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Chapter 29 The Monetary System - Some Logics

The document discusses the mechanism of money creation and the logic of monetary policy tools. It explains that the money supply (MS) is determined by the money multiplier (1/R), where R is the overall reserve ratio. It then outlines three monetary policy tools used by central banks: (1) open market operations that increase or decrease the money supply by buying or selling government bonds, (2) adjusting the discount rate to influence bank borrowing and lending, (3) changing reserve requirements or interest on reserves to impact the money multiplier and money supply. The goal is for central banks to use these tools to implement expansionary or contractionary monetary policy.

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Minh Châu Tạ Thị
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148 views

Chapter 29 The Monetary System - Some Logics

The document discusses the mechanism of money creation and the logic of monetary policy tools. It explains that the money supply (MS) is determined by the money multiplier (1/R), where R is the overall reserve ratio. It then outlines three monetary policy tools used by central banks: (1) open market operations that increase or decrease the money supply by buying or selling government bonds, (2) adjusting the discount rate to influence bank borrowing and lending, (3) changing reserve requirements or interest on reserves to impact the money multiplier and money supply. The goal is for central banks to use these tools to implement expansionary or contractionary monetary policy.

Uploaded by

Minh Châu Tạ Thị
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Xuan Lam, Nguyen

The mechanism of money creation

MS  100  90  81  72.9  ...

 (1  0.9  0.9 2  0.93  ...)  100

For 0 < x < 1, we can prove that

1
1  x  x 2  x 3  ... 
1 x

Hence,

1
MS   100
1  0 .9

1
  100  1,000
0 .1

We generalize as follows:

1 1
MS   D where is money multiplier
R R

Note: R is actually the overall reserve ratio, with

Reserves Required reserve + Excess reserve


R= =
Deposits Deposits

Required reserve Excess reserve


= + = Rr + Re
Deposits Deposits

where Rr is required reserve ratio and Re is excess reserve ratio

1
Xuan Lam, Nguyen
The logic of monetary policy tools

1. Open-Market Operations

Central Bank buys government bonds and pays money for the public → money in the
 Some of these new money are held as currency → Cu ↑ → MS ↑

economy ↑ →  1
 Some are deposited in banks → D ↑ → R  D  MS ↑

Central Bank sells government bonds → the public buys government bonds and pays
 currency → Cu ↓ → MS ↓

by  1
 deposits → D ↓ → R  D  MS ↓

2. Central Bank changes the discount rate

Discount rate ↓ → borrowings of banks ↑ → excess reserve at banks ↑ → loans ↑ →


Cu ↑ → MS ↑

Discount rate ↑ → borrowings of banks ↓ → excess reserve at banks ↓ → loans ↓ →


Cu ↓ → MS ↓

3. Central Bank influences the reserve ratio

3.1. Changing the required reserve ratio

1 1
Rr ↓ → R ↓ → ↑→  D  MS ↑
R R

1 1
Rr ↑ → R ↑ → ↓→  D  MS ↓
R R

2
Xuan Lam, Nguyen
3.2. Changing interest paid on reserves at the Central Bank

Interest paid on reserves ↓ → excess reserves of banks at the Central Bank ↓ → Re ↓


1 1
→R↓→ ↑→  D  MS ↑
R R

Interest paid on reserves ↑ → excess reserves of banks at the Central Bank ↑ → Re ↑


1 1
→R↑→ ↓→  D  MS ↓
R R

Notes:

 Expansionary monetary policy (Loosening monetary policy): Increase supply of


money and lower interest rate

 Contractionary monetary policy (Tightening monetary policy): Decrease supply


of money and raise interest rate

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