Lecture Notes: Understanding Monetary Policy and Banking Systems

Introduction

Central banks have three traditional tools:
- Reserve Requirement
- Discount Rate
- Open Market Operations
These tools are simplified in textbooks, not reflecting current realities.

Reserve Requirement: In the US, the requirement is zero; banks can fully loan out deposits.
Money Multiplier Concept: While traditionally used to calculate money supply changes, it doesn’t apply due to zero reserve requirement, making the multiplier infinite.
Pre-2008 Banking System: Characterized by limited reserves. Small changes in money supply had significant impact on interest rates.
Post-2008 Banking System: Transitioned to holding ample reserves due to regulations and interest payments by the Fed.

Interest on Reserves: Introduced post-2008 to influence bank behavior.
Federal Funds Rate: The rate at which banks lend to each other overnight.
- Inverse Relationship: High Federal Funds Rate reduces bank deposits at the Fed; low rate does the opposite.
Discount Rate: Acts as a cap on the Federal Funds Rate.
Demand and Supply of Reserves Graph:
- Supply: Set by the central bank, shown as vertical.
- Demand: Downward sloping but flattens at the interest on reserves rate.

Traditional Tools Ineffectiveness: More reserves mean traditional tools have little impact on interest rates.
Fed's Current Tool: Manipulating the interest on reserves to conduct monetary policy.

Expansionary: Lowering interest on reserves to reduce interest rates and stimulate the economy.
Contractionary: Increasing interest on reserves to raise interest rates, used currently to combat inflation.

Limited Reserves: Traditional tools apply.
Ample Reserves: Interest on reserves used instead by the Fed.
Educational Emphasis: Despite changes, traditional concepts remain in textbooks for basic understanding.