanism

• Process by which monetary policy decisions affect the overall economy, particularly inflation.
• Two stages: interest rate adjustments then economic impact.
• Complex with uncertainty in timing and the magnitude of effects.

The Monetary Transmission Mechanism (Stages)

• Stage 1: Changes to monetary policy affect interest rates in the economy.
• Stage 2: Changes in interest rates affect economic activity and inflation. This involves various channels, such as savings and investment, cash flow, and asset prices.

Aggregate Demand

• Aggregate demand is the total spending on domestic goods and services in an economy.
• Aggregate supply is the total quantity of output an economy produces.
• Lower interest rates, may lead to higher inflation.
• Lag exists, as adjustments to monetary policy take time for households and businesses to alter their behaviors.

Inflation Expectations

• Inflation expectations are a key factor in how monetary policy works.
• If people expect inflation to rise, they will ask for higher wages, leading to a self-fulfilling prophecy.

Channels of Monetary Policy Transmission

• Several mechanisms through which a central bank's monetary policy affects different sectors in the economy: •Saving and Investment Channel: lower interest rates reduce the incentive to save and encourage spending/borrowing. •Cash-Flow Channel: lower interest rates increase available cash for spending •Asset Channel: Lower interest rates boost asset prices (e.g., housing, equities), encouraging spending and investment. •Exchange Rate Channel: interest rate differences impact the exchange rate, which affects international trade and inflation.

Discussion Questions

• Question 1: Monetary policy uses different channels to operate, making it both an advantage (more tools to address various sectors) and a disadvantage (creates more complexity in predicting and managing full economic impact).
• Question 2: Expansionary policy would require a decrease in the reserve requirements, giving more funds for banks to lend and potentially increase the money supply. Contractionary policy increases reserve requirements which reduces the amount of resources available for lending, reducing the money supply.