The Tools of Monetary Policy (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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
Official Rate | Market Rates | Asset Prices |
Exchange Rate | Net External Demand | Inflation |
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
Examiner Tips and Tricks
Quantitative easing may seem very similar to open market operations. The key difference is that for QE, the Central Bank creates new electronic credits. It effectively 'prints' new money to ease liquidity in the market. Traditional open market operations uses existing reserves
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