Introduction to Monetary Policy

By Taha Bhatti

As talk around monetary policy, interest rates and quantitative easing run rampant, it is important to take a step back and find calm in the midst of chaos. In this article we take a look at the mechanics behind the monetary system. First, we understand the fractional-reserve banking system and the cycle of money. Second, we look at the role of central banks, including their goals, strategies and impacts. Finally, we take a look at the potential problems and consequences that central banks have to face.

1. Fractional-reserve banking system

Practiced by the majority of commercial banks globally, fractional-reserve banking is a system by which banks retain a fraction of their deposits as a ‘reserve’, lending out the remainder to borrowers. It is a process of creating money in order to theoretically expand the economy.

To illustrate, let’s say Stacy deposits $1000 into her bank. The bank reserves $100 (assuming 10% reserve requirement) and lends out the remaining $900 to Tom as a loan. Tom then buys a basketball hoop from Clarke for $900. Although the bank only has $100 of liquid assets (reserves), there is $1900 of money supply in the system. Now let’s say Clarke deposits that $900 into his bank, the cycle has just started again.

fractional reserve banking system monetary policy — Visual representation of fractional reserve banking.

This continues until the original $1000 deposit has become $10,000. In other words, the initial money has been multiplied by a factor of 10.

Although this is a powerful tool for generating profit, it relies on the vital assumption that depositors will not withdraw their money at the same time, as the bank may not have enough liquid assets (reserves) to pay everyone.

The general system

Now that we have a basic understanding of the fractional-reserve banking system, we can gain a clearer perspective of the system at play.

Within this system are transactions between the central bank, financial intermediaries (e.g. banks), and the public (individuals and firms). Transactions between and within these participants may include lending, borrowing, purchasing and selling. For example, the central bank may buy securities from banks, or financial intermediaries may lend to one another through overnight market operations (more on this later).

Tools of Monetary Policy - by Ahiliya Nat [Infographic]

In a healthy economy, the money flows through these participants freely and efficiently. However, as soon as some transactions slowdown, it creates a ripple effect throughout the economy. The speed of which money flows through the economy is the velocity of money. Think of the system as a human body with blood flowing to all parts efficiently. As soon as there is a blockage, the entire body suffers the pain.

What is a blockage and how is it created?

Blockages are a slowdown in transactions and typically arise as a result of deteriorating consumer confidence. For example, commercial banks may decide to reduce the availability of loans to both the public and other banks as they anticipate a rise in defaults. This was the case in the 2008 credit crunch, which was driven by a sharp rise in defaults on subprime mortgages. This decrease in loan availability created blockages in the system which restricted the flow of money and therefore slowed down the economy.

2. The role of central banks

The long-term goals of central banks are to:

Promote sustainable output and employment
Promote stable prices (control inflation)

Machine generated alternative text:
FRED
Consumer Price Index for All Urban Consumers: All Items in U.S. City Average
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15.0
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Shaded areas indicate U.S. recessions
Source: U.S. Bureau of Labor Statistics
fred.stlouisfed.org — Greyed areas mark periods of recession.
Consumer Price Index (CPI) for Urban Consumers – All Items in U,S. City Average
Inflation targeting has helped stabilise prices in modern times.

Source: St. Louis Fed

Strategy to achieve goals

In order to achieve their long-term objectives, the immediate goal of central banks is to maintain liquidity in the system. Through effective monetary policy, central banks can adjust money supply, which supports long term economic growth and therefore employment.

In order to combat a slowdown in the velocity of money, the central bank may increase the money supply. Think of this as an injection to fix the blockages restricting blood flow in the body. As the supply of money (credit) in the system increases, the price of borrowing (interest rates) decreases, fueling economic growth. This is also known as expansionary policy.

On the other hand, central banks may decrease the money supply to restrain an inflationary boom. As the supply of money (credit) in the system decreases, the price of borrowing (interest rates) increases, restricting economic growth, and therefore inflation. This is known as contractionary monetary policy.

velocity of money and nominal gdp — As velocity of money decreases, central banks aim to increase the money supply to limit GDP contraction.

How interest rates impact the economy

Interest rates impact all areas of the economy, some may include:

Spending behaviour: An increase in interest rates may discourage discretionary spending from consumers who may prioritise cash reserves (for example paying off mortgage rather than discretionary spending).
Availability of credit: A decrease in interest rates may encourage borrowing/lending in firms and households and increase the velocity of money.
Asset prices: Increased liquidity in the system may increase speculative investments and make its way to financial markets.
Exchange rate: Higher interest rates (return for lenders), may attract foreign capital investment, causing the exchange rate to rise.
Inflation: A decrease in interest rates, resulting in an increase in aggregate demand through factors mentioned above, may increase the level of inflation in the economy. (Note: There are many factors that may alter this relationship, which can be discussed another time).

Graph 3 — Some of the most important relationships affecting interest rates.

How do central banks adjust money supply?

The central bank has two main weapons in its arsenal to undertake monetary policy:

Reserve requirements of banks

Explanation: Amount of money banks are legally required to hold in order to cover withdrawals. The money multiplier has an inversely proportional relationship with the reserve requirement.

Expansionary policy: A decrease in the reserve requirement may increase the percentage of deposits banks lend out, and therefore increase profit made via the fractional-reserve banking system. This increase in money supply decreases interest rates and fuels economic growth.

Contractionary policy: An increase in the reserve requirement may decrease the percentage of deposits banks lend out, and therefore decrease profit made via the fractional-reserve banking system. This decrease in money supply increases interest rates and restricts economic growth.

Open Market Operations

Explanation: Banks may lend out too much on a certain day and need to borrow funds overnight to meet reserve requirements. They usually borrow from other financial intermediaries through overnight market operations (loans). The rate charged in these loans is the overnight rate (also known as the federal funds rate in the US, or the cash rate in Australia). A target overnight rate is the primary objective of monetary policy, as it influences other interest rates throughout the economy, fuelling economic activity.

effective funds rate and interest rate IMF St louis fed — A sharp decrease in the federal funds rate can be noticed in recessionary periods in the U.S.

Source: St. Louis Fed

In standard monetary policy, open market operations involve the central bank buying/selling short term government securities (i.e. treasury bills) from/to banks in order to influence the supply of funds available to banks in the money market.

Expansionary: The central bank may digitally print money and buy short term bonds from banks overnight, injecting money into the system. This is an expansion of its balance sheet. This increase in money supply decreases overnight rates, and consequently fuels economic growth.

Contractionary: Similarly, the central bank may sell short term bonds overnight to banks, restricting money supply in the system. This is a contraction of its balance sheet. This reduction in money supply increases overnight rates, slowing down the economy in order to control inflation (less demand for goods).

Open Market Operations - AP Monetary Policy — Visual representation of open market operations

What happens when the overnight rate is already too low?

A modern solution to the liquidity trap is quantitative easing.

Explanation: This unconventional method is being implemented in modern times as a result of ineffective standard monetary policy. When the interest rate is already extremely low, decreasing it will be inefficient – a situation called the liquidity trap. The only option left is for the central bank to buy up longer term assets i.e. long-term bonds or mortgage backed securities, as opposed to standard short-term (overnight) government bonds i.e. treasury bills. These additional assets allow the central bank to target long term rates (rather than overnight rates) as well as specific parts of the economy.

For example, buying mortgage securities can imply that lower interest rates also translate to lower mortgage interest rates, which will help home buyers. Buying these assets will inject money into commercial banks, who may feel confident to lend/borrow and fix the blockage in the system. Buying long term bonds should also increase their price (demand increases), which will in turn decrease yields. A decrease in yields may encourage speculative activity in riskier assets, such as the stock market (as compared to bonds). This can discourage banks from investing increased liquidity in government bonds, effectively a saving mechanism which does not prevent the blockage of money flow in the system.

On the other hand, quantitative tightening is when the central bank sells longer term assets, or in the case of bonds, let’s them expire. This reduces money supply for banks, which increases interest rates, slows down economic activity and reduces inflation.

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FRED
Assets: Total Assets: Total Assets (Less Eliminations From Consolidation): Wednesday Level
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Shaded areas indicate U.S. recessions
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fred.stlouisfed.org
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Board of Governors of the Federal Reserve System (US) — The U.S. Federal Reserve balance sheet

Source: St. Louis Fed

3. Issues faced by central banks

Because of the lag between expansionary policy and its consequences (mainly inflation), central banks can technically inject as much money as they like within this period. Increasing the money supply becomes progressively challenging for central banks. Dramatically increasing the money supply may amplify the effects increased money velocity has on inflation (MV=PQ).

Digital printing of US dollars could depreciate the value of the dollar, which is an issue for foreign investors holding US dollars (e.g. China). Why QE hasn’t led to inflation in the past few years is a discussion for another time, but excess reserves in depository institutions may have a part to play.

The most pertinent factor is that the whole system is reliant on consumer confidence. If firms, businesses, and individuals become risk averse and decide to save, the velocity of money slows down, and if they all decide to withdraw, banks fail. At the end of the day you can’t force people to spend money despite how much money you throw at them. Because we can’t control consumer behavior, and how quickly they spend, velocity of money is often a given.

The central bank can only really control money supply, and if consumer confidence spirals out of control, it will need an arsenal to both limit the damage and foster new growth. Let’s look at two elements of consumer confidence that may significantly increase the carnage central banks have to deal with.

As the federal reserve increases money supply, depository institutions increase excess reserves. Not all excess money finds its way through the system.

Source: St. Louis Fed

As the velocity of money drops, the Federal Reserve increases the money supply.

Source: St. Louis Fed

Defaults: In a recessionary environment with falling asset prices, we expect to see an increase in defaults, these reduce money supply and create the need for further expansionary policy. Let’s revisit our fractional-reserve banking scenario, if Tom defaults on the $900 he borrowed, the money supply decreases from $1900 to $1000, and banks lose profit. Again, the central bank injects further money supply to fix the damage, the expansion continues, and its consequences become more likely.

Greyed areas mark periods of U.S. recessions,
During recessions, there is an increase in delinquency rates.

Source: St. Louis Fed

Withdrawals: In extreme circumstances, consumers start to lose confidence in the financial stability of banks, and may start to convert their deposits into cash, resulting in a banking panic. If Stacy and Clarke both withdraw their money at the same time, the bank doesn’t have enough liquid assets to pay them, and it fails. This creates additional pressure for central banks to limit disastrous consequences. The banking panic was a major catalyst for the great depression, resulting in a rapid decrease in money supply.