Lecture 12 - Money Supply

Question 1

In this model, what are the exogenous variables? What does each exogenous variable depend on?

Answer 1

• monetary base, B (= C + R), controlled by the central bank
• reserve-deposit ratio, rr (= R/D), depends on regulations and bank policies
• currency-deposit ratio, cr (= C/D), depends on households’ preferences

Question 2

Show that M = (B(cr + 1))/(cr + rr)

Answer 2

• M = C + D
• M = ((C+D)B)/B
• M = B x ((C+D)/(C+R))
• then, (C+D)/(C+R) = (C/D+1)/(C/D+R/D)
• = (cr+1)/(cr+rr)
• therefore M = (B(cr + 1))/(cr + rr)

Question 3

What does m represent? What does m equal?

Answer 3

• the money multiplier
• m = (cr+1)/(cr+rr)

Question 4

Define m, the money multiplier

Answer 4

the increase in the money supply resulting from a one-pound increase in the monetary base

Question 5

How does the central bank manage the monetary base through open market operations?

Answer 5

• national currency is circulated or withdrawn by buying or selling government securities (i.e. gov bonds, foreign currency, gold)
• use new currency to buy assets or redeem old currency by selling assets in the open market

Question 6

How does the central bank manage the monetary base through the repo/refinance/discount/base rate?

Answer 6

• is the interest rate that the central bank charges for loans to other banks
• low repo rate means banks borrow more from CB and monetary base increases

Question 7

How does the central bank manage the money supply through reserve requirements?

Answer 7

• the central bank may impose a minimum reserve deposit ratio
• lowering the rr ratio requirement increases the money supply

Question 8

How does the central bank manage the money supply through interest on excess reserves?

Answer 8

• the central bank has ‘current accounts’ for banks to hold their excess reserves, which pays interest usually in line with the bank rate
• if interest paid on excess reserves is low, then banks want to keep less reserves deposited at the central bank and the rr ratio decreases (money increases)

Question 9

Independent central banks care about keeping the economy healthy, for example…

Answer 9

• price stabilisation
• output stabilisation
• low unemployment
• liquidity and smooth market functioning

Question 10

If the inflation rate is less than 1% or more than 3%, what does the BoE do?

Answer 10

write a formal letter to the Chancellor explaining why

Question 11

When did the Bank of England become independent?

Answer 11

1997

Question 12

Give 3 examples of ‘conventional’ monetary policy

Answer 12

• inflation targeting
• money growth targeting
• employment target, stable prices, and moderate long-term interest rates

Question 13

Typically, how is interest rate targeting achieved?

Answer 13

via open market operations: sales and purchases of short-term, safe government bonds

Question 14

If short term interest rates are low, then what does the central bank do?

Answer 14

buys bonds and increases monetary base

Question 15

When short term interest rates are near zero, are usual open market operations effective or not? Why?

Answer 15

• they are ineffective
• indifference between bonds and cash

Question 16

What is the difference between quantitative easing and credit easing?

Answer 16

• quantitative easing is the sales and purchases of longer-term, government bonds
• credit easing is the sales and purchases of corporate bonds and assets

Question 17

Give 3 ‘unconventional’ monetary policies

Answer 17

• quantitative easing
• credit easing
• forward guidance

Question 18

What is seignorage or the inflation tax?

Answer 18

printing money to raise revenue which causes inflation