The Tools of Monetary Policy (DP IB Economics)

The Process of Money Creation by Commercial Banks

• The process of money creation by commercial banks, also known as fractional reserve banking, involves a cycle of lending and deposit creation

An initial deposit of $100 is multiplied as successive rounds of borrowing and deposits occur in the banking system 

The Money Creation Process (Fractional Banking)

1. Initial Deposit

• A customer deposits $100 into a commercial bank
   

2. Reserve Requirement

• Banks are required by the Central Bank to hold a certain percentage of their deposits as reserves so as to meet the demands of customers who want a portion of their money back

• In this example the reserve requirement is 20%, so $20 must be retained
   

3. Lending and Loan Creation

• Banks keeps a fraction of the deposit (20%) and lends out the remainder to borrowers
   

4. Deposit Expansion

• The loaned amount is then received by the borrower, who deposit the funds into their own bank account

• These new deposits can be used by the other bank as the basis for creating further loans

• The cycle continues as banks retain a portion of the new deposits as reserves and lend out the rest, leading to further loan creation, deposit expansion, and potential new rounds of lending
   

5. Money Supply Expansion

• Through this process, new loans and subsequent deposit creation increase the overall money supply in the economy

• The original deposit has effectively multiplied into multiple deposits across the banking system

Tools of Monetary Policy: Open Market Operations

• There are four main tools available to the Central Bank which can be used to influence the supply of money in an economy

The four tools of monetary policy 

Open Market Operations

• This refers to the buying and selling of government securities (e.g. bonds), by the Central Bank in the open market

• These transactions are typically conducted with commercial banks and other financial institutions such as insurance companies
   

Impact on the money supply

• By buying the government bonds back from private owners, the Central Bank injects money into the system

• Conversely, selling government bonds withdraws money from free circulation as private institutions receive the bonds and the Central Bank receives the cash
   

Impact on interest rates

• When the Central Bank buys back government bonds, it increases commercial bank reserves, making it easier for banks to lend money

  • This increased lending capacity leads to more funds available in the market, potentially lowering interest rates
     

• When the Central Bank sells government bonds, it reduces commercial bank reserves, making it harder for banks to lend money

  • This decreased lending capacity can lead to higher interest rates

Tools of Monetary Policy: Minimum Reserve Requirements

• Minimum reserve requirements refer to the regulations set by the Central Bank that mandate the minimum percentage of customer deposits that commercial banks must hold as reserves

  • These reserves are typically in the form of cash or deposits held with the Central Bank

  • The Central Bank specifies the reserve ratio, which is the percentage of customer deposits that banks must hold as reserves

    • E.g. If the reserve ratio is set at 10%, a bank with $100 million in customer deposits would be required to hold $10 million as reserves
       

• The main objective of imposing minimum reserve requirements is to ensure the stability and soundness of the banking system

  • By mandating reserves, Central Banks aim to enhance the liquidity and solvency of banks

  • This provides a buffer against deposit withdrawals or unexpected financial shocks
     

Impact on Money Supply

• Adjusting minimum reserve requirements can be used as a tool to influence the lending capacity of banks and manage liquidity in the banking system

  • When banks are required to hold a higher reserve ratio, they have less money available to lend or invest and the money supply decreases

  • When banks are allowed to decrease their reserve ratio, they have more money available to lend or invest and the money supply increases

Tools of Monetary Policy: Changes to the Base Rate

• The base rate is the interest rate at which the Central Bank lends money to commercial banks such as HSBC

  • This rate is then used as the benchmark for interest rates generally

  • The base rate is also known as the official rate

     

The transmission mechanisms caused by changes to the base rate

• Changes to the base rate have a ripple effect through an economy

• This ripple effect is referred to as a transmission mechanism

  • A transmission mechanism has an activator and several steps in a process resulting in a particular outcome 

Key Terminology to Understand the Transmission Mechanisms Explained Below

Example 1 - Expansionary Monetary Policy

• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases
  

Example 2 - Expansionary Monetary Policy

• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase 
  

Example 3 - Expansionary Monetary Policy

• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4 - Contractionary Monetary Policy

• Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5 - Contractionary Monetary Policy

• Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

Tools of Monetary Policy: Quantitative Easing

• Quantitative easing (QE) is a monetary policy tool used by Central Banks to stimulate the economy when traditional monetary policy measures, such as interest rate cuts, have become less effective

The QE process as an expansionary monetary policy  

• The Central Bank creates new electronic reserves (digital money) and purchases government bonds from commercial banks or financial institutions

• These electronic reserves are credited (added) to the accounts of the selling institutions, effectively injecting new money into the financial system

• These increased reserves can lead to a higher capacity for lending and money creation in the economy

• Interest rates decline due to the added availability of money

• Borrowing increases and AD is stimulated through investment and consumption  

• QE is considered an unconventional monetary policy tool because it involves the central bank directly intervening in financial markets and expanding its balance sheet through large-scale asset purchases

  • It is typically employed when interest rates are already near zero and traditional policy measures are insufficient to address economic challenges
       

• The primary objective of QE is to increase the money supply, lower long-term interest rates, and encourage lending and investment to stimulate economic activity

  • It aims to address issues like low inflation, deflationary pressures, and stagnant economic growth 

Quantitative Easing Transmission Mechanism

• The Bank of England commits to buy £60bn of bonds a month → commercial banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases → inflation increases

An Evaluation of Monetary Policy

Strengths of Monetary Policy

• Central Banks can operate independently from the Government (political process)

  • Central Banks can consider the long-term outlook
     

• Contractionary policy is often effective when there is an inflationary gap

  • Targets inflation and maintains stable prices
     

• The frequency of policy alterations (4-8 times per year) allows for constant adjustments to macroeconomic variables

  • Rate changes can quickly be amended or reversed if necessary

Weaknesses of Monetary Policy

• Conflicting goals e.g economic growth puts upward pressure on inflation 

• Expansionary policy is less effective during a deflationary gap

  • The larger the output gap the less effective it can be 

  • Consumers may not respond to lower interest rates when confidence is low
     

• Expansionary policy leads to cheaper credit which can inflate asset prices (houses) in the long term 

• The interest rate has limitations on downward adjustment

  • The closer it gets to zero the less effective changes are
     

• QE may help to solve current issues in the market, but the extra money supply may lead to rapid inflation once the market fundamentals have improved