3. Monetary policy
†Now, typically the domain of central banks
†In most developed countries, central banks control interest rates
and money supply independently
†Both interest rates and money supply are closely linked
Monday, 26 March, 12
4. Central banks & money supply
†Central banks have three main ways to inïŹuence the supply of money
in an economy
†Directly increasing/decreasing money supply by selling/buying
government bonds (U.S., Europe, Japan)
†Raising/lowering deposit & lending rates (China)
†Changing commercial banksâ reserve ratio (China)
Monday, 26 March, 12
5. Interest rates
†Most countries have a âbaseâ interest rate, upon which all other
domestic rates (deposit rates, mortgage rates) depend
†Typically, these are target rates for overnight loans between banks
†Fed funds target rate in U.S. (zero-0.25%)
†Overnight call rate in Japan (0.10%)
Monday, 26 March, 12
6. Impact of interest rate
adjustments/open-market ops
Open-market Money supply All interest rates
PURCHASES UP DOWN
Open-market Money supply All interest rates
SALES DOWN UP
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9. U.S. Money Supply
February 2010 (provisional)
billions of 9,000
U.S. dollars Money Mkt Funds
Time Deposits
6,750
Savings
4,500 Deposits
2,250
M1
Currency
0
M1 M2
Source: U.S. Federal Reserve
Monday, 26 March, 12
11. Role of the banking system
†To channel individualsâ savings to others who want to borrow money
†To serve as a ïŹnancial intermediary
Monday, 26 March, 12
12. The Banking System
Prime rate
Home/car
Commercial
Bank Loans
Interbank Commercial
rate Bank
Interbank
Commercial market
Bank
Deposits
Commercial Deposit rate Home/car
Bank Loans
Finance
Open- Discount Business Company
Market window loans
Ops Discount rate Commercial
lending rate Money
Central Market Fund
Commercial
Bank Paper
Monday, 26 March, 12
14. Structure of the Banking System
†The central bank sets a target rate for overnight lending by banks
†Commercial banks borrow from each other to meet short-term needs
in the interbank market
†Commercial banks take deposits from individuals and lend out some of
those deposits
†Corporations issue short-term debt in form of commercial paper, which
is purchased by banks & money-market funds
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15. The âShadow Banking Systemâ
†Any non-bank ïŹnancial institution that is subject to less oversight
than traditional lenders like commercial banks
†Finance companies
†Money-market funds
†Hedge funds
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16. Interbank rates
†H.K.: Hong Kong Interbank Offer Rate (Hibor)
†U.K.: London Interbank Offer Rate (Libor)
†Fed sets Fed Funds target rate; supply/demand determine Hibor &
Libor
†Banksâ other lending rates often based on local interbank rate
Monday, 26 March, 12
17. Commercial Banks
†Take deposits †Make loans
†Deposits are banksâ liabilities †Loans (& reserves) are
assets
†Pay depositors interest
(deposit rate) †Banks keep some reserves,
lend out the rest
†Earn interest from
borrowers
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18. Reserve Ratio
†Typically set by the central bank
†Indicates the percentage of deposits a bank must keep as reserves
†In U.S., reserve ratio is now 10% for deposits above $55.2 million
†An increase in the reserve ratio forces banks to curtail lending, a
decrease leads to more lending and an expansion of the money supply
Monday, 26 March, 12
22. How the multiplier works
Original deposit $100
Jeffâs Bank lending $90 (.9 x $100)
Masatoâs Bank lending $81 (.9 x $90)
Wylieâs Bank lending $72.90 (.9 x $81)
etc. etc.
Total money supply $1,000
Monday, 26 March, 12
