The document discusses monetary policy tools and money supply. It explains that central banks use tools like open market operations, adjusting reserve requirements and the discount rate to influence money supply and interest rates. Changing the monetary base through open market purchases affects money multiplier and money supply. Raising reserve requirements shifts demand for reserves right, raising rates. The discount rate only impacts rates if banks borrow, otherwise it has no effect. Money supply (M2) in Bangladesh grew 5.31% in 2017 to support growth while absorbing inflation.

1. Lecture 2
Monetary Policy
(Multiple Deposit Creation and
the Money Supply Process
& Tools of Monetary Policy)

2. Monetary Policy
•Monetary policy refers to
•systematic actions taken by a central bank
•affecting money supply, interest rates and
exchange rate,
•in order to influence inflation
•to ensure economic growth
•through achieving high output growth and
low unemployment.
13-2

3. Goals of Monetary Policy
•Six goals are continually mentioned by
central bank officials when they discuss the
objectives of monetary policy:
•(1) Price Stability
• (2)high employment and output stability
•(3) economic growth
•(4) stability of financial markets
•(5) interest-rate stability
•(6) stability in foreign exchange markets
But Goals often conflict

4. Conflict Among Goals
•Many of the goals mentioned are consistent with each
other as, for example,
•high employment with economic growth, and i
stability with financial market stability.
•However, P stability is in conflict with i stability and low u
in the short run (may not be in the long run).
•For example, when the economy is expanding and u 
both  and i may start to . If the Bank tries to prevent
an  in i, this may cause the economy to overheat and
stimulate . But if the Bank  i to prevent , in the short
run u may .
•The conflict among goals may thus present central banks
with some hard choices!

5. Money Supply
•The total amount of money in circulation, or in
existence, in a country.
•Components of money supply:
•1. Currency Outside banks
•2. Deposits of Financial Institutions with
Bangladesh Bank
•3. Demand Deposits with Financial Institutions
•4. Time Deposits with Financial Institutions
•5. Money Supply (M1) (1+2+3)
•6. Money Supply(M2) (4+5)
13-5

6. Monetary Aggregates
Currency
Traveler’s Checks
Demand Deposits
Other Check. Dep
M1 (4)
M2 (4+3)
M3 (4+3+4)
Small Den. Dep.
Savings and MM
Money Market Mutual
Funds Shares

7. Money Supply (contd.)
•movements in the money supply affect
interest rates and the overall health of the
economy.
•important to understand
•how the money supply is determined.
•Who controls it?
•What causes it to change?
•How might control of it be improved?
13-7

8. Players in the Money Supply Process
•Central bank (Federal Reserve System)
•Banks (depository institutions; financial
intermediaries)
•Depositors (individuals and institutions)
•Borrowers (individuals and institutions)
13-8

9. Central Bank’s Balance Sheet
•Monetary Liabilities
• Currency in circulation—in the hands of the public
• Reserves—bank deposits at the Fed and vault cash in banks
•Assets
• Government securities—holdings by the Fed that affect money
supply and earn interest
• Discount loans—provide loans to banks and earn the discount
rate (the interest rate that Fed charges banks for these loans)
13-9
Federal Reserve System
Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves

10. Monetary Base
13-10
High-powered money
= +
= currency in circulation
= total reserves in the banking system
MB C R
C
R
• The first two liabilities on the balance sheet.
• Increase in it will lead to a multiple increase
in the money supply.
• Also called:

11. Multiple Deposit Creation
13-11
When the Central Bank supplies the
banking system with $1 of additional
reserves, deposits increase by a multiple of
this amount; the process called multiple
deposit creation.
Example: Fed made a $100 open market
purchase from First National Bank.

12. Deposit Creation: Single Bank
Excess reserves increase
Bank loans out the excess reserves
Creates a checking account
Borrower makes purchases
The money supply has increased
13-12
A. First National Bank B. First National Bank
Assets Liabilities Assets Liabilities
Securities -$100 Securities -$100 Checkable
deposits
+$100
Reserves +$100 Reserves +$100
Loans +$100
C. First National Bank
Assets Liabilities
Securities -$100
Loans +$100

13. Deposit Creation: The Banking System
13-13
Bank A Bank A
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable
deposits
+$100 Reserves +$10 Checkable
deposits
+$100
Loans +$90
Bank B Bank B
Assets Liabilities Assets Liabilities
Reserves +$90 Checkable
deposits
+$90 Reserves +$9 Checkable
deposits
+$90
Loans +$81

14. 13-14

15. Critique of the Simple Model
•Holding cash stops the process
•Banks may not use all of their excess
reserves to buy securities or make loans
13-15

16. M m MB
 
The Money Multiplier
•Define money as currency plus checkable
deposits: M1
•Link the money supply (M) to the monetary
base (MB) [i.e., currency in circulation plus
total reserves in the banking system] and,
• Let m be the money multiplier; which tells us
how much the money supply changes for a
given change in the monetary base MB

17. Deriving the Money Multiplier

18. Intuition Behind Money Multiplier

19. 15-19
Tools of Monetary Policy
•Open market operations
•Affect the quantity of reserves and the monetary base
•Changes in the discount rate
•Affect interest rates and the monetary base by
influencing the quantity of discount loans
•Changes in reserve requirements
•Affect the money multiplier
Federal funds rate (iff)—the interest rate on
overnight loans of reserves from one bank to
another

20. 13-20
Figure 1: Equilibrium in the market for reserves

21. How Changes in the Tools of Monetary Policy
Affect the Federal Funds Rate: Open Market
Operation
•An open market purchase leads to a greater
quantity of reserves supplied because of the
higher amount of non-borrowed reserves, which
rises from R1n to R2n.
•An open market purchase therefore shifts the
supply curve to the right from Rs1 to Rs2 and
moves the equilibrium from point 1 to point 2,
lowering the federal funds rate from i1ff to i2ff
(see Figure 2).
13-21

22. 13-22
Figure 2: Response to an open market operation

23. How Changes in the Tools of Monetary Policy
Affect the Federal Funds Rate: Open Market
Operation (contd.)
•Similarly, an open market sale decreases the
quantity of reserves supplied, shifts the supply
curve to the left and causes the iff to rise.
•The result is that an open market purchase
causes the federal funds rate (iff) to fall,
whereas an open market sale causes the
federal funds rate (iff) to rise.
13-23

24. How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate:
Discount Rate
•The effect of a discount rate change depends on whether
the demand curve intersects the supply curve in its vertical
section versus its flat section.
•Panel (a) in Figure 3 shows what happens if the intersection
occurs at the vertical section of the supply curve:
•So, there is no discount lending.
•In this case, when the discount rate (id) is lowered by the
Fed from i1d to i2d, the vertical section of the supply curve
where there is no discount lending just shortens, as in
Rs2, while the intersection of the supply and demand
curve remains at the same point (Point 1).
•Thus, in this case there is no change in the equilibrium
federal funds rate (i ), which remains at i .
13-24

25. 13-25
Figure 3: Response to a change in discount rate

26. How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate:
Discount Rate (contd.)
•Because this is the typical situation—since the Fed now
usually keeps the discount rate above its target for the
federal funds rate—the conclusion is that:
•most changes in the discount rate have no effect on the
federal funds rate.
13-26

27. How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate:
Discount Rate (contd.)
•If demand curve intersects supply curve on its flat section:
•So there is some discount lending, as in Panel (b) of Figure
3, changes in the discount rate (id) DO affect the federal
funds rate.
•In this case, initially discount lending is positive and the
equilibrium federal funds rate equals the discount rate, i1ff=
i1d.
•When the discount rate is lowered by the Fed from i1d to
i2d, the horizontal section of the supply curve Rs2 falls,
moving the equilibrium from point 1 to point 2, and the
equilibrium federal funds rate falls from i1ff to i2ff (= i2d) in
Panel b. 13-27

28. How Changes in the Tools of Monetary Policy
Affect the Federal Funds Rate: Reserve
Requirement
• When the required reserve ratio increases, required
reserves increase and hence the quantity of reserves
demanded increases for any given interest rate.
• Thus, a rise in the required reserve ratio (Figure 4)
•shifts the demand curve to the right from Rd1 to Rd2 in,
•moves the equilibrium from point 1 to point 2, and
•in turn, raises the federal funds rate from i1ff to i1ff.
• The result is that,
•when the Fed raises reserve requirements, the federal
funds rate (iff) rises.

29. 13-29
Figure 4: Response to a change in reserve requirement

30. Advantages of Open Market Operations
•The Fed has complete control over the volume
•It is Flexible and precise
•Can be Quickly implemented
•Can be Easily reversed

31. Advantages and Disadvantages of Discount
Policy
•Used to perform role of lender of last resort
•Cannot be controlled by the Fed; the decision
maker is the bank
•Discount facility is used as a backup facility to
prevent the federal funds rate from rising too far
above the target

32. Disadvantages of Reserve Requirements
•Can cause liquidity problems
•Increases uncertainty for banks

33. Bangladesh context

34. Money Supply
•M2 is a measure of money supply that includes cash
and checking deposits (M1) as well as near money
(savings deposits, money market mutual funds and
other time deposits, which are less liquid and not as
suitable as exchange mediums but can be quickly
converted into cash or checking deposits).
•The broad money recorded of Taka 10160.77 billion
at the end of April-June 2017 term; an increase of
5.31% from Taka 9648.22 billion at the end of Jan-
March 2017
•This stance of money supply complies with the
growth target, absorbs moderate inflation, and
finally takes required level of monetization into
account.

35. Money Supply (contd.)
•The twelve-month average inflation pushed
up to 5.44 percent in June 2017 from 5.39%
in March 2017.
•The weighted average call money rate in the
inter-bank money market moved within the
range of lowest 1.75% to highest 4.50%.
•Reserve money recorded at Taka 2246.59
billion during Apr-Jun 2017; a 16.64%
increase from Taka 1926.13 billion at the
end of Jan-Mar 2017.

36. Monetary Policy
•Monetary policy in Bangladesh is framed using
projected real GDP growth rate.
•The targeted rate of inflation adopts Reserve
Money (RM) and Broad money (M2) as operating
and intermediate targets respectively.
•The RM is influenced by the indirect market based
instruments such as CRR, SLR, repo, reverse repo,
open market operation and moral suasion.

37. Bank Rate, Repo & Reverse Repo
• The bank rate (or discount rate) is used by commercial banks when
they borrow money from the central bank because of the anticipated
shortage of funds in these banks.
• Repo is used in a banking transaction like a repurchase agreement
where central bank sells securities to commercial banks and agrees to
repurchase these securities after a certain period of time at a pre-
defined price. The interest rate used in these securities for repurchase
is known as a repo or repurchase rate.
• Reverse Repo rate is the short term borrowing rate at which central
bank borrows money from commercial banks. Central bank uses this
tool when it feels there is too much money floating in the banking
system. An increase in the reverse repo rate means that the banks will
get a higher rate of interest from BB.
• Bank rate is a long term concept whereas Repo or Reverse Repo are
short term concepts.

38. Tools of Monetary Policy
•The most recent changes on repo and reverse repo
rates were made on 14 Jan 2016; that Repo rate
6.75% and Reverse Repo rate 4.75%
•The Cash Reserve Requirement (CRR) for the
scheduled banks with the Bangladesh Bank
remained unchanged at 6.50% of their total demand
and time liabilities for implementing the objectives
of Monetary Policy. Banks are required to maintain
CRR at the rate of 6.50% on average on bi-weekly
basis provided that the CRR would not be less than
6.00% in any day (with effect from 24 June 2014).

39. Tools of Monetary Policy (contd.)
•According to the amendment of subsection (2)
under section 33 of Bank Company Act, 1991,
banks should have maintained statutory liquidity
ratio separately as follows:
•for the conventional banks, the statutory liquid assets
inside Bangladesh which also includes excess reserves
with Bangladesh Bank shall not be less than 13.0% of
their total demand and time liabilities, and
•for the Shariah based Islami banks, this rate shall not
be less than 5.5% (effective from 1 February, 2014).
•The bank rate remained unchanged at 5.0 percent
in FY16. This rate has been in effect from 6
November 2003.