TOPIC 12

THE CENTRAL BANK SYSTEM

(MONETARY POLICY)

10-Jan-24 1
 The Central Bank
 The central bank is an authority that responsible in
managing and regulate the financial system of a nation
 Example:
 the Federal Reserve System - central bank of the US,
Bank of Sweden, Bank of England, Bank of Japan, Bank
Negara Malaysia

 The most important responsibility of the central bank is to

conduct monetary policy, or control the money supply

10-Jan-24 2
 Bank Negara Malaysia - BNM
 Bank Negara Malaysia is the central bank for Malaysia.

 It was established on 26 January 1959, under the Central

Bank of Malaya Ordinance, 1958

 Section 9 (1) of the Central Bank of Malaysia Act 1958

provides that the Governor shall be appointed by the Yang
Di Pertuan Agong, and the Deputy Governors by the
Minister of Finance.

10-Jan-24 3
 BNM : Objectives

1. To issue currency and keep reserves safeguarding the

value of the currency;
2. To act as a banker and financial adviser to the
Government;
3. To promote monetary stability and a sound financial
structure;
4. To promote the reliable, efficient and smooth operation of
national payment and settlement systems and to ensure
that the national payment and settlement systems policy is
directed to the advantage of Malaysia; and
5. To influence the credit situation to the advantage of the
country.

10-Jan-24 4
 BNM: Organisation Structure

 The Governor is the Chief Executive Officer of the Bank

and is assisted by 2 Deputy Governors and 5 Assistant
Governors.
 Departments in the Bank are organised in 5 divisions:-
1. Economics,
2. Investments & Operations,
3. Organisational Development,
4. Supervision
5. Regulation.

10-Jan-24 5
The Functions of BNM

1. Bank for Currency Issue

• arrange for the printing of currency notes and the
minting of coins.
• issue, re-issue and exchange notes and coins at its
office and at such agencies as it may, from time to
time and establish or appoint
• arrange for the safe custody of unissued stocks of
currency and for the preparation, safe custody and
destruction of plates paper for the printing of notes
and of dies for the minting of coins.
2. Keeper of International Reserves

The country’s official external reserves are held and

maintained by BNM.

 Gold
 Foreign exchange assets and reserve in International
Monetary Fund (IMF)
 Holdings of Special Drawing Rights
 investments denominated in the major international
currencies, such as bank balances, Treasury Bills, Bonds
and other appropriate term securities to secure the best
result and returns/benefits for the country.
3. Government Banker and Financial Advisor

Management of Government Accounts

It provides cheque facilities, accepts funds and makes
payments on behalf of the government and undertakes the
foreign exchange business of the government

Source of Funds to Government

It provides temporary advances to the Government to cover
any deficit in the budget revenue.

Management of National Debt

It advises the government on its loan programmes,
including terms and timing of loans and the issue of new
types of securities.
4. To Promote Monetary Stability and Influence the Credit
Situation to the Advantage of the Country.

•BNM is obliged to ensure that the supply of money and

the volume of credit are sufficiently elastic to the demands
in the domestic economy without creating undue pressure
on resources.

•Influence the level of inflation

•Promote saving deposit
•Preserving price stability
•Sustaining economic
5. Banker to the Banks

• Promote a sound financial structure

• Licensing of banks and non-banks
• Banking relationship
• Currency distribution
• Inspection and investigation of banks and non banks
• Lender of the last resort
 HOW THE CENTRAL BANK CONTROLS
THE MONEY SUPPLY (MS)
 Monetary policy is the exercise of the central bank’s
control over the money supply (MS) as an instrument
for achieving the objectives of general economic policy.

CH 12 • 11
 QUANTITATIVE VS QUALITATIVE TOOLS
Quantitative
 The methods used by the central
bank to influence the total volume of
credit in the banking system, without
any regard for the use to which it is
put,
 Also known as general methods of
credit control.
 These methods regulate the lending
ability of the financial sector of the
whole economy and do not
discriminate among the various
sectors of the economy.
 The important quantitative methods
of credit control are (i) required
reserve ratio (ii) discount rate (ii)
open market operations
Qualitative
• The methods used by the central
bank to regulate the flows of credit
into particular directions of the
economy
• Also known as selective methods of
credit control.
• These methods affect the types of
credit, extended by the commercial
banks; they affect the composition
rather than the size of credit in the
economy.
• The important qualitative or selective
methods of credit control are (i)
marginal requirements (ii) regulation
of consumer credit, (iii) control
through directives, (iv) credit
rationing, (v) moral suasion (vi) direct
action. (read by yourself)
CH 9 • 12
 QUANTITATIVE INSTRUMENTS
 The central bank has three quantitative instruments at
its disposal that it can use to control the MS:

i. Open market operations (OMO)

ii. The required reserve ratio (RRR)
iii. The discount rate (DR)

CH 12 • 13
 [1] Open market operations (OMO)

 The central bank buys or sells the government securities

in the financial markets
 when it buys securities, it is engaged in an open market
purchase
 when it sells securities, it is engaged in an open market
sale
 Both open market purchases and open market sales
affect the money supply

10-Jan-24 14
 [a] open market purchases
 Suppose the central bank buys $5 million of government
securities from bank ABC
 central bank hold the securities, bank ABC assets
(securities) decreases by $5 million
 The central bank pays for the government securities by
increasing the balance in bank ABC’s reserve account at
the central bank
 Money supply increases; the amount of increase depends
on the value of the money multiplier

 the transactions affect both the central bank and bank

ABC T-accounts:

10-Jan-24 15
 The central bank
Assets liabilities
Government securities + 5 million Reserves bank ABC + 5 million

Bank ABC

Assets Liabilities

Government securities - 5 million

Reserves at central bank + 5 million

 therefore, open market purchase by the central bank

increases the bank’s reserves, and thus money supply
[b] open market sales
 Suppose the central bank sells $5 million of government
securities to bank XYZ
 The central bank surrenders the securities to bank XYZ
 Bank XYZ paid the amount by reducing its reserve
account at the central bank
 Bank XYZ reserves declined by $5 million, thus reducing
the money supply

 the transactions affect both the central bank and bank

XYZ T-accounts:
 The central bank
Assets Liabilities
Government securities - 5 million Reserves bank XYZ - 5 million

Bank XYZ
Assets Liabilities
Government securities + 5 million
Reserve at central bank - 5 million

 therefore, the open market sales reduces bank’s

reserves, and thus the money supply
The Banking System Creates
Checkable Deposits (Money)

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 In summary, the effect of OMO:
1
 open market purchase  bank reserves   Ms  by R
Rr
1
 open market sales  bank reserves   Ms  by R
Rr
 [2]The required Reserve Ratio (RRR)

 The central bank can influence the money supply by

changing the required reserve ratio
 RRR is the minimum percentages of deposits that
depository institutions must hold as reserves either as
deposits at the central bank or in vault cash
 changes in RRR will affect the ability of banks to make
loans and thus the money supply
 maximum changes in deposits:
1
 x R
Rr

10-Jan-24 21
 example:
 if reserves (R) increase by $1,000 and the required
reserve ratio (Rr) is 10%, then the maximum change in
demand deposits @ increase in money supply (Ms) :

1 1
 R  1000  10 000
r 0.1

 if the central bank increase the required reserve ratio from

10% to 20%, the amount of demand deposits @ the
money supply declines:
1 1
 R  1000  5000
r 0.2
 Thus, an increase in the required reserve ratio (r) leads to
a decrease in the money supply; a decrease in the
required reserve ratio leads to an increase in the money
supply

↑ r → ↓ in checkable deposits
↓ r → ↑ in checkable deposits
 [3] the Discount Rate

 Banks that are short of reserves can make loans from the
central bank or in the federal funds market
 the interest rate it pays for a loan from the central bank is
the discount rate, i.e. the interest rate the central bank
charges depository institutions that borrow reserves from it

 Federal Funds Market: - a market where banks lend

reserves to one another, usually for short periods
 federal funds rate is the interest rate in the federal funds
market; the interest rate banks charge one another to
borrow reserves.

10-Jan-24 24
 If the discount rate is lower (below the federal funds rate),
banks will borrow from the central bank
 bank reserves increase, thus increase the reserves of the
banking system, and so the money supply increases

 If the discount rate is raised (above the federal funds rate),

banks do not borrow from the central bank
 the banks pay back their loans that they previously had
taken out, so reserves fall, and thus the money supply
declines
10-Jan-24 26
Qualitative credit control
• Margin requirement
The central bank can order the commercial banks to lend an
amount lower than the volume of a security. A higher margin
used during inflationary situation will reduce the amount of
loan given by the banks.
• Rationing of credit
Credit rationing is a method of controlling and regulating the
purpose for which the banks grant credit
• Regulation of consumer credit
The central bank can regulate the terms and conditions
under which consumer credit is to be given by the banks
 Qualitative credit control
• Differential rate of interest
Under this scheme the central bank fixes up different rates on
interest to be charged by the banks from different borrowers
who borrow for different purposes
• Moral suasion
It implies persuasion and request made by the central bank to
commercial banks to follow the general policy of central bank
• Direct action
Direct action refers to all the controls and directions, which the
central bank may enforce on all banks or any bank in particular
concerning lending and investment
 Money Supply Curve (MS)

Interest MS2 MS0 MS1

rate
(r)

0 Qt of money (M)

 If the Fed’s MS behavior is not influenced by the interest

rate, the MS curve is a vertical line (MS0)
 MS   MS curve shift to the right (MS1)
 MS   MS curve shift to the left (MS2)

29
LOOKING AHEAD
 This part has discussed only the supply side of the
money market.

 In the next part, we turn to the demand side of the

money market and see how the supply & demand for
money determined the equilibrium interest rate.

 Because interest rate plays an important role in the

economy, it is important for us to understand exactly
what it is.

CH 12 • 30
 Interest and Interest Rate
 Interest is the fee that a borrower pays to a lender for the
use of his or her funds.
 Firms and government borrow funds by issuing bonds, and
they pay interest to the firms and household (the lenders)
that purchase those bonds.
 Household and firms that have borrowed from a bank must
pay interest on those loans to the bank.

 The interest rate is the annual interest payment on a loan

expressed as a percentage of the loan.
 For example, a $1000 bond (representing a $1000 loan from
household to a firm) that pays $100 in interest per year has
an interest rate of 10%.
 Note that interest rate is expressed as an annual rate.
 It is equal to the amount of interest received per year
divided by the amount of the loan.
CH 12 • 31
 Nominal VS Real Interest Rate
 Nominal interest rate (NIR)
 The interest rate without any correction for the effects of inflation.
 The advertised or stated interest rates we see on bonds, loans or bank
accounts is usually a nominal one.
 The nominal interest rate may not be the true cost of borrowing
because part of the nominal interest rate is a reflection of the
expected inflation rate.

 Real interest rate (RIR)

 refers to the interest rate adjusted to remove the effects of inflation.
 describes the real yield of lending money or the real cost of borrowing
money.

 Real interest rate = nominal interest rate – expected inflation rate

 Example: NIR =3%, expected inflation rate = 1%
 RIR = 3% – 1% = 2% CH 12 • 32
 While they are many different interest rate, for the
purposes of our analysis we will assume that there is
only one interest rate in the economy.

 This simplifies our analysis but still provides us with a

valuable tool for understanding how the various parts
of the macroeconomy relate to one another.

CH 12 • 33
 THE DEMAND FOR MONEY (MD)
 Concerned with the question of
 how much of your financial assets you want to hold in
the form of money, which does not earn interest.
 how much of your financial assets you want to hold in
the form of interest-bearing securities such as bonds,
which does earn interest.

 The demand for money depends negatively on the

interest rate.
 The higher the interest rate, the higher the opportunity
cost (more interest forgone) from holding money.
 Less money people will want to hold.
 Thus: Interest rate  Qt demand for money ↓
(MD curve slopes downward).

CH 12 • 34
 MOTIVE FOR HOLDING MONEY
 There are THREE motives for holding money:
i. Transaction
ii. Speculation
iii. Precautionary

i. Transaction motive
 The main reason people hold money – to buy
things.
 The total dollar volume of transactions depends on
both the total number of transactions & the
average transaction amount.

CH 12 • 35
ii. Speculation motive
 One reason for holding bond instead of money.

 Market value of bonds is inversely related to the interest rate

 interest rates  value of bonds 
 interest rates  value of bonds 

 So, investors may wish to

 hold the bonds when interest rates  (value of bonds  )
 sell the bonds when interest rates  (value of bonds  )

 The speculative motive for holding money is closely tied to

the function of money to store wealth (value).

CH 12 • 36
 If the interest rate is higher than normal (implies that the
price of bond is low), people may expect the interest rate to
 in the future (value of bonds ). In this circumstances,
investors or speculators may want to hold bond than money.

 On the contrary, if the market interest rate is lower than

normal (implies that the price of bond is high), people may
expect the interest rate to  in the future (value of bonds ) .
In this circumstances, investors or speculators may want to
hold money than bond.

CH 12 • 37
iii. Precautionary motive
 A desire to hold cash in order to be able to deal effectively
with unexpected events that require cash outlay
(emergency). For example: admitted to the hospital

 The amount of money holding positively related with the

income level
 Income  money demand 
 income  money demand 

 Precautionary demand for money have no relationship with

interest rate

CH 12 • 38
 Determinants of Demand for Money
 The demand for money (MD) depends on

i. The interest rate (r)

 r  quantity of money demanded ↓
 r ↓ quantity of money demanded 

ii. Aggregate output (real GDP) (Y)

 Y  MD 
 Y ↓ MD ↓

iii. Aggregate price level (P).

 P  MD 
 P ↓ MD ↓

CH 12 • 39
 Equilibrium (The Money Market)
 The demand curve for money illustrates the inverse
relationship between the quantity demanded of money & the
interest rate (the opportunity cost of holding money).

 the money supply curve as a vertical line, suggesting that the

quantity of money is fixed at a level determined by the Fed.

 Equilibrium in the money market exists when the quantity

demanded of money (MD) = the quantity supplied (MS).

 At any interest rate above the equilibrium rate, there is an

excess supply of money.
At any interest rate below the equilibrium rate, there is an
excess demand for money.
CH 12 • 40
 Equilibrium (The Money Market)
MD = MS

MS0
interest rate(r)

r0

MD0

Qt of money (M)

41
 MS0
interest rate(r)
> MS
r1

r0

r2
>MD MD0

Qt of money (M)

r0  Equilibrium interest rate

 If r  to r1  excess MS (MS > MD)
 If r  to r2  excess MD (MS < MD)

42
MS  , MD did not 
MS0 MS1
Interest rate (r)

ro

r1

MD0

Qt of money (M)
Equilibrium  MS0, MD0, r0
If MS  from MS0 to MS1 & MD did not 
MS curve shift to the right
MS > MD  r  from r0 to r1
New equilibrium  MS1, MD0 , r1
43
MS  , MD did not 
MS1 MS0
Interest rate (r)

r1

r0

MD0

Qt of money (M)

Equilibrium  MS0, MD0, r0

If MS  from MS0 to MS1 & MD did not 
MS curve shift to the left
MS < MD  r  from r0 to r1
New equilibrium  MS1, MD0 , r1

44
Summary
If MS  , MD did not   MS > MD  r 
MS  , MD did not   MS < MD  r 

Factors Cause the MS Curve to Shift

(i) Required reserve ratio (RRR)
(ii) Discount Rate (DR)
(iii) Open market operations

If:
(i) RRR  MS  RRR  MS 
(ii) DR  MS  DR  MS 

(iii) Open market purchase  MS 

Open market sale  MS 

45
 Shift in Money Demand (MD)
MD , MS did not 

Interest rate (r) MS0

r1

r0

MD1
MD0

Qt of money (M)
Equilibrium  MS0, MD0, r0
If MD  from MD0 to MD1 & MS did not 
MD > MS  r  from r0 to r1
New equilibrium  MS0, MD1 , r1

46
MD  , MS did not 
MS0
Interest rate (r)

r0

r1

MD0
MD1

Qt of money (M)
Equilibrium  MS0, MD0, r0
If MD  from MD0 to MD1 & MS did not 
MD < MS  r  from r0 to r1
New equilibrium  MS0, MD1 , r1

47
Summary
If MD  , MS did not   MD > MS  r 
MD  , MS did not   MD < MS  r 

Factors Cause the MD Curve to Shift

(i) Real aggregate output (income): Y
(ii) Aggregate price level (P)
Note: r does not shift the md curve, but will move along the
md curve

If Y  MD  Y  MD 
P  MD  P  MD 

48
 Exercise

• Using a graph, show an interest rate

equilibrium and quantity of money
equilibrium when
1. Inflation happen (MD)-right =
2. Central Bank buy securities in OMO
3. income decreases

49