Money supply and Monetary Policies

Money supply Central Bank (Fed/RB/State Bank) roles Monetary policies SR/LR Phillips curve

2007 Thomson South-Western

Two Measures of the Money Stock

Billions of Dollars Savings deposits Small time deposits Money market mutual funds A few minor categories

Demand deposits Travelers checks Other checkable deposits

(11.5%/GDP in New Zealand)

Everything in M1

Currency 0
1.9%/GDP in New Zealand
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THE RESERVE BANK

The RB serves as the nations central bank with 3 functions.
It is designed to oversee the banking system. It regulates the quantity of money in the economy It operates like a bank with the last of resort for banking system.

2007 Thomson South-Western

BANKS AND THE MONEY SUPPLY

Reserves are deposits that banks have received but have not loaned out. In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. R is required reserve and this becomes bank deposits to RB

2007 Thomson South-Western

BANKS AND THE MONEY SUPPLY

The reserve ratio is the fraction of deposits that banks hold as reserves.

2007 Thomson South-Western

Money Creation with Fractional-Reserve Banking

When a bank makes a loan from its reserves, the money supply increases. The money supply is affected by the amount deposited in banks and the amount that banks loan.
Deposits into a bank are recorded as both assets and liabilities. The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. Loans become an asset to the bank.
2007 Thomson South-Western

Banking Money Creation with FractionalReserve

This T-Account shows a bank that
accepts deposits, keeps a portion as reserves, and lends out the rest.

First National Bank

Assets Liabilities
Deposits $100.00

Reserves $10.00
Loans

It assumes a reserve ratio of 10%.

$90.00
Total Assets $100.00 Total Liabilities $100.00

2007 Thomson South-Western

Money Creation with Fractional-Reserve Banking

When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases.

2007 Thomson South-Western

The Money Multiplier

How much money is eventually created by the new deposit in this economy?

2007 Thomson South-Western

The Money Multiplier

The money multiplier is the amount of money the banking system generates with each dollar of reserves.

2007 Thomson South-Western

The Money Multiplier

Increase in the Money Supply = $190.00!
First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Assets Total Liabilities $100.00 $100.00

Second National Bank

Assets
Reserves $9.00 Loans $81.00 Total Assets $90.00 Total Liabilities $90.00
2007 Thomson South-Western

Liabilities
Deposits $100.00

Liabilities
Deposits $90.00

The Money Multiplier

Original deposit = $100.00 1st Natl. Lending = 90.00 (=.9 x $100.00) 2nd Natl. Lending = 81.00 (=.9 x $ 90.00) 3rd Natl. Lending = 72.90 (=.9 x $ 81.00) and on until there are just pennies left to lend! Total money created by this $100.00 deposit is $1000.00. (= 1/.1 x $100.00)
2007 Thomson South-Western

Tools of Monetary Control

The RB has five tools:
Open-market operations Changing the reserve requirement Changing the discount rate Changing in OCR (Official Cash Rate by the RB) MPR and Inflation target

2007 Thomson South-Western

The Feds Tools of Monetary Control

Open-Market Operations
The RB conducts open-market operations when it buys government bonds from or sells government bonds to the public:
When the Fed sells government bonds, the money supply decreases. When the Fed buys government bonds, the money supply increases.

2007 Thomson South-Western

The RB Tools of Monetary Control

Reserve Requirements
The Fed also influences the money supply with reserve requirements. Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

2007 Thomson South-Western

The RB Tools of Monetary Control

Changing the Reserve Requirement
The reserve requirement is the amount (%) of a banks total reserves that may not be loaned out. Increasing the reserve requirement decreases the money supply. Decreasing the reserve requirement increases the money supply.

2007 Thomson South-Western

The RB Tools of Monetary Control

Changing the Discount Rate
The discount rate is the interest rate RB charges banks for loans.
Increasing the discount rate decreases the money supply. Decreasing the discount rate increases the money supply.

2007 Thomson South-Western

Official Cash Rate

New Zealand/Developed Countries are using of OCR to do MP Key short term interest rate RB pays for demand deposits held by CBs with the RB Demand deposits are known as Settlement Acc OCR (short term deposit rate) and OCR+50 basis points (short term loan rate) are announced/fixed by the RB RB decide OCR and then other nominal interest rates will follow up It will give effect on MS as well as interest rate from CBs paying/charging the others
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The OCR and the 90-day bank bill rate

9.00

8.00

7.00

Interest rate (%)

6.00

5.00

4.00

3.00

2.00 Apr-99 Oct-99 Apr-00 Oct-00 Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09

Date OCR 90 day bank bill rate

2007 Thomson South-Western

OCR

Interest rates Exchange Rate

Economic Activity

Inflationary expectations

CPI Inflation

Trading partner inflation

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MP and MPR

Depending on economy situation (recession/boom) Easier MPR will be applied to recession economy (MPR shift down to keep the same target inflation rate with lower nominal/real interest rate) OCR will fall then we could recover the economy from recession Class discussion 10 munites. Case study: pp:746-747
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