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ECN 3102 - MACROECONOMICS

ECN 3102 - MACROECONOMICS. CHAPTER 14. CENTRAL BANK. BANK A. BANK B. Depository institution. 1. MONETARY SYSTEM. Central bank controls the country monetary system. 2. MONEY SUPPLY DETERMINATION. Assumed that CB controls M. In reality not true, the control is actually indirect.

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ECN 3102 - MACROECONOMICS

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  1. ECN 3102 - MACROECONOMICS CHAPTER 14

  2. CENTRAL BANK BANK A BANK B Depository institution 1. MONETARY SYSTEM • Central bank controls the country monetary system.

  3. 2. MONEY SUPPLY DETERMINATION • Assumed that CB controls M. • In reality not true, the control is actually indirect. • 3 groups that affect M: • Central Banks • Depository institutions • Public

  4. 3. MONEY CREATION 3.1 M in an All-Currency Economy • The liabilities of the CB that are usable as money are called monetary base or high- powered money. • In a situation where there is no banking system, M = currency held by public. • Therefore M = monetary base

  5. 3. MONEY CREATION (cont.) 3.2 M under Fractional Reserve Banking • As an economy becomes more financially sophisticated, banks develop. • People may want to hold their money in bank deposits and none in currency Consolidated Balance Sheet of Banks

  6. 3. MONEY CREATION (cont.) • Bank reserves  currency that banks hold in the bank and at the central bank • When bank reserves = deposits  100% reserve banking • Reserve deposit ratio  the banking system is allowed to lent some of the reserves based on the ratio. Consolidated Balance Sheet of Banks

  7. 3. MONEY CREATION (cont.) • Suppose the commercial bank required reserve deposit ratio (rrr) is 20%, this means the banks reserve is 20 and 80 can be loan to people • Money redeposited by public in the bank create rounds of loans. This process is known as multiple expansion of loans and deposits. • If public holds no currency, then the bank deposits are the money supply. And therefore the money supply equals the total quantity of deposits

  8. 4. THE RELATIONSHIP OF M AND BASE M = Money Supply BASE = Monetary Base DEP = Total Bank Deposits RES = Total Bank Reserves res = Reserve Deposit Ratio • No currency held by public M = DEP

  9. 4. THE RELATIONSHIP OF M AND BASE (cont.) • At the end of multiple bank reserve equals amount of currency distributed by CB (res) (DEP) = BASE • Money Supply M  DEP = BASE res • Multiple expansion of loans and deposits allows the economy to create M that > than the BASE.

  10. 4. THE RELATIONSHIP OF M AND BASE (cont.) 4.1 With public holding currency and bank reserves M = CU + DEP BASE = CU + RES • CB controls the amount of BASE but does not directly control M. M CU + DEP BASE CU + RES • Divide both numerator and denominator on the right hand side by DEP: M (CU + DEP) + 1 BASE (CU/DEP) + (RES/DEP)

  11. 4. THE RELATIONSHIP OF M AND BASE (cont.) • CU/DEP = currency deposit ratio (cu) • The ratio of the currency held by public-to-public deposits in banks. • Determine by the public • RES/DEP = reserve deposit ratio (res) • Determine by the bank/central bank • Decision of how much to lend. • When the process of multiple expansions of loans and deposits is completed: cu = res

  12. 4. THE RELATIONSHIP OF M AND BASE (cont.) • Substitute cu for CU/DEP and res for RES/DEP and multiply both side by BASE M (CU + DEP) + 1 BASE (CU/DEP) + (RES/DEP) M cu + 1 BASE cu + res money multiplier

  13. 4. THE RELATIONSHIP OF M AND BASE (cont.) • Money multiplier is the number of dollars of money supply that can be created from each dollar of BASE Money multiplier > 1 as long as res is < 1 • If public holds no currency (cu = 0), then the money multiplier equal 1/res • Bank runs • Occurs when people think a bank won’t be able to give them their money, they panic and rush to withdraw their money.

  14. 5. HOW DOES CB CONTROL M? • Open Market Operation • Discount Window Lending • Required Reserve Ratio 5.1 Open Market Operation • To change money supply, CB must change the amount of monetary base (BASE) or change the money multiplier (1/res). • For any value of money multiplier (constant), a change in BASE will cause a proportional change in money supply.

  15. 5. HOW DOES CB CONTROL M? (cont.) 5.2 Discount Window Lending • Discount window lending is lending reserves to banks so that they can meet depositors’ demand or reserve requirements • The interest rate on such borrowing is called the discount rate • A discount loan increases the monetary base.

  16. 5. HOW DOES CB CONTROL M? (cont.) •  discount rate, discourage borrowing and reduce monetary base • summary: • res, cu or rrr  no effect on the monetary base,  multiplier and  MS •  discount window borrowing,  discount rate and an open market purchase  monetary base, no effect on multiplier and  MS

  17. 5. HOW DOES CB CONTROL M? (cont.) 5.3 Required Reserve Ratio • The CB sets the minimum fraction of deposits that a bank must hold as reserve. • An increase in rrr forces banks to hold more reserves, thus reducing money multiplier.

  18. 5. HOW DOES CB CONTROL M? (cont.) 5.4 Intermediate Targets • Intermediate targets are variable that CB cannot directly control but can influence predictably. They are related to the CB goals. • CB can use intermediate targets to guide policy as a step between its tools or instruments and its goals (price stability and stable economic growth) • Frequently used targets are monetary aggregates (M1 and M2) and short term interest rates such as the discount rate • The CB cannot target both the MS and discount rate simultaneously.

  19. 6. MONETARY POLICY IN PRACTICE • IS-LM model makes monetary policy look easy – just change the money supply to move the economy to the best point possible. • In reality it is not so easy because of lags in the effect of policy and uncertainty about the ways MP works. • Take fairly long time for changes in MP to have impact on the economy. • Interest rate change quickly but output and inflation barely respond after few months of changes in money growth.

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