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Chapter 29/30

Monetary Policy

Monetary Policy

l The Bank Indonesia’s control over the supply

of money is the key mechanism to monetary
policy:
– Monetary policy is the use of money and credit
controls to influence macroeconomic activity.

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Monetary Policy

Bank Indonesia

l Perform many critical services, including the

following:
– Clearing checks between private banks
– Holding bank reserves
– Providing currency
– Providing loans (called discounting)

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Bank Indonesia

l Bank Indonesia Governor is Agus D. W.

Martowardojo

Monetary Tools

l The Central Bank (Bank Indonesia) has the

power to alter the money supply:
– The money supply (M1) consists of currency
held by the public, plus balances in transactions
accounts.
l https://www.youtube.com/watch?v=2CStPH8
Hq_M

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Monetary Tools

l The three basic tools of monetary policy are:

– Reserve requirements
– Discount rates
– Open-market operations

Reserve Requirements

l By changing the reserve requirement, the

Central Bank can directly alter the lending
capacity of the banking system.
– Required reserves are the minimum amount of
reserves a bank is required to hold by
government regulation.
– The ability of the banking system to make
additional loans (create deposits) is determined
by the amount of excess reserves banks hold and
the money multiplier:

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Reserve Requirements

l A decrease in required reserves directly

increases excess reserves.
l Excess reserves are bank reserves in
excess of required reserves

A Decrease in Required Reserves

l A lower reserve requirement increases the

value of the money multiplier:
l The money multiplier is the number of
deposit (loan) dollars that the banking
system can create from Rp1 of excess
reserves.

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A Decrease in Required Reserves

l A lower reserve requirement increases the

value of the money multiplier:

1
Money Multiplier = --------------------------
Required Reserve Ratio

The Impact of a Decreased Reserve

Requirement

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The Discount Rate

l Discounting is Central Bank lending of

reserves to private banks.
l The discount rate is the rate of interest
charged by the Central Bank for lending
reserves to private banks.
l Sometimes bank reserves run low and they
must replenish their reserves temporarily.

l There are three sources of last-minute extra

reserves:
– Money Market - borrow from a reserve-rich bank.
– Securities Sales.
– Discounting - obtaining reserve credits from the
Central Bank

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Money Market

l Money Market Rate is the interest rate banks

charge each other for lending reserves.

The Discount Rate

l By raising or lowering the discount rate, the

Central Bank changes the cost of money for
banks and therewith the incentive to borrow
reserves.

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Open-Market Operations

l Open-market operations are the principal

mechanism for directly altering the reserves
of the banking system.
l Open-market operations are designed to
affect portfolio decisions and the decision to
hold money or bonds

Open-Market Activity

l Open-market operations - the Central Bank

purchases and sales of government bonds to
alter bank reserves:
– If the central Bank buys bonds - it increases
bank reserves.
– If the central Bank sells bonds - it reduces bank
reserves.

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Shifting Aggregate Demand

l The ultimate goal of all macro policy is to

stabilize the economy at its full-employment
potential.
l Monetary policy may be used to shift
aggregate demand.

Monetary Policy Guidelines

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a. Expansionary Policy

l Monetary policy can be used to move the economy

to its full-employment potential.
l The Central Bank can increase AD (by increasing
the money supply) by:
– Lowering reserve requirements.
– Dropping the discount rate.
– Buying more bonds to increase bank lending capacity.
l Banks make more loans so AD shifts to the right,
reflecting increased purchasing power.

b. Restrictive Policy
(contractionary)

l Monetary policy can also be used to cool an

overheating economy.
l The Central Bank can decrease AD (by
decreasing the money supply) by:
– Raising reserve requirements.
– Increasing the discount rate.
– Selling bonds in the open market.

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Aggregate Demand

l Increases in the money supply shift AD to the

right.

Aggregate Supply

l Aggregate supply is the total quantity of output

producers are willing and able to supply at
alternative price levels in a given time period, ceteris
paribus.
l The shape of the AS curve determines the
effectiveness of expansionary monetary policy.
l With an upward-sloping AS curve, expansionary
policy causes some inflation and restrictive policy
causes some unemployment.

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Inflation Targeting

l The Central Bank should set an upper limit

on inflation (“inflation targeting”), then
manipulate interest rates and the money
supply to achieve it.

Measures to Control
Unemployment

l Monetary Policy
Govt may practice expansionary monetary policyè
increase money supply.
1. Open Market Operation: BI buy short term bonds or
government security from individual or from institutional
2. Lowering reserve requirement: increase cash
resources of commercial banksè offer more loan.
3. Decline in discount rate: will be followed by decrease
in interest rateè offer more loan
4. Lowering the interest rate: commercial reduce rateè
reduce the level of saving and spending more

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Measures to Control Inflation

l Measures to control inflation are contrary to

measure to control unemployment

To Control Inflation:
Monetary Policy

l Open Market Operations : selling of securities or short

term bondsè directly reduce cash balances
l Raising the Reserve requirement: Central Bank raise
RRè reduce the cash resource in commercial banks
and it will reduce the ability to provide loansè reduce
the money supply
l Raising the Discount Rate/ Bank Rate: it will raise the
prices of borrowing funds from Banksè forces the
banking system to reexamine its lending policy
l Raising the Interest Rate: The high interest rate will
attract and encourage more people to save.

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