Money and Monetary Policy

Question 1

Explain a Central Bank use of monetary policy

Answer 1

• Main tool is the nominal interest rate (IR targeting)
• Central Bank choose a rate of interest and adjusts it for economic condition changes
• Sets Sm at a level where r is at target
• This is done by buying/selling bonds to set Sm at the fixed rate

Question 2

Explain Open Market Operations

Answer 2

• To increase the Supply of Money, Central Banks will buy bonds which the banks lend out to consumers (reduces i)
• To decrease the Supply of Money, Central Banks will sell bonds which the banks lend out to consumers (increases i)

Question 3

What is the distinction between the Supply of Money and the Demand for Money?

Answer 3

• Supply of Money is controlled by the Central Bank
• Demand for Money is the amount of wealth held in money form
• This means that i is the opportunity cost of demanding money

Question 4

What shifts Sm?

Answer 4

• Central Bank decision on QE and interest rates

Question 5

What shifts Dm?

Answer 5

• Changes in aggregate spending, changes in transaction technology, changes in spending patterns

Question 6

What is the Money Equation?

Answer 6

• M = C + D
• Where C is money in circulation and D is checking deposits
• Central banks don’t direct create money by printing anymore; instead issue currency to commercial banks
• Banks and their customers create checking deposits

Question 7

What is a Monetary Base? What is the Base Equation?

Answer 7

• The Base is the total amount of money created by the central bank
• B = C + R
• Where C is money in circulation and R is bank reserves
• C & R are seen as liabilities to the private sector
• Currency circulation is the money that we have
• Reserves are in bank vaults and BoE deposits

Question 8

What are assets to the Private Sector

Answer 8

• Bonds
• Loans to Banks

Question 9

What are liabilities to the Private Sector

Answer 9

• Currency in Circulation
• Reserves

Question 10

What is the Money Supply Formula?

Answer 10

• M/B = (C+D) / (C+R)
• If you divide by D,
  M/B = [(C/D) + 1] / [(C/D) + (R/D)]
• Hence, M = [(C/D) + 1] / [(C/D) + (R/D)] X B

Question 11

If M= αB (where α>0), what is the formula for α?

Answer 11

• α = [(C/D) + 1] / [(C/D) + (R/D)]

Question 12

In Bank Runs, what happens to the multiplier and thus the Money Supply?

Answer 12

• In a bank run, people withdraw their deposits
• This reduces the α multiplier
• If B is constant, M will reduce
• R will increase from the Bank’s perspective

Question 13

What does increases in either R/D or C/D mean to α or M?

Answer 13

• Increasing either R/D or C/D will reduce α and thus reduce M

Question 14

What is a Reserve Requirement?

Answer 14

• Regulations that set a minimum ratio for the R:D level (can go above)
• Increasing the RR will decrease α and M

Question 15

How can Historical Case Studies by Examined (1929 WSC) ?

Answer 15

• Both R/D and C/D increased- (Higher reserves and increased Demand for Cash)
• Money Multiplier went from 3.8 to 2.4 in 3 years
• As base stayed fairly fixed, M fell by 33% and RGDP fell by 31%
• M fell due to actions of Public & Banks
• FED allowed M to fall; prioritised B
• Could have increased B which would have seen M fall less

Question 16

How can Historical Case Studies by Examined (2009 GFC) ?

Answer 16

• R/D increased, but C/D fell
• This could’ve been from QE or they may have learnt from mistakes
• However, Huge reduction in lending to reassess debt levels
• Learned to increase B and make M falling impact lower
• However, banks could sit on the money (multiplier turns to a divider)
• M was fairly stable from B increasing

Question 17

What does MRU say about What is Money?

Answer 17

• Money is a medium of exchange that can be used to purchase goods or services
• For an asset to be counted as ‘money’, it must be easily converted into cash (i.e. Stocks, Shares, Mutual funds)
• Monetary Base [Currency + Reserves]
• M1 [Currency + Checking/Savings Deposits]
• M2 [M1 + Other less liquid forms of money]
• Base is important, as it is the most easily affectable- but they must also manipulate M1 and M2 in the Long Run

Question 18

What does MRU say about the Money Multiplier?

Answer 18

• US reserve requirement must be at least 10% but can be higher if the firm wants to be more liquid
• System increases money supply as people who receive loans get the money in their bank account, which isn’t the case with a cheque
• The Money Multiplier (1/RR) is the amount of additional money created by an extra unit of deposit
• Central Bank has an indirect control of the money supply, and the money multiplier is often much lower than 1/RR, as during periods of low confidence banks can sit on money

Question 19

What does MRU say about the FED before 2009?

Answer 19

• Targeted the Federal Fund Rate (LIBOR) via open market operations
• To increase the money supply, the Central Bank would buy bonds, increasing the cash in an economy for banks to loan out, reducing the interest rate
• Communication of the central bank is vital in signalling their intentions of how they want markets to act

Question 20

What does MRU say about the FED after 2009?

Answer 20

• Falling IR and structural changes to industries meant that traditional OMO were flawed
• Hence, the Fed bought other assets to impact different sectors of the economy (mortgages, primes…)
• QE increases banks reserves and improves liquidity (1,350x increase since 2008 at $2bn)
• Fed put a rate on deposits held there to manipulate the market further
• Repo and Reverse Repo schemes were used in conjunction with OMO to control the Money Supply

Question 21

What does Tutor2U say about Liquidity Traps?

Answer 21

• A Liquidity trap is where low nominal interest rates fail to stimulate demand due to interest elasticity of demand being low
• Banks become risk-averse, so lend out less or charge more as a risk premium
• Confidence is often low in these times so the propensity to take out a loan is smaller
• To overcome a liquidity trap; Fiscal policy, QE to increase liquidity between banks, Negative nominal IR or changing the EXR