Macroeconomics

‭Since‬ ‭in‬ ‭such‬ ‭banking‬ ‭systems,‬ ‭the‬ ‭tools‬ ‭of‬ ‭traditional‬ ‭monetary‬ ‭policy,‬ ‭such‬ ‭as‬ ‭OMOs,‬ ‭have‬ ‭limited‬ ‭effectiveness‬ ‭in‬ ‭influencing‬ ‭interest‬ ‭rates,‬ ‭the‬ ‭central‬ ‭bank‬ ‭will‬ ‭adjust‬ ‭the‬ ‭IOR‬ ‭to‬ ‭stimulate or slow down the economy.‬ ‭How the interest on reserves works:‬ ‭ ➔ ‬ ‭When‬ ‭the‬ ‭Fed‬ ‭increases‬ ‭the‬ ‭IOR,‬ ‭banks‬ ‭are‬ ‭more‬ ‭encouraged‬ ‭to‬ ‭keep‬ ‭additional‬ ‭deposits within the Fed.‬ ‭ ➔ ‬ ‭As more reserves are held with the Fed, banks’ lending ability decreases.‬ ‭ ➔ ‬ ‭This‬ ‭reduces‬ ‭investment‬ ‭and‬ ‭aggregate‬‭demand‬‭since‬‭frms’‬‭and‬‭households’‬‭need‬‭for‬ ‭borrowing is not always met.‬ ‭ ➔ ‬ ‭The opposite of these steps applies when the Fed reduces IOR instead.‬ ‭Therefore,‬‭increasing‬‭IOR‬‭is‬‭part‬‭of‬‭a‬‭contractionary‬‭monetary‬‭policy,‬‭whereas‬‭decreasing‬‭IOR‬‭is‬‭part‬‭of‬ ‭an expansionary monetary policy.‬ ‭The Reserve Requirement (rr)‬ ‭As‬‭explained‬‭in‬‭Section‬‭E‬‭of‬‭this‬‭chapter,‬‭the‬‭fractional-reserve‬‭banking‬‭system‬‭controls‬‭how‬‭banks‬‭lend‬ ‭and‬‭ultimately‬‭create‬‭money‬‭in‬‭an‬‭economy.‬‭One‬‭of‬‭the‬‭cornerstones‬‭of‬‭this‬‭system‬‭is‬‭banks’‬‭reserves.‬ ‭Therefore,‬ ‭to‬‭impact‬‭money‬‭supply,‬‭a‬‭central‬‭bank‬‭can‬‭also‬‭influence‬‭reserves‬‭through‬‭the‬‭required‬ ‭reserve ratio or reserve requirement (rr)‬ ‭.‬ ‭However,‬ ‭this‬ ‭is‬ ‭a‬ ‭tool‬ ‭mainly‬‭used‬‭in‬‭banking‬‭systems‬‭with‬‭limited‬‭reserves‬‭due‬‭to‬‭the‬‭multiplier‬ ‭effect‬ ‭that‬‭impacts‬‭money‬‭supply.‬‭Recall‬‭that‬ ‭in‬‭an‬‭ample‬‭reserves‬‭banking‬‭system‬ ‭,‬‭money‬‭supply‬‭has‬ ‭no‬ ‭signifcant‬ ‭effect‬ ‭on‬ ‭interest‬ ‭rate;‬ ‭therefore,‬ ‭the‬ ‭use‬ ‭of‬‭the‬‭multiplier‬‭to‬‭change‬‭money‬‭supply‬‭is‬ ‭dropped‬ ‭.‬ ‭Using‬ ‭this‬ ‭tool,‬ ‭the‬ ‭Fed‬ ‭indirectly‬ ‭impacts‬ ‭money‬ ‭supply‬ ‭by‬ ‭targeting‬ ‭the‬ ‭monetary‬ ‭base‬ ‭through‬ ‭changing reserves.‬ ‭How the required reserve works:‬ ‭ ➔ ‬ ‭When the Fed changes the rr, reserves are affected.‬ ‭ ➔ ‬ ‭Since‬‭reserves‬‭are‬‭a‬‭component‬‭of‬‭the‬‭monetary‬‭base‬‭(MB‬‭=‬‭cash‬‭and‬‭coins‬‭in‬‭circulation‬‭+‬‭bank‬ ‭reserves), a change in reserves changes the MB.‬ ‭ ➔ ‬ ‭If‬ ‭the‬ ‭Fed‬ ‭knows‬ ‭the‬ ‭money‬ ‭multiplier‬ ‭in‬ ‭the‬ ‭economy,‬ ‭it‬ ‭can‬ ‭deduce‬ ‭the‬ ‭change‬ ‭in‬ ‭money‬ ‭supply following the change in rr by using Ms = MB × MM.‬ ‭A‬ ‭decrease‬ ‭in‬ ‭the‬ ‭required‬ ‭reserve‬ ‭is‬ ‭an‬ ‭expansionary‬ ‭monetary‬ ‭policy‬ ‭tool‬ ‭that‬ ‭results‬ ‭in‬ ‭the‬ ‭following effects:‬ ‭rr ↓‬ ‭→‬ ‭deposits ↑‬ ‭→‬ ‭monetary base↑‬ ‭→‬ ‭loans ↑‬ ‭→‬ ‭money‬‭supply ↑‬

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