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Macroeconomics: the tools of the central bank

 

Tools of central bank policy:

  • The RRR: it changes the amount of excess reserves in commercial banks, and changes the size of the money multiplier and thus impact how much money the banking system can create.
    • In an expansionary policy, the Fed wants to lower the RRR in order to increase the amount of excess reserves. Commercial banks are then incentivized to loan it out. This will increase the supply of money in the economy which will then lower the nominal interest rate (i.e banks agree to loan out more at lower rates than before).
    • In a contractionary policy, the Fed wants to increase the RRR, which will reduce the supply of money in the economy. The number of loans diminishes and the nominal interest rate goes up.
    • Assume the RRR goes from 20% to 25%:
    • we see that the money multiplier (m) goes from 5 to 4. Commercial banks create less money than before and make less loans. In the money market, the money supply curve shifts to the left, which causes the real interest rate to increase (since the nominal interest rate goes up, assuming constant inflation), which reduces the number of investment (i.e less loans). Then this implies that the AD curve shifts to the left, this is a contractionary policy.
  • Discount rate (DR): the interest rate the Fed charges commercial banks for short term loans borrowed from the central bank.
    • Usually commercial banks borrow from the Fed in order to have enough liquidity for a particular day (especially to meet the RRR). However, financial firms can interpret this as a negative signal.
    • Usually, the DR is higher than the federal funds rate (also set by the Fed). Then, it makes sense to think as the Fed as the lender of last resort.
    • If the Fed lowers the DR, this signals commercial banks that it is easier and cheaper to borrow money to meet the RRR. This increases the money supply and the number of loans, lowering the real interest rate, and shifting the AD curve to the right, expansionary policy.

  • Open market operations (OMO): the action of buying and selling government bonds by the central bank from commercial banks. This aims at reducing (selling bonds) or increasing (buying bonds) the excess reserve in the banking system, which then influences the federal reserve rate.
    • If the Fed wants to increase the supply of liquid money in the system, it must buy government bonds from commercial banks (expansionary policy).  In order to decrease the supply of money, the Fed must sell government bonds (contractionary policy).
    • OMO affects the federal funds rate (FFR) by reducing or increasing the amount of excess reserve. Thereby influencing how much banks can lend to each other and to the public as well.
  • Monetary equation of exchange: M denotes the amount of money at a point in time, V the velocity of money (i.e average number of transaction for each unit of money in a period of time), P is the price level, and Y is the level of output produced.
    • This formula is useful in determining a monetary policy that promotes economic growth and price stability, the two mandates of the central bank. 
    • Just by rearranging this formula, one can see that if money supply grows more rapidly than output growth, it will cause inflation (whereas the opposite would cause deflation).
    • In order to ensure price stability, the growth rate of the money supply should approximately match the growth rate of the national output.
References:
  1. Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 169-178.
  2. Fed St Louis for the graph


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Location: Boston, MA, USA

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