What is monetary policy?

“…the process by
which the
monetary
authority of a
country controls
the supply of
money.”
What for?
What for?
Expansionary Contractionary
 Problem Remedy Means

• unemployment • induce an • Buy bonds in

and deflation expansion in the open
the supply of market
money, and
therefore
spending, by
reducing the
interest rate
 Problem Remedy Means

• inflation • induce a • Sell bonds in

contraction in the open
the supply of market
money, and
therefore
spending, by
increasing the
interest rate
 Open Market Operations

The buying and selling of government securities by

the Reserve Bank on secondary markets
 OMOs aim to…

manipulate the short manipulate the supply control the total money supply
term interest rate of base money
 How OMOs Work: Buying
securities from commercial bank

Fed/ CB
• Gives up • Increases
securities • Pays the reserves
bank
Bank Bank
 How OMOs Work: Buying
securities from public

Fed/ CB Bank
• Gives up • Deposits
securities • Pays in bank • Increases
reserves
Public Public
How OMOs Work: Selling securities
to commercial bank

• Gives up
Bank • Decreases
securities • Pays reserves

Fed/CB Bank
How OMOs Work: Selling securities
to public

• Gives up
Public • Decreases
securities • Pays by reserves
check from
bank
Fed/CB Bank
Understanding The Reserve
Requirements

Required reserves
A certain fraction of
deposits that a depository
institution is required to
reserve.
Set by the central bank

Affects the size of loan

that the bank can offer
Required Reserve and Monetary Policy
Required Reserve and Monetary Policy
 Other tool:
Discount Rate

The interest rate charged

by Federal Reserve Banks
to depository institutions
on short-term loans.
Goals of Monetary Policy

Price stability
 Nominal Anchor in Price Stability
Goal
Nominal anchor uses a certain
nominal variable which ties down
the price level.

For example: maintaining an

inflation rate between 2% - 4 %
might be an anchor.
Time-Inconsistency Problem
This problem arises
because policy makers are
always tempted to pursue
monetary policy that is
more expansionary
because it would boost
economic output.
 “…does not mean that
unemployment is at zero”

High Employment
 “…ensuring that resources
are not idle”

Economic Growth
 “…crises can
interfere with the
main function”

Stability of Financial
Markets
 “…fluctuations can
create uncertainty
in economy”

Interest-Rate Stability
 “…stability makes it
easier for businesses to
plan ahead”

Stability in Foreign
Exchange Market