Monetary Policy: Study Guide (Macroeconomics 4.6)

What monetary policy is

A central bank is the institution that manages a country’s money and banking system. Monetary policy is what it does to influence interest rates and the money supply in order to reach macroeconomic goals. The main goals are price stability (low, steady inflation) and full employment (output close to its potential level).

There are two directions:

• Expansionary (easy) monetary policy lowers interest rates. It is used when the economy is in a recessionary (negative) output gap: real GDP is below potential and unemployment is above its natural rate.
• Contractionary (tight) monetary policy raises interest rates. It is used when the economy is in an inflationary (positive) output gap: real GDP is above potential and inflation is rising.

Many central banks set a target range for the overnight interbank lending rate. This is the interest rate banks charge each other for very short loans of reserves. It is often called the central bank’s policy rate. In the United States the policy rate is the federal funds rate. In our fictional economy, Valdoria, the Central Bank of Valdoria (CBV) targets the Valdorian overnight rate.

Limited reserves and ample reserves

How a central bank moves its policy rate depends on how many reserves the banking system holds.

• Limited reserves. Banks hold little more than their required reserves. Reserves are scarce, so if the central bank adds or removes even a small amount, the overnight rate changes. The central bank works by changing the quantity of reserves, which changes the money supply and so the interest rate.
• Ample reserves. Banks hold far more reserves than they need. A small change in the quantity of reserves does not change the overnight rate, because no bank is short of reserves. Instead the central bank changes the interest rates it sets itself, its administered rates, especially the interest on reserves.

The United States is an example of the second kind of system. Its banks hold ample reserves, so the Federal Reserve steers its policy rate mainly by setting the interest it pays on reserves.

The tools

Tool	What it is	Expansionary use	Contractionary use	Main system
Open market operations (OMOs)	The central bank buys or sells government bonds	Buy bonds: reserves rise	Sell bonds: reserves fall	Limited reserves
Required reserve ratio	The share of deposits banks must hold as reserves	Lower it: more excess reserves to lend	Raise it: fewer excess reserves	Limited reserves
Discount rate	The interest rate the central bank charges banks that borrow reserves from it	Lower it: borrowing reserves is cheaper	Raise it: borrowing reserves is dearer	Both
Interest on reserves (IOR)	The interest rate the central bank pays banks on the reserves they hold with it	Lower it	Raise it	Ample reserves (key tool)

Why does interest on reserves move the policy rate? A bank will not lend its reserves to another bank overnight for less than it can earn by simply keeping them at the central bank. So when the CBV raises the interest on reserves, the overnight rate rises with it. When it lowers the interest on reserves, the overnight rate falls.

Worked example 1: an open market purchase with limited reserves

Question. Valdoria’s banking system has limited reserves and a required reserve ratio of 20%. The CBV buys VD 5 bn of government bonds from commercial banks. (a) Show the change on each balance sheet. (b) Find the change in the monetary base. (c) Find the maximum change in the money supply. (d) What happens to the nominal interest rate?

(a) The CBV pays for the bonds by crediting the banks’ reserve accounts.

Central Bank of Valdoria (changes only):

Assets		Liabilities
Government bonds	+VD 5 bn	Reserves of commercial banks	+VD 5 bn

Commercial banks (changes only):

Assets		Liabilities
Government bonds	−VD 5 bn	(no change)
Reserves	+VD 5 bn

No new deposits were created, so required reserves do not change. All of the VD 5 bn is excess reserves.

(b) Bank reserves are part of the monetary base, so the monetary base rises by VD 5 bn.

(c) Maximum money multiplier = 1 ÷ 0.20 = 5. Maximum change in the money supply = 5 bn × 5 = VD 25 bn. Banks lend out the excess reserves, the loans are spent and redeposited, and deposits grow through the banking system.

(d) The money supply curve shifts right, so the equilibrium nominal interest rate falls (Topic 4.5).

Check 1. The money supply rises by more than the monetary base (VD 25 bn against VD 5 bn). That is the money multiplier at work. The actual rise will be smaller if banks keep some excess reserves or people hold more cash.

Check 2. If the CBV had bought the bonds from the public instead, the sellers would deposit VD 5 bn. That deposit is already new money. Required reserves rise by 0.20 × 5 = VD 1 bn, so excess reserves are VD 4 bn, and new loans can add up to 4 × 5 = VD 20 bn. The total is still 5 + 20 = VD 25 bn.

An open market sale of VD 5 bn works in reverse: reserves and the monetary base fall by VD 5 bn and the money supply can fall by up to VD 25 bn.

The reserve market model

The reserve market shows how the policy rate is set.

• Vertical axis: policy rate. Horizontal axis: quantity of reserves.
• Supply of reserves (SR) is vertical. The central bank decides how many reserves exist.
• Demand for reserves (DR) slopes down: at a lower overnight rate, banks are happier to hold more reserves. At the interest on reserves, the curve becomes flat. No bank will lend reserves for less than the central bank pays, so in this model the rate cannot fall below this level.

Panel (b) also shows why open market operations do not work well with ample reserves. Moving SR a little to the left or right keeps it on the flat part of demand, so the policy rate does not change.

From the policy rate to output and prices

When the policy rate changes, other nominal interest rates (on loans, mortgages and bonds) tend to move in the same direction. This is how monetary policy reaches the real economy.

Expansionary policy (recessionary gap):

lower policy rate → lower interest rates on loans → investment and interest-sensitive consumption (such as cars and houses bought on credit) rise → AD shifts right → real output rises, unemployment falls and the price level rises.

Contractionary policy (inflationary gap):

higher policy rate → higher interest rates on loans → investment and interest-sensitive consumption fall → AD shifts left → real output falls and the price level falls (or rises more slowly).

Interest rates also affect international capital flows and exchange rates. You will meet those links in Unit 6.

Worked example 2: closing a recessionary gap

Question. Valdoria’s real GDP is VD 900 bn, while potential (full-employment) output is VD 960 bn. Its banking system has ample reserves. (a) Identify the output gap. (b) State the monetary policy the CBV should use and name the tool. (c) Explain the effects on the policy rate, investment, AD, real output and the price level. (d) What could the CBV do if Valdoria had limited reserves instead?

(a) Real GDP is VD 960 − 900 = VD 60 bn below potential (60 ÷ 960 × 100 = 6.25%). This is a recessionary (negative) output gap.

(b) Expansionary monetary policy. With ample reserves, the key tool is to lower the interest on reserves (and its other administered rates).

(c) Lower interest on reserves → the flat part of reserve demand moves down → the policy rate falls → banks and borrowers face lower interest rates → investment and interest-sensitive consumption rise → AD shifts right → real output rises towards VD 960 bn and the price level rises. Unemployment falls.

(d) With limited reserves, the CBV could buy government bonds, lower the required reserve ratio or lower the discount rate. Each raises banks’ excess reserves or makes reserves cheaper, so the money supply rises and the nominal interest rate falls.

Check. Monetary policy shifts AD, not SRAS or LRAS. The price level rises as output rises: expansionary policy closes a recessionary gap at the cost of some inflation.

Why monetary policy works with lags

Monetary policy does not work instantly. There are delays:

• Recognising the problem. Data on output, unemployment and prices arrive weeks or months after the events they describe, so the central bank may not know a recession or an inflation problem has started.
• The economy adjusting. Even after rates change, firms take time to plan and start new investment projects, and households take time to change big purchases. The full effect on AD, output and prices can take many months.

Because of these lags, a policy chosen for today’s problem may take effect when conditions have already changed. A central bank that cuts rates late in a recession could add to inflation in the recovery.

Common misconceptions

• “Buying bonds is contractionary.” A central bank purchase of bonds adds reserves and is expansionary. Selling bonds is contractionary.
• “Monetary policy changes government spending or taxes.” That is fiscal policy. Monetary policy works through interest rates and the money supply.
• “The money supply rises by the amount of the bond purchase.” That is the change in the monetary base. With limited reserves, the money supply can rise by a multiple of it.
• “Open market operations always move the policy rate.” With ample reserves, small changes in reserves leave the policy rate unchanged; the central bank uses its administered rates instead.
• “Raising the interest on reserves is expansionary.” A higher interest on reserves raises the policy rate; it is contractionary.
• “The discount rate is the policy rate.” The discount rate is what the central bank charges banks for loans; the policy rate is the overnight rate banks charge each other.
• “Expansionary policy shifts SRAS right.” It shifts AD right.
• “Monetary policy works immediately.” Recognition and adjustment take time.

Where this leads

Next, Topic 4.7 introduces the loanable funds market, where the real interest rate is set by saving and borrowing: go to the Loanable Funds Market study guide. First, try the practice questions, then use the revision notes and the checklist to consolidate.