Course work in macroeconomics

The Formula for the Reserve Ratio

Reserve Ratio=Deposits x Reserve Requirement

1.2 Types of Monetary Policy.

         Based on the selected tools for regulating economic indicators, number of types of monetary policy are distinguished, each of which is characterized by its specific goals.

         In the context of inflation, a policy of "expensive money" (credit restriction policy) is pursued. It is aimed at tightening conditions and limiting the volume of credit operations of commercial banks, i.e. to reduce the supply of money.

         The Central Bank, pursuing a restriction policy, takes the following actions: sells government securities on the open market; increases the reserve ratio; increases the discount rate. If these measures are not effective enough, the central bank uses administrative restrictions: lowers the ceiling on loans, limits deposits, reduces the volume of consumer loans, etc. The policy of “expensive money” is to limit the supply of money in order to lower costs and curb inflationary pressures .

          During periods of decline in production, a “cheap money” policy (expansionary monetary policy) is pursued to stimulate business activity. It consists in expanding the scope of lending, weakening control over money supply growth, and increasing money supply. To do this, the central bank buys government securities, reduces the reserve rate and discount rate. Created more favorable conditions for the provision of loans to economic entities. It looks like this: the loan interest rate is reduced, which causes an increase in investment costs. In the aggregate demand, and therefore in GDP, the share of investments is increasing, which will allow in the future to expand production and provide a higher level of employment. The goal of “cheap money” is to make money readily available in order to increase total spending and employment.

And one another major regulating policy is contractionary - a form of economic policy used to fight inflation which involves decreasing the money supply in order to increase the cost of borrowing which in turn decreases GDP and dampens inflation.

Contractionary monetary policy is driven by increases in the various base interest rates controlled by modern central banks or other means, producing growth in the money supply. The goal is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to quell unsustainable speculation and capital investment that previous expansionary policies may have triggered.

In the United States, contractionary policy is typically performed by raising the target federal funds rate, which is the interest rate banks charge each other overnight, in order to meet their reserve requirements. The Fed may also raise reserve requirements for member banks, in a bid to shrink the money supply or perform open-market operations, by selling assets like U.S. Treasuries, to large investors. This large number of sales lowers the market price of such assets and increases their yields, making it more economical for savers and bondholders.

Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases demand. It boosts economic growth. It lowers the value of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary monetary policy.

Expansionary monetary policy deters the contractionary phase of the business cycle. But it is difficult for policymakers to catch this in time. As a result, you typically see expansionary policy used after a recession has started. Let`s see how it functions in the example of US economy. The U.S. central bank, the Federal Reserve, is a good example of how expansionary monetary policy works. It usually uses three of its many tools to boost the economy. It rarely uses a fourth tool, changing the reserve requirement.

          The central bank chooses one or another type of monetary policy based on the state of the country's economy. When developing a monetary policy, it is necessary to take into account that, firstly, a certain time elapses between the holding of an event and the appearance of the effect of its implementation; secondly, monetary regulation can only affect the monetary factors of instability.