Skip to main content

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


Labels:
Location: Boston, MA, USA

Comments

Post a Comment

Popular posts from this blog

Macroeconomics: real vs nominal gross domestic product

Nominal GDP:   A nominal GDP measures the value of a nation's output produced in a year, given the prices charged for that year. However, if prices increase while the output level stays constant in a given year, the nominal GDP will drastically increase, even though the level of production is equal to that of the previous year. Estimating real GDP: To determine the actual change in output from one year to the next, we must adjust the nominal value of a country's output in a year based on changes in the average price level during that year.  Inflation is when the price level increases, whereas deflation is when the price level is decreasing. To determine whether the nominal GDP overestimates or underestimates the output of a country, one must know whether the average price level has increased or decreased. In order to achieve this task can use a price index known as the GDP deflator. The GDP deflator: Real GDP is calculated by replacing the prices for that current year with tho...
Post a Comment
Read more

Microeconomics: Firms and cost in the short run

In Economics, the term short run refers to a time period where at least one variable of interest does not change . In our case, the short run for a firm is when at least one input  (labor, land, capital) stays fixed. Usually land and capital are considered fixed in the short run.  If an input is fixed during a period time, no matter how much the total product a firm produces, its cost stays the same. This cost is commonly known as fixed cost (FC). Examples of fixed costs: rent, property taxes, loan payments. Labor is often considered to be a part of the  variable cost (VC) . Variable cost can be defined as the cost a firm has control over during the short run. Unlike fixed cost, variable cost increases (decreases) as a firm's total product increases (decreases). Examples of variable costs include: utility bills, wages, raw materials A firm's total cost (TC) is the sum of its variable and fixed costs. As you can see, the fixed cost...
Post a Comment
Read more

Macroeconomics: the money market and loanable funds market

  The money market: The money market combines the supply of money and the demand for money for a country. The supply curve (Sm) is inelastic and is determined by the central bank. The demand curve (Dm) is the horizontal summation of the asset and transaction demand curves and is sloping downward. The intersection between the Sm and Dm is the equilibrium interest rate for a country. A change in the nominal interest rate implies that either or both curves (i.e Sm and Dm) have shifted to the right or left. An increase in nominal GDP (P*Y) will lead to an increase in the transaction demand for money which will shift the total demand (Dm) to the right. The nominal interest rate goes up. A decrease in the level of output (Y) will shift the Dm curve to the left. The Sm curve will shift whenever the central bank decides to change the money supply due to a monetary policy decision. The Fed expands the supply of excess reserves in commercial banks, by purchasing bonds from banks, Sm shi...
Post a Comment
Read more