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Lesson 28 Monetary Policy Continued

This document contains summaries of different tools of monetary policy used by central banks, including open market operations, changes to the discount rate, required reserve ratios, and interest rates on reserves. It discusses how each tool can be used to raise and lower money market interest rates depending on the initial level of rates, and how an interest rate corridor system limits fluctuations in money market rates.

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Usama Waqar
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11 views

Lesson 28 Monetary Policy Continued

This document contains summaries of different tools of monetary policy used by central banks, including open market operations, changes to the discount rate, required reserve ratios, and interest rates on reserves. It discusses how each tool can be used to raise and lower money market interest rates depending on the initial level of rates, and how an interest rate corridor system limits fluctuations in money market rates.

Uploaded by

Usama Waqar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Lesson 28

Monetary Policy Continued


Tools of Monetary Policy: open
market operation and The Money
Market Rate

Lecture No. 121


Open Market Operation

This tool is used to alter non-borrowed reserves

OMO sale and OMO purchase

Effect on money market rate depends on the initial level


of this interest rate
Effect of OMO Purchase when money market
rate is above floor rate
Money
Market rate

𝑖𝑑
𝑅1 𝑠 𝑅2 𝑠

1
f
𝑖𝑚 𝑟 1 2

𝑖𝑚 𝑟 2 2
f
𝑖𝑜𝑟 2
𝑅1 𝑑

Quantity of
𝑁𝐵𝑅1 𝑁𝐵𝑅2
Reserves, R
Effect of OMO Purchase when money market
rate is at floor
Money
Market rate

𝑖𝑑
𝑅1 𝑠 𝑅2 𝑠

1 2
𝑖𝑚 𝑟 1 = 𝑖𝑚 𝑟 2 = 𝑖𝑜𝑟 f f 𝑅1 𝑑
2 2

Quantity of
𝑁𝐵𝑅1 𝑁𝐵𝑅2
Reserves, R
In Nutshell

Open market purchase leads to fall in money market rate

Open market sale causes the money market rate to rise

Open market purchase does not affect money market rate if it is


already at floor
Open market sale may or may not affect money market rate if it is
already at floor
Tools of Monetary Policy: change
in discount rate and The Money
Market Rate
Lecture No. 122
Discount rate

The rate at which a central bank lend to commercial banks,


while performing its function as lender of last resort

Discount rate is ceiling on the money market rate

Effect on money market rate depends on the initial level of


money market interest rate
Effect of Change in Discount Rate when
money market rate is below ceiling rate
Money
Market rate

𝑖𝑑 1 𝑅1 𝑠

𝑖𝑑 2 𝑅2 𝑠

𝑖𝑚 𝑟 1 1
f
2
𝑖𝑜𝑟 𝑅1 𝑑

Quantity of
NBR
Reserves, R
Effect of Change in Discount Rate when
money market rate is at ceiling
Money
Market rate

1
𝑖𝑚 𝑟 1 =𝑖𝑑 1 𝑅1 𝑠
f
= 2 2
𝑖𝑚 𝑟 2 = 𝑖𝑑 2 𝑅2 𝑠
f
2

𝑖𝑜𝑟 𝑅1 𝑑

𝐵𝑅1
𝐵𝑅2

Quantity of
NBR Reserves, R
In Nutshell

Decrease in discount rate leads to fall in money market


rate if it is already at ceiling

Increase in discount rate leads to rise in money market


rate if it is already at ceiling

Changes in discount rate do not affect money market rate


if it is below ceiling
Tools of Monetary Policy: change in
required reserve ratio and The
Money Market Rate

Lecture No. 123


Required reserve ratio

Central banks set required ratio for deposits in


commercial banks

Increase in required reserve ratio increases reserves one-


for-one

Effect on money market rate depends on the initial level


of money market interest rate
Effect of increase in required reserve ratio
when money market rate is below ceiling rate
Effect of increase in required reserve ratio
when money market rate is at ceiling
Money
Market Rate

𝑖𝑚 𝑟 1 𝑅1 𝑠
1 2
f
2 f
2

𝑖𝑜𝑟 𝑅2 𝑑

𝑅1 𝑑

Quantity of
NBR Reserves, R
In Nutshell

Increase in reserve requirements causes rise in the


money market rate

Decrease in reserve requirements causes fall in the


money market rate

Changes in required reserve ratio do not affect money


market rate if it is at ceiling
Tools of Monetary Policy: change in
interest rate on reserves and The
Money Market Rate

Lecture No. 124


Interest rate paid on reserves

Excess reserves are now remunerated by central banks

Interest rate on excess reserves is below money market


rate; set as floor

Effect on money market rate depends on the initial level


of money market interest rate
Effect of increase in interest rate on reserves
when money market rate is above floor

Money
Market Rate

𝑅𝑠
𝑖𝑑

1
f
𝑖𝑚 𝑟 1
2 𝑅2 𝑑
2
𝑖𝑜𝑟 𝑅1 𝑑
𝑖𝑜𝑟

Quantity of
NBR Reserves, R
Effect of increase in interest rate on reserves
when money market rate is at floor

Money
Market Rate

𝑖𝑑 𝑅𝑠

𝑖𝑚 𝑟 2 = 𝑖𝑜𝑟 2 2 𝑅2 𝑑
f 𝑅1 𝑑
𝑖𝑚 𝑟 1 = 𝑖𝑜𝑟 1
21
f
2

Quantity of
NBR
Reserves, R
In Nutshell

Increase in interest rate on reserves causes rise in the


money market rate when money market rate is at floor

Decrease in interest rate on reserves causes fall in the


money market rate when money market rate is at floor

Changes in interest rate on reserves do not affect money


market rate if it is above floor
Tools of Monetary Policy: Interest
rate corridor and fluctuations in
money market rate

Lecture No 125
Interest rate corridor system

Central bank sets policy (target) rate and limits around it

Target for overnight interbank money market repo rate

Money market rate is bounded below by the interest rate paid to


commercial banks on excess reserves; Repo (Floor)
Money market rate is bounded above by the interest rate charged
from commercial banks on discount loans; Reverse Repo (Ceiling)
Large fluctuations in demand but limited
fluctuation in money market rate

Large changes in demand for reserves cause


only moderate changes in money market rate

Because of boundedness of money market


rate due to limits set by central banks
Effect of large shifts in demand for reserves
and fluctuation in money market rate
∗∗
Money Market 𝑅𝑑
Rate , ∗
𝑅𝑑 𝑅𝑑

∗∗
𝑅𝑠
𝑖𝑚 𝑟 = 𝑖𝑑

𝑖𝑚 𝑟 𝑇

𝑖𝑚 𝑟 , = 𝑖𝑜𝑟

NBR Quantity of
Reserves, R
In Nutshell

The interest rate corridor system limits


fluctuations of the money market rate
as it remains in the range of interest
rate paid on excess reserves and
interest rate charged on discount loans.

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