Monetary Policy Tools

1. Monetary Policy Tools

2. Monetary Policy Changes in Monetary Policy Tools in order to affect Aggregate Expenditures Expansionary Policy Increase AE Contractionary Policy Decrease AE

3. Monetary Policy Objectives • Maintain “stable prices” = inflation below 3%. • today:? www.mnb.hu • Maintain “sustainable economic growth” = Output Growth at least 3% • Today:?

4. GDP - Hungary • 2007 1.Q.: 102,3% • 2008 1.Q.: 101,9% • 2009 1.Q.: 93,3% • 2009 4.Q.: 92,8% • 2010 1.Q :100,1% • 2010 2.Q: 100,9%

6. Monetary policy goals • Price stability • Highemployment • Economicgrowth • Interest ratestability • Stability of financialmarkets • Stability in foreignexchangemarkets

7. Monetary Policy Tools • Open Market Operations: Buying or Selling Bonds to the public. • Required Reserve Ratio. • Changing the Discount Rate. • Changing Margin Requirements • Using “Moral Suasion”.

8. 1. Open Market Operations • Name: from the Bank of England • Refinancing loans only to special institutions • Government papers are on the open market, for everyone

9. 1. Open Market Operations • To sell open market instruments = • Reduce national bank money • To buy open market instruments= • Create money

10. 1. Mechanism of Open Market Operations Example r = 20% The entire banking system consists of only five banks and they hold their reserves at the Fed.

11. Hungarian required rate of reserves • 1994 13% + 6% • 1995 17% +8.5% • 2000 11% + 4% • 2008 2% -

12. D=100,000 d1= 10,000 d2= 30,000 d3= 40,000 d4= 15,000 d5= 5,000 Banking System Deposits • Bank 1 has 10,000 • Bank 2 has 30,000 • Bank 3 has 40,000 • Bank 4 has 15,000 • Bank 5 has 5,000 Total deposits in the banking system are $100,000

13. All Banks Reserves R=20,000 Reserves = 20% of Deposits • Bank 1 has 10,000 (0.2) = 2,000 in reserves • Bank 2 has 30,000(0.2) =6,000 in reserves. • Bank 3 has 40,000(0.2) =8,000 in reserves • Bank 4 has 15,000(0.2)=3,000 in reserves • Bank 4 has 5,000(0.2)=1,000 in reserves Total reserves in the banking system are $20,000

14. All Banks Deposits D=100,000 All Banks Reserves d1= 10,000 d2= 30,000 d3= 40,000 d4= 15,000 R=20,000 d5= 5,000 Ms = Deposits + Currency outside banks. r = 0.2 R=20,000 D=100,000 L= 80,000 Ms = 100,000 80,000 are in loans.

15. Bank 1= 2,000 Bank 2= 6,000 Bank 3= 8,000 R=20,000 Bank 4= 3,000 Bank 5= 1,000 The Fed’s Account Federal Reserve Bank Liabilities Assets Bonds The Fed holds Government bonds as part of their Assets. Bank’s reserves are liabilities to the Fed

16. Bank 1= 2,000 Bank 2= 6,000 Bank 3= 8,000 R=20,000 Bank 4= 3,000 Bank 5= 1,000 The Fed Buys $100 in Bonds From Mr. Anderson Liabilities Assets FED 5000 Bonds 5100 Bonds 100 Bond Mr. Anderson $100 Fed pays with a check

17. All Banks Deposits D=100,000 d1= 10,000 d2= 30,000 d3= 40,000 d4= 15,000 d5= 5,000 Mr. Anderson Deposits the Fed’s Check at Bank 1 Fed pays with a check New deposit At bank One $100 $100 d1=10,100

18. Bank 1= 2,000 Bank 2= 6,000 Bank 3= 8,000 R=20,000 Bank 4= 3,000 Bank 5= 1,000 A Bond Purchase Increases Bank’s Reserves Liabilities Assets FED 5100 Bonds 5000 Bonds =2,100 Fed credits Bank One’s reserves 100 Bond Mr. Anderson sells bond Bank 1 presents the check to the Fed for clearing $100

19. D R x 1 r 1 100 x 0.2 With $100 in extra reserves… D D = D D=500 D D = Deposits increase by 500 when reserves increase by 100. This 500 includes a 400 increase in loans.

20. When Bank One’s Reserves Increase • Bank One holds now more reserves than required, • Bank One will make more loans • To other banks • To the public • The loans generated become new deposits at other banks which keep 20% as reserves and loan the rest…

21. All Banks Deposits D=100,500 All Banks Reserves d1= 10,100 d2= 30,100 d3= 40,100 d4= 15,100 R=20,100 d5= 5,100 The Effect of a 100 purchase of bonds by the Fed. r = 0.2 R=20,100 D=100,500 L= 80,400 Note that deposits increased in all banks… Ms = 100,500 and 80,400 of that is loans.

22. Three Kinds of Reserves • Required Reserves (RR). The amount that must be held by law, the required reserve ratio times deposits: RR = r(D) • Actual Reserves (AR). The amount of reserves actually held by the bank. This could be higher or lower than RR. • Excess Reserves(ER). Any amount held above required reserves.

23. The Fed’s Purchase Step by Step Bank One r=20% Deposits = 10,000 Reserves = 2,000 Hold as reserves=20 New Deposit= 100 Bank Two Loans = 8,000 New Loan = 80 r=20% Reserves = 6,000 Deposits = 30,000 Hold as reserves=16 New Deposit= 80 Loans = 24,000 New Loan = 64 Bank Three After three steps, deposits have increased by: 100 + 80 + 64 = 244… r=20% Reserves = 8,000 Deposits = 40,000 Hold as reserves = 12.8 New Deposit= 64 Loans = 32,000 Becomes a new deposit New Loan = 64

24. At the end of the Money Multiplier Process… All Banks After All Banks Before r=20% r=20% D = 100,000 D = 100,500 R = 20,000 R = 20,100 L = 80,000 L = 80,400 D R=100;D D=500; D L = 400

25. r=20% D = 100,000 R = 20,000 L = 80,000 In Summary • When the Fed Buys Bonds • New Reserves become available for banks to loan out • Money is created • The Money Supply increases. R=20% DD = DR(1/r) DR = Fed’s Purchase DL = DD - DR

26. Open Market Operations Fed buys/sells bonds from the public or banks Fed Injects/ erase new reserves to the banking system Money/Credit easier/harder to get Investment Changes Long Term interest rates change All Short term interest rates change with the fed funds rate Federal Funds Rate Decreases/Increases

27. 2. Reserve ratio • 1913 FED • To ensure: • banks’ liquidity • To defend depositors • Now: • To serve monetary policy • Usually differentiated rates

28. 2. Reserve ratio • Influence loan interest rates • How?

29. 2.Changing the Required Reserve Ratio. DD = DR(1/r) All Banks r=20% r = 10% DD = 10,000(1/0.1) AR = 20,000 RR = 10,000 ER = 10,000 D = 200,000 D = 100,000 R = 20,000 DD = 100,000 L = 80,000 Hold 10%=1,000 New loan = 10,000 New Deposit Hold 10%= 900 New loan = 9,000 New Deposit Hold 10%=810 New loan = 8100 New Deposit New loan …

30. All Banks After All Banks Before r=10% r=20% D = 100,000 R = 20,000 L = 80,000 Changing the Required Reserve Ratio. R = 20,000 D = 200,000 L = 180,000 Reserves did not change. Now 20,000 in reserves must be 10% of total deposits The Fed Decreases r to 10% D = 20,000/0.1 D= 200,000 20,000= (0.1) D

31. When the Required Reserve Ratio decreases to 10% Deposits increase by 100,000.

32. . Reserve Required Ratio • Wheretofind? • www.federalreserve.gov • www.mnb.hu

33. The Discount Rate: d d=5% The interest rate charged by the Federal Reserve Bank on loans to Banks.

34. Decreasing the Discount Rate d • When funds from the Fed become “cheaper” banks find it less necessary to hold excess reserves… • In case of need, banks can borrow funds from the Fed at low d. • Banks are induced to borrow from the fed rather than keep excess reserves to cover emergencies…

35. A decrease in d: two possible scenarios • Banks borrow more reserves from the Fed • Reserves in the banking system increase: the Fed injects new reserves which generate new loans and new deposits • Decreases Excess Reserves • Banks hold on to less excess reserves and thus make more loans generating new deposits. The Money Supply Increases

36. 4. Margin Requirements The fraction of the stock’s price that must be put up by the person buying the stock: the Down payment

37. Year Margin Year Margin 1940 50 1960 70 WAR Inflation 1942 75 1962 50 1945 100 1963 70 1947 75 1970 65 Recession 1953 50 1974 50 1958 90 1994 50 Margin RequirementsSelected Years

38. 5. Moral Suasion and theGentlemensAgreements: The Omen of things to come “Those found cheating will be suspended from school”

39. Fed’s Actions • Public Statement • “The Fed hopes that banks show more restraint in providing consumer credit, because inflation is a problem” • Official Fed Policy Statements • “The Fed will raise interest rates by 25 basis points” • Direct Appeals • Letters to bank presidents.

40. Thankyou!