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Banks Central bank
Special functions in the economy Commercial banks
Profit making financial institutes
A B
Deposit Loan
Loan payment+
Interest payment
Deposit withdrawal+
Interest
Money Supply
M1 = Cash held by the public + Demand deposits in LBs
M2 = M1 + Savings and time deposits in LBs
+ NCD issued by LBs which held by the public
M3 = M2 + Deposits & NCD in RBs & DTCs
Money Supply Mr. A has $1,000 cash
Mr. A saves his $1,000 cash into saving deposit
The bank agrees to lend $1,000 to Mr. B (agreement made)
Mr. B cash out his loan $1,000 from the bank
Mr. B saves his $1,000 into the bank
MS = M1 = $1,000 (M1 = Cash = $1,000)
MS = M2 = $1,000 (M1 = Cash = $0) (M2 = M1 + Deposit in LB from
Mr. A= $1,000) MS = M2 = $1,000
Cash = $0 Mr. A’s deposit = $1,000
MS = M2 = $2,000 Cash = $1,000 Mr. A’s deposit = $1,000
MS = M2 = $2,000 Cash = $0 Mr. A & B’s deposit = $2,000
Deposit creation Through making saving and lending process
Bank gains from difference in interest Loan will lead to
Deposit Money supply (from $1,000 to $2,000 in above case)
The process is know as Deposit creation or Credit creation
The reserve system of banks In order to protect depositors, banks
Cannot lend out all the deposits Keep enough cash in case of withdrawal
Cash held by bank = Reserve (儲備 )
Reserve ratio = Reserve-to-deposit
Reserve ratio = x 100%
Calculation of reserve ratio Bank’s balance sheet
Cash: Assets held by the bank Deposits: Liabilities that the bank owes the depositors
Case 1 With cash reserves equals total deposits Reserve ratio = ($1000/$1000) x 100%
= 100%
Assets ($) Liabilities ($)
Cash reserves $1,000 Deposits $1,000
Calculation of reserve ratio
Case 2 The bank loan out $500 Cash reserves = $1,000-$500 = $500 Reserve ratio = ($500/$1000) x 100%
= 50%
Assets ($) Liabilities ($)
Cash reserves($1,000-$500) $500Loans(+$500) $500
Deposits $1,000
Calculation of reserve ratio
Case 3 The bank loan out $1,000 Cash reserves = $1,000-$1,000 = $0 Reserve ratio = ($0/$1000) x 100%
= 0%
Assets ($) Liabilities ($)
Cash reserves($1,000-$1,000) $0Loans(+$1,000) $1,000
Deposits $1,000
Calculation of reserve ratio
Try this: Given the deposit = $5,000 The bank loan out $3,000 Cash reserves = $5,000-$3,000 = $2,000 Reserve ratio = ($2,000/$5,000) x 100%
= 40%
Assets ($) Liabilities ($)
Cash reserves($5,000-$3,000) $2,000Loans(+$3,000) $3,000
Deposits $5,000
The minimum reserve requirement
The Gov’t sets a lowest limit to the reserve ratio To protect public interests Maintain stability of the financial system
Required reserve ratio (RRR) orMinimum reserve ratio
In US, RRR=10%, i.e. for every $100 saving the bank must keep $10 for cash reserve and the bank can loan out $90 for profit marking
The fractional reserve system
Fractional reserve system
Banks are required to hold only a portion of their deposits as reserves.
No need to hold all the deposits as reserve.
Can be loaned out for making profit.
The fractional reserve system and RRR
Country RRR(%) Remarks
United Kingdom None
Canada None
Australia None
New Zealand None
Japan 0.77
Taiwan 7.00
United States 10.00 No reserve required on savings accounts since 1990
Brazil 20.00Up from 15%, effective from 2010-12-06 - Ratio is for requirement on term deposits.RRR for foreign currency positions increased to 43.00 on 15/6/2010
China 20.00Ratio is for major Chinese Banks on 2012-05-12;[18] down from a 21.5% high in June 2011.Small and medium-size banks have a lower rate of 18.50%.
Hong Kong None Liquidity ratio ≥ 25% (Banking Ordinance – Sect.102)
Member of EU (e.g. Greece, Germany, etc.)
Subject to minimum reserve framework of the Eurosystem(http://www.ecb.int/mopo/implement/mr/html/calc.en.html)
Excess reserve Additional reserve apart from the required or Reserve hold by banks which is in excess of the required
reserve.
Excess reserve = Actual reserve – Required reserve
Example Given RRR = 20% and deposit = $1,000
Required reserve = $1,000 x 20% = $200If the bank hold reserve = $500Excess reserve = $500 - $200 = $300
This $300 excess reserve is not required to hold by the gov’t The bank decides to hold more in case of risk of cash withdrawal However, maximum loan drops from $800 to $500
Excess reserve Pros
More protection to depositor If bad debt, the bank cannot get back the loan
More confidence Low reserve ratio If any rumours, easy to have bank run
Cons Cash reserve makes no interest
Unable to earn from making loans Less ability to earn
Unfavourable to attract investors
Whether holding excess reserve or not?Risk vs. Return
Money supply with 100% reserve ratio In an economy without bank
MS = Cash only If gov’t issues $1,000 cash, MS = $1,000
Having a bank with 100% reserve $1,000 cash can be saved as deposits MS = $1,000
No loans can be made No additional deposit MS remains unchanged
Cash$1,000
Deposit$0
Money Supply$1,000
Cash$0
Deposit$1,000
Money Supply$1,000
Money supply with 100% reserve ratio Conclusion
With 100% reserve ratio Deposit is kept totally as cash reserve in bank Bank has no further money to make loan No loan No additional deposit MS remains unchanged
With 100%-reserve banking, the existence of banks does not affect the money supply. It only changes its composition.
In other words with reserve ratio < 100% MS
A model of deposit creation under a fractional reserve system
Assumptions ** Minimum reserve ratio < 100% No excess cash reserve,
bank loan out all the reserves in excess of the legal requirement Sufficient demand of loan
the public is willing to borrow money from the bank Public doesn’t hold cash
people deposit their loan into the bank No cash drain or leakage
A model of deposit creation under a fractional reserve system
Illustration Given required reserve ratio = 20% Assume Mr. A deposits $1,000 cash in a bank Balance sheet of the bank after the initial deposit :
Assets ($) Liabilities ($)
Reserves 1000 Deposits
1,000
A model of deposit creation under a fractional reserve system
Illustration 20% of deposit is reserved = $200 80% of deposit can be loan out = $800 Balance sheet of the bank after the initial deposit (w/ loan):
Money supply = $1,000
Assets ($) Liabilities ($)
Reserves Loan
200800
Deposits
1,000
A model of deposit creation under a fractional reserve system
Illustration Suppose Mr. B apply $800 loan from the bank Then he deposit the $800 into the bank Balance sheet of the bank after the second deposit:
Assets ($) Liabilities ($)
Reserves(+800)Loan
$1000
$800
Deposit(+800)
$1,800
A model of deposit creation under a fractional reserve system
Illustration 20% of deposit is reserved
= $200 + $160 = $360 80% of deposit can be loan out
= $800 + $640 = $1440 Balance sheet of the bank after the second deposit (w/ loan):
Money supply = $1,800
Assets ($) Liabilities ($)
ReservesLoan
3601,440
Deposits 1,800
A model of deposit creation under a fractional reserve system
Illustration Suppose Mr. C apply $640 loan from the bank Then he deposit the $640 into the bank Balance sheet of the bank after the third deposit:
Assets ($) Liabilities ($)
Reserves(+640)Loan
1,000
1,440
Deposit(+640)
2,440
A model of deposit creation under a fractional reserve system
Illustration 20% of deposit is reserved
= $200 + $160 + $128 = $488 80% of deposit can be loan out
= $800 + $640 + $512 = $1,952 Balance sheet of the bank after the third deposit (w/ loan):
Money supply = $2,440
Assets ($) Liabilities ($)
ReservesLoan
4881,952
Deposit 2,440
A model of deposit creation under a fractional reserve system
Illustration Suppose Mr. D apply $512 loan from the bank Then he deposit the $512 into the bank Balance sheet of the bank after the fourth deposit:
Money supply = $2,952
Assets ($) Liabilities ($)
Reserves (+512)Loan
1,000
1,952
Deposit(+512)
2,952
A model of deposit creation under a fractional reserve system
The public Change in deposits Change in loans[Deposit x (1-20%)]
1st $1000 $800
2nd $800
[$1000 x 0.8]$640
3rd $640
[$1000 x 0.82]$512
4th $512
[$1000 x 0.83]$409.6
5th $409.6[$1000 x 0.84]
$327.68
6th $327.68
[$1000 x 0.85]$262.144
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.
.
A model of deposit creation under a fractional reserve system
Total deposits:The
publicChange in deposits Total
deposits
1st $1,000 $1,000
2nd $1000 x 0.8 = $800 $1,800
3rd $1000 x 0.82 = $640 $2,440
4th $1000 x 0.83 = $512 $2,952
5th $1000 x 0.84 = $409.6 $3,361.6
6th $1000 x 0.85 = $327.86 $3,689.46
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...
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.
A model of deposit creation under a fractional reserve system
Total deposits
= $1,000 + $1,000(0.8) + $1,000(0.82) + $1,000(0.83) +…
By geometric progression
= $1,000 x
= $1,000 x [ i.e. Initial deposit x ]
= $5,000
A model of deposit creation under a fractional reserve system
Given that reserve ratio = 20% meaning that 80% of deposits can be loaned out
Total loans = Total deposits – required reserve
= $5,000 - $5,000 x 20%
= $5,000 x (1 – 20%)
= $5,000 x 80%
= $4,000
A model of deposit creation under a fractional reserve system
Illustration After many deposits and loans The final status of the bank’s balance sheet:
Money supply increase from $1,000 to $5,000 i.e. MS = $4,000
Assets ($) Liabilities ($)
ReservesLoan
1,0004,000
Deposit 5,000
Deposit creation and the banking multiplier
Given reserve ratio = 20%
Reserves = Deposits x Reserve ratio
Deposits = Reserves x
= Reserves x Banking multiplier
= Initial deposit x Banking multiplier
Money supply increase from $1,000 to $5,000 i.e. MS = $4,000
Assets ($) Liabilities ($)
ReservesLoan
1,0004,000
Deposit 5,000
$5,000 x 20%$1,000
$1,000 x $5,000
$1,000 x 5
Deposit creation and the bank multiplier
The banking multiplier
Banking multiplier =
Minimum reserve ratio (RRR) is the lowest reserve ratio
Max banking multiplier =
=
Money supply increase from $1,000 to $5,000 i.e. MS = $4,000
Deposit-creation ability and the banking multiplier
Deposits = Reserve x
Max. Deposits = Reserve
Example 1: Given the RRR is 20%. If a person saves $1,000 into the bank and the bank keeps the required reserves and loans out the remaining part, what is the maximum increase in deposits?Solution:
Max. Deposits = Reserve x = $1,000 x = $5,000
Money supply increase from $1,000 to $5,000 i.e. MS = $4,000
Example 2Below shows the balance sheet of a bank
a. Suppose there is no excess reserves, calculate i. the required reserve ratio andii. The maximum banking multiplier.
b. Suppose $500 cash is deposited into the bank, calculate the change in deposit.
Assets ($) Liabilities ($)
ReservesLoan
1,0004,000
Deposit 5,000
Example 2Below shows the balance sheet of a bank.
a. Suppose there is no excess reserves, calculate i. The required reserve ratio = x 100% = 20%ii. The maximum banking multiplier = = 5
b. Suppose $500 cash is deposited into the bank, calculate the change in deposit.
The change in deposit = Reserve = $500 x = $2500
Assets ($) Liabilities ($)
ReservesLoan
1,0004,000
Deposit 5,000
Example 3Below shows the balance sheet of a banking system.
Suppose the required reserve ratio is 20% and the public do not hold cash. Determine whether the following statements are true or false.a. The bank reserve ratio is 20%.b. The maximum amount of deposits is $12,500.c. The bank hold excess reserves of $100d. The bank can increase its loans by at most $1,000.
Assets ($) Liabilities ($)
ReservesLoan
7001,800
Deposit 2,500
Example 3a. The bank reserve ratio = x 100% = 28%
(The bank reserve ratio is 20%” is false.)
b. The maximum amount of deposits = Reserve = $700 x = $3500( The maximum amount of deposits is $12,500” is false)
c. Excess reserves held by the banks= Actual reserve - Required reserve= $700 – ($2,500 x 20%)= $700 - $500= $200( “The bank hold excess reserves of $100” is false.)
Example 3
d. Since excess reserve = $200
The banks can loan out the excess reserve.
The max. increase in loan
= Additional loan x banking multiplier
= $200 x = $1000
(‘ The bank can increase its loans by at most $1,000’
is correct.)
Example 4Fill in the balance sheet below to show the final situation if $1,000 cash in deposited into the banking system with required reserve ratio 25% without excess reserve.
Think about:i. What is the banking multiplier? = 4ii. The initial $1,000 deposit dollars is kept and used to support
the final deposit. Then what is the meaning of this $1,000 in the balance sheet? Reserves
iii. How much is the max deposit can be supported by this $1,000 in the banking system? $1,000 x 4 = $4,000
Assets ($) Liabilities ($)
ReservesLoan
1,0003,000
Deposit 4,000
Deposit-creation and money supply
MS = Cash held by the public (C) + Deposit (D)
MS = C + D
Given RRR = 20%If the public save $1,000 cash into the bank
Currency in circulation: $1,000 [i.e. C = - $1,000] Deposits: $5,000 [i.e. D = $1,000 x = $5,000]
MS = C + D = -$1,000 + $5,000
= $4,000
HKCEE 2009/Paper 1/Q.6Study the following balance sheet of a banking system.
Suppose the legal reserve ratio is 20%.a. Calculate the excess reserve of the banking system. (2 marks)
Excess reserve = $300 – ($1000 x 20%)= $100
b. Suppose all excess reserve is loaned out. Calculate the maximum possible amount of total deposits in the banking system. (2 marks)
Max. deposits = $300 x = $1500
c. Hence, calculate the change in money supply. (2 marks)Change in money supply = Change in cash (held by the public) + Change in deposit
= $0 + ($1500 - $1000)= $500
Assets ($) Liabilities ($)
ReservesLoan
300700
Deposit 1,000
Monetary base ( 貨幣基礎 / 銀根 )
MS = Cash held by the public + Total Deposit
MS = Cash held by the public + Initial deposits x
Monetary base
Total Deposit = Initial deposit x Banking multiplier = Reserves x Banking multiplier
= Reserves x
ExampleGiven RRR = 20%, Cash held by the public = $500 andInitial deposit = $1000.Find i. Monetary base & ii. Money supply
Solution:i. Monetary base = Cash held by the public + Initial deposits
= $500 + $1000= $1500
ii. Money supply = Cash held by the public + Deposits= Cash held by the public + Reserves x = $500 + $1000 x 1/0.2= $5,500
HKDSE Practice Paper 2/Q.14The following table shows the balance sheet of the banking system of an economy:
Suppose the public in this economy always holds $500 million cash and the banking system never holds excess reserves.
a. Calculate the monetary base and money supply of the economy. (2 marks)
b. Suppose the central bank lowers the minimum reserve ratio of the banking system by 5%.i. Explain whether the monetary base of the economy changes. (2 marks) ii. Calculate the new money supply. Show your working. (4 marks)
Assets ($million) Liabilities ($million)
ReservesLoan
10003000
Deposit 4000
HKDSE Practice Paper 2/Q.14The following table shows the balance sheet of the banking system of an economy:
a. Monetary base = $1 000 million + $500 million = $1 500 million (1)Money supply = $4 000 million + $500 million = $4 500 million (1)
b. (i) No, because (1) the policy affects neither the amount of reserves nor the cash held by the general public. (1)(ii) Before the policy change, the minimum reserve ratio = $4 000million / $1 000million = 0.25 (1) The new minimum reserve ratio = 0.25 – 0.05 = 0.2 (1) The banks will lend out the excess reserves. New deposits = $1 000 million x = $5 000 million (1) New money supply = $500 million + $5 000 million = $5 500 million (1)
Assets ($million) Liabilities ($million)
ReservesLoan
10003000
Deposit 4000
No. of banks and the form of loans do not affect deposit creation In reality, many banks Do not affect deposit creation
Loan from Bank A Deposit to Bank B Loan from Bank B Deposit to Bank C …
For details, read p.110
The public
Change in deposits Change in loans[Deposit x (1-20%)]
1st $1000 $800
2nd $800 $640
3rd $640 $512
4th $512 $409.6
5th $409.6 $327.68
6th $327.86 $262.144
. . .Deposit as a whole is not affected
Realistic assumption Assumptions of maximum deposit creation
1. Banks adopts fractional reserve system2. No excess reserves held by banks3. Sufficient demand of loans4. No cash drain / leakage
In real world: Only assumption 1 is true. Assumption 2. Reason: for risk management Assumption 3. Reason: interest rate loans Assumption 4. Reason: the public need cash
Violations of assumption Violation of assumption 2: Excess reserve
Banks usually hold excess reserve to reduce risk Actual reserve ratio Banking multiplier
Violation of assumption 3: Insufficient demand of loan High reserves Less amount for loan
Banks’ profit interest rate Demand of loan
Violation of assumption 4: Cash leakage The public holds cash less loan get back to the banks as deposit Deposit Loan Deposit creation can’t be maximized
Conclusion:Model of deposit creation
Assumption Able to have deposit creation?
Able to maximize deposit?
Fractional reserve system -
No excess reserves -
Sufficient loans -
No cash leakage -
Necessary conditions for maximizing deposit
Necessary condition for deposit creation
Reserve shortage What happen if Mr. A withdraws $100 from
the bank?
Total deposit = $5,000 - $100 = $4,900
Assets ($) Liabilities ($)
ReservesLoan
1,0004,000
Deposit 5,000
Assets ($) Liabilities ($)
Reserves(-100)Loan
900
4,000
Deposit(-100)
4,900
Reserve shortage
After withdrawal,
Reserve ratio = x 100% = 18.37% However, required reserve ratio (RRR) = 20% Not accepted by the law:
Actual reserve ratio < RRR necessary to increase reserves to fulfill the
minimum reserve requirement
Assets ($) Liabilities ($)
Reserves(-100)Loan
900
4,000
Deposit(-100)
4,900
Reserve shortage
If deposit = $4,900 & RRR = 20%
Required reserves = $4,900 x 20% = $980 However, after $100 withdrawal
Actual reserves = $900 Reserve shortage:
Actual reserves < Required reserves Amount of reserve shortage = $980 - $900
= $80
Assets ($) Liabilities ($)
Reserves(-100)Loan
900
4,000
Deposit(-100)
4,900
Deposit contraction( 存款收縮 )
Reserve shortage = $80, what can the banks do?
Recall loans The bank recalls loans from Mr. B = $80
Since bank holds 20% reserves & loans out 80% of deposit For every $1 withdrawal, the bank has to recall $0.8 of loans to
maintain sufficient reserves
Effect Mr. B doesn’t have cash
When a bank recalls loans, he needs to withdraw $80 from his deposit
Another round of reserve shortage occurs
Deposit contraction( 存款收縮 ) Reserve shortage:
Recall loans from Mr. B
Mr. B’s withdrawal
Assets ($) Liabilities ($)
ReservesLoan
9004,000
Deposit 4,900
Assets ($) Liabilities ($)
Reserves(+80)Loan(-80)
980
3,920
Deposit 4,900
Assets ($) Liabilities ($)
Reserves(-80)Loan
900
3,920
Deposit(-80)
4,820
Deposit contraction( 存款收縮 )
Withdrawal Change in deposits Change in loans
1st - $100 - $80
2nd - $80 - $64
3rd - $64 - $51.2
4th - $51.2 - $40.96
5th - $40.96 - $32.768
6th - $32.768 - $26.2144
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.
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Deposit contraction Initial withdrawal
Mr. A withdraws $100 from a bank To keep enough reserves, the bank recalls $80 from Mr. B
2nd round withdrawal Mr. B withdraws $80 from a bank to repay his debt To keep enough reserves, the bank recalls $64 from Mr. C
3rd round withdrawal Mr. C withdraws $64 from a bank to repay his debt To keep enough reserves, the bank recalls $51.2 from Mr. D
Deposit contraction and the banking multiplier
Deposits = Reserve x
Max. Deposits = Reserve
Deposits = Reserve x
= - $100 x
= - $500
Deposit contraction
Before withdrawal:
After withdrawal:Max. change of loans = Change in deposits – Change in reserves
= - $500 – [-$500 x 20%]
= - $500 x (1 – RRR)
= - $500 x (1 – 20%)
= - $400
Assets ($) Liabilities ($)
Reserves(-100)Loan(-400)
900
3,600
Deposit(-500)
4,500
Assets ($) Liabilities ($)
ReservesLoan
1,0004,000
Deposit 5,000
ExampleBelow is the balance sheet of the banking system. Suppose the bank has no excess reserves:
If a depositor withdraws $100 cash from the bank, what is the maximum change in the deposits?Answers:Reserve ratio = x 100% = 20%Change in deposits = Reserve x
= - $100 x
= - $500
Assets ($) Liabilities ($)
ReservesLoan
4001,600
Deposit 2,000
Assets ($) Liabilities ($)
ReservesLoan
3001,200
Deposit 1,500
Monetary policy
Interest
rate
Borrow $$ to buy car now? ( Yes / No )
Borrow $$ from the bank to expand production? ( Yes / No )
Apply mortgage to buy a house now? ( Yes / No )
Consumption
Investment Production
Monetary policy ( 貨幣政策 )
The central bank’s control of
1. the money supply or
2. the interest rate
to achieve certain economic objectives
MS = Cash held by the public + Deposits How to control the amount of cash in public? How to influence deposits?
I. Monetary policy tools
1. Issuing banknotes Cash held by the public
Money supply Cash
Deposit Reserves Loans Deposit creation
Money supply Most likely for MS increasing
I. Monetary policy tools
2. Minimum reserve requirement RRR
Cash reserves in banks Ability to make loans Deposits creation Money supply
RRR Cash reserves in banks Ability to make loans
Deposits creation Money supply
I. Monetary policy tools
3. Open market operation Controlled by central banks
Reserves and deposits at the central bank Operation with commercial banks Buying and selling gov’t bonds
I. Monetary policy tools3. Open market operation
a. Open market purchase Assume ABC Company (the public) holds gov’t bond Central bank buys bonds (worth $1million) by paying cheque
to ABC Co. ABC Co. deposits the cheque into commercial bank Central bank pays Bank A $1million for cheque clearing Deposit: Increase by $1 million Through deposit creation, MS
Central bank Bank A ABC Co.[holding Gov’t
bonds]
$1million
ChequeDeposit
Illustration
After the open market purchase:
In short, both reserves and deposits increase by $1 million.Given the RRR=20%Total Deposits = Initial deposits x Banking multiplier
= $1,000,000 x
= $5,000,000 Ms = Cash + Deposits
= $0 + $5,000,000= $5,000,000
Assets ($) Liabilities ($)
Reserves +1,000,000 Deposits +1,000,000
I. Monetary policy tools3. Open market operation
b. Open market sale Gov’t sell bonds to the public ABC Company bank buys bonds (worth $1million) by paying
cheque to the central bank Central bank withdraws $1million for ABC’s account Deposit: decrease by $1 million Through deposit contraction, MS
Central bank Bank A ABC Co.[holding Gov’t
bonds]
$1million
Deposit
$1million
I. Monetary policy tools4. Discount rate
Interest rate (Cost) of loan from the central bank to commercial banks
If discount rate Cost of loan Commercial banks: less incentive to borrow
Loan out Deposit Reserve Ability of deposit creation Ms
Conclusion: Discount rate Reserves and Ms
I. Monetary policy tools4. Discount rate
If discount rate Cost of loan Commercial banks: more incentive to borrow
Loan out Deposit Reserve Ability of deposit creation Ms
Conclusion: Discount rate Reserves and Ms
Conclusion: Monetary policy tools
Money Supply
Open market operations
Discount rate
Minimum reserve ratio
Issuance of banknotes
Monetarypolicytools
Cash held by the public
Commercial banks’ deposits at the
central bankReserves Deposits
II. Controlling of interest rateEffects on interest rate
If Gov’t sell bonds,
Ms (i.e. capital in the market flow towards the central bank)
Deposit
Reserve
Loanable fund in the market Interest rate
Quantity of money
Interest rate (%)
0
MS1
MS2
Q1
r1
r2
Md
Q2
II. Controlling of interest rate By controlling Ms,
the gov’t indirectly controls interest rate affect the incentive of loan making
Relationship:
Ms interest rate
Ms interest rate
Types of monetary policy
Carry out by the central bank Expansionary monetary policy Contractionary monetary policy
Monetary policy
Types Expansionary Contractionary
Central bank controlsMoney supply Interest rate
Money supply Interest rate
Tools
Open market operation Buy bonds Sell bonds
Discount rate
Minimum reserve ratio
Issuance of banknotes
Effects of monetary policy
Expansionary monetary policy ( Ms , r ) Banks have more to loan out More people are willing to borrow
Consumption Investment
GDP
Gov’t uses expansionary monetary policy to booth the economic growth E.g. the US Gov’t adopted QE (Quantitative ease) in 2008
& QE2 policies in 2010
Effects of monetary policy
Expansionary monetary policy ( Ms , r ) Pros
GDP Consumption Investment
Employment Investment Firms will hire more labour
Cons Inflation
Consumption Demand of goods Price
Effects of monetary policy
Contractionary monetary policy ( Ms , r ) Banks have less to loan out With high interest rate, less people make loan
Consumption Investment
GDP
Gov’t uses contractionary monetary policy to prevent overheated economy
Effects of monetary policy
Contractionary monetary policy ( Ms , r ) Pros
Avoid economic overheat Investment Production
Avoid inflation Consumption Demand of goods Price
Cons Unemployment
Investment
Firms will not hire or even lay off excess labour
Monetary policy in Hong Kong Easy to be affected by foreign economies No HK bonds buying or selling
Linked exchange rate system Aim at keeping exchange rate: HKD7.8 = USD 1 Operation:
Linked exchange rate [ HKD7.8 = USD1 ]
Exchange rateHKD exchange rate[ HKD7.5 = USD1 ]
HKD exchange rate [ HKD8 = USD1 ]
HKMA’s actionSell HK Dollar
- to lower the price of HKD- Maintain HKD7.8 = USD1
Buy HK Dollar- to raise the price of HKD- Maintain HKD7.8 = USD1
Result Ms Ms
Monetary policy in Hong Kong Conclusion
Issuance of banknotes - usually around Chinese New Year
Minimum reserve ratio- Liquidity ratio ≥ 25%
Discount rate- Replaced by HIBOR (Hong Kong Inter-bank offered rate)
Open market operation Replaced by the “Linked Exchange Rate System” Chance to be attacked by global speculators, lost the
function of controlling money supply