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
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4. Central banks & money supply
✤ Central banks have three main ways to influence 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 banks’ reserve ratio (China)
Monday, 26 March, 12
5. Interest rates
✤ Most countries have a “base” 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%)
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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
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11. Role of the banking system
✤ To channel individuals’ savings to others who want to borrow money
✤ To serve as a financial intermediary
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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
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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 “Shadow Banking System”
✤ Any non-bank financial 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
✤ Banks’ other lending rates often based on local interbank rate
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17. Commercial Banks
✤ Take deposits ✤ Make loans
✤ Deposits are banks’ 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
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22. How the multiplier works
Original deposit $100
Jeff’s Bank lending $90 (.9 x $100)
Masato’s Bank lending $81 (.9 x $90)
Wylie’s Bank lending $72.90 (.9 x $81)
etc. etc.
Total money supply $1,000
Monday, 26 March, 12
