Lecture 10 Monetary Policy

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Lecture 10
Monetary Policy
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Monetary Policy

• Monetary policy is the process by which
  the monetary authority ( Central Bank , For
  example- Bangladesh Bank ) of a country controls
  the supply of money for promoting economic growth
  and stability. When the govt. changes the money
  supply it will affect the interest rate and which
  turn affect the economic growth, employment and
  inflation. Monetary theory provides insight into
  how to craft optimal monetary policy.
• There are two types of monetary policy
• 1) Expansionary monetary policy  
• 2) Contractionary Expansionary policy

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Expansionary Monetary Policy

• Expansionary Monetary Policy It is a monetary
  policy that increase the total supply of money in
  the economy to stimulate the economy
  .Expansionary policy is used to
  reduce unemployment in a recession. When the
  central bank increases money supply, interest
  rate will decrease which will increase
  investment. As a result there will be employment
  generation and aggregate expenditure will
  increase.

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Expansionary Monetary Policy
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Contractionary Monetary Policy

• Contractionary Monetary Policy It is a monetary
  policy that decrease the total supply of money
  in the economy to achieve stability like
  reducing inflation.
• When the central bank decreases money supply,
  interest rate will increase which will decrease
  investment and consumption. As a result the
  aggregate demand decreases and which leads to a
  decrease in price level, that means inflation
  will be reduced.

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Contractionary Monetary Policy
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Tools of Monetary Policy
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Discount rate and Supply of money by banks
Discount rate the interest rate that the
central bank charges on the commercial banks.


If the central bank reduce the discount rate then
the commercial banks will be willing to borrow
more from central bank and then provide more loan
to individuals. So money supply increases. On
the other hand if the central bank increase the
discount rate then the commercial banks will
reduce their borrowing from central bank and also
provide less loan to individuals. So money supply
decreases.
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Required reserve ratio and Supply of money by bank
Required reserve ratio (RRR) percentage of
deposits that is required by the commercial bank
to keep as reserves in the central bank.


Example if RRR 10 , of an initial deposit Tk
100 Required reserve Tk 100 10 Tk
10 Excess reserves Tk 100 -10 Tk 90
Total Reserve Required reserve Excess
reserve
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Supply of bank loan from a savings
Money supply of a bank is based on deposits and
RRR.
Potential loan supply Initial Deposit x
Mm
Actual loan supply Excess Reserve x Mm

Actual Supply of loan is be less than the
Potential amount Because a bank has to
maintain RRR and Loanable amount is decided on
the Excess Reserve
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Example1
If RRR 20, and an initial deposit Tk 7000 at
Bank A. What is the amount of loans can the
banking system create out of this deposit ?
Answer
Required Reserve Deposit x RRR Excess Reserve
Total Reserve - Required Reserve
5600
1400
We have the Multiplier Mm 1 / RRR 1/20
5 Total loans (by the banking system) 5600 x 5
28000
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How an expansionary monetary policy works
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How a contractionary monetary policy works