2. Monetary Policy Tools 1

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

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

5. 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% 4

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7. Monetary policy goals Price stability High employment Economic growth Interest rate stability Stability of financial markets Stability in foreign exchange markets 6

8. Monetary Policy Tools 1.Open Market Operations: Buying or Selling Bonds to the public. 2.Required Reserve Ratio. 3.Changing the Discount Rate. 4.Changing Margin Requirements 5.Using Moral Suasion. 7

9. 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 8

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

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

12. Hungarian required rate of reserves 199413% + 6% 199517% +8.5% 200011% + 4% 20082% - 11

13. 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 D=100,000 d1= 10,000 d2= 30,000 d3= 40,000 d4= 15,000 d5= 5,000 Total deposits in the banking system are $100,000 12

14. 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 All Banks Reserves R=20,000 Total reserves in the banking system are $20,000 13

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

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

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

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

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

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

21. When Bank Ones 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… 20

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

23. 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. 22

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

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

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

27. All Short term interest rates change with the fed funds rate Fed Injects/ erase new reserves to the banking system 1.Open Market Operations Fed buys/sells bonds from the public or banks Money/Credit easier/harder to get Federal Funds Rate Decreases/In creases Long Term interest rates change Investment Changes 26

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

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

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

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

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

33. Reserve Required Ratio Where to find? www.federalreserve.gov www.mnb.hu 32.

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

35. Decreasing the Discount Rate 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 Banks are induced to borrow from the fed rather than keep excess reserves to cover emergencies… 34

36. A decrease in : two possible scenarios 1.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 2.Decreases Excess Reserves Banks hold on to less excess reserves and thus make more loans generating new deposits. The Money Supply Increases 35

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

38. Margin Requirements Selected Years 501994901958 501974501953 651970751947 7019631001945 501962751942 701960501940 MarginYearMarginYear WAR Inflation Recession 37

39. 5. Moral Suasion and the Gentlemens Agreements: The Omen of things to come Those found cheating will be suspended from school 38

40. Feds 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. 39

41. Thank you! 40