Chapter 24 Monetary Policy PDF

CHAPTER 24: MONETARY POLICY KOONG SEOW SHIN Principles of Economics | 1  Learning Outcomes 24.1 To describe how does money evolve 24.2 To explain the process of money creation and the money multiplier 24.3 To identify the monetary poli...

CHAPTER 24: MONETARY POLICY KOONG SEOW SHIN Principles of Economics | 1  Learning Outcomes 24.1 To describe how does money evolve 24.2 To explain the process of money creation and the money multiplier 24.3 To identify the monetary policy objectives and its framework 24.4 To discuss the tools that central bank use to control money supply Principles of Economics | 2  What is Money? Barter system is a system where people trade by exchanging goods and services for other goods and services directly. The need of double coincidence of wants is difficult to maintain. Two reasons: 1) goods and services are difficult to divide, for instance the value of half a head of cow is equivalent to the value of one head of goat, and 2) some goods are perishable (e.g. fruits, breads and vegetables) which the value of goods cannot be transported from one time period to another. Principles of Economics | 3  What is Money? Because of the difficulties in maintaining the double coincidence of wants, people started to use commodity money to ease the transactions. Commodity money evolved into fiat money with its greater flexibility in storing and transporting money values from one time to another time. Principles of Economics | 4  Commodity Money vs. Fiat Money Commodity money is money designated with intrinsic value, which means the money itself has values, other than its face values. For instance, gold, silver and bronze. Fiat money is money designated with no intrinsic value, which means the money itself has no values, other than its face values. For instance, bank notes. Principles of Economics | 5  Characteristics of Money Money as a medium of exchange. unit of account. store of value. Principles of Economics | 6  The Money Creation Process Given an initial amount of deposit and a ratio for required reserve, banks can create a total of money supply. It is also known as money creation with fractional-reserve banking. Three important terms: 1. Deposit 2. Required reserve 3. Excess reserve Assumption: The banking system is closed. Principles of Economics | 7  Example of Money Creation Suppose the required reserve set by the Central Bank is 10%, initial deposit in Bank A is RM1000. The money creation process can be explained using the T-account in banks. Bank A’s T-account Assets Liabilities Required reserve RM 100 Deposits RM 1000 Excess reserve/ Loan RM 900 Total RM 1000 Total RM 1000 Principles of Economics | 8  Example of Money Creation (Cont) Bank B’s T-account Assets Liabilities Required reserve RM 90 Deposits RM 900 Excess reserve/ Loan RM 810 Total RM 900 Total RM 900 Principles of Economics | 9  Example of Money Creation (Cont) Bank C’s T-account Assets Liabilities Required reserve RM 81 Deposits RM 810 Excess reserve/ Loan RM 729 Total RM 1000 Total RM 810 Principles of Economics | 10  Example of Money Creation (Cont) The process continues until the column for “excess reserve/ loan” reaches zero. The exact amount of money created by the banks in this case is RM 10000. However, it would be very time consuming to prepare the T-accounts to calculate the total money created by the banks. To get the amount of money created, it is much simpler to use money multiplier. Principles of Economics | 11  Money Multiplier Money multiplier is defined as the multiple by which the money supply changes as a result of a change in the monetary base. Money multiplier equals to one divided by the required reserve ratio (rrr). Total money created = money multiplier  (initial deposit – required reserve) Principles of Economics | 12  Monetary Policy Objective The objectives of implementing monetary policy are: 1. To maintain price stability, 2. To provide continuous supports for growth, 3. To promote monetary stability, and 4. Ensuring sufficient credit is available to finance promising investments and ultimately boost economic growth. Principles of Economics | 13  Monetary Policy Objective Central bank uses monetary policy to solve the problems of inflation and unemployment. If the economy is in recession that is high unemployment and low inflation, central bank would implement expansionary monetary policy to increase the money supply in the market. If the economy is overheated that is low unemployment and high inflation, central bank would implement contractionary monetary policy to reduce the money supply in the market. Principles of Economics | 14  Inflation Targeting Inflation targeting means when a monetary authority intends to keep the inflation rate within some specified band over some specified horizon by setting its level of interest rate. Generally, if a central bank emphasizes on inflation targeting, it announces a target value of inflation rate for a period of time, say for a year or beyond, and then it sets its level of interest rate with an intention of keeping the actual inflation rate within some specified band around the target value. Principles of Economics | 15  How Does Central Bank Control Money Supply Three ways to control money supply by the central bank, namely: 1. Statutory reserve requirement, also known as required reserve ratio (rrr), 2. Discount rate and 3. Open market operation. Principles of Economics | 16 The Statutory Reserve Requirement Case 1: When required reserve ratio = 10% Commercial Bank’s T-account Assets Liabilities Required reserve RM 100 Deposits RM 1000 Excess reserve/ Loan RM 900 Total RM 1000 Total RM 1000 Central Bank of Malaysia’s T-account Assets Liabilities Government securities RM 300 Reserve RM 100 Currency RM 200 Total RM 300 Total RM 300 Principles of Economics | 17 The Statutory Reserve Requirement Case 2: When required reserve ratio = 20% Commercial Bank’s T-account Assets Liabilities Required reserve RM 200 Deposits RM 1000 Excess reserve/ Loan RM 800 Total RM 1000 Total RM 1000 Central Bank of Malaysia’s T-account Assets Liabilities Government securities RM 400 Reserve RM 200 Currency RM 200 Total RM 400 Total RM 400 Principles of Economics | 18  The Statutory Reserve Requirement To reduce money supply → increase required reserve ratio To increase money supply → decrease required reserve ratio Principles of Economics | 19  The Discount Rate Discount rate is the interest rate that charges on the loan borrow by commercial bank from central bank. To reduce money supply → increase discount rate To increase money supply → decrease discount rate Principles of Economics | 20  Open Market Operations Open market operations involve the buy and sell of government securities or government bonds by the central bank. To reduce money supply → Central Bank sells government securities to banks To increase money supply → Central Bank buys government securities from banks Principles of Economics | 21  The Overnight Policy Rate (OPR) The OPR was introduced by Bank Negara Malaysia in 2004 at the rate of 2.70%. The OPR is the interest rate at which a depository institution lends instantly available funds to another depository institution overnight. The OPR serves as two roles: 1) a signaling device to indicate the monetary policy stance, and 2) a target rate for day-to-day liquidity operations of the central bank. Principles of Economics | 22 Figure 24.1: Overnight Policy Rate in Malaysia, 2004 - 2015 Principles of Economics | 23