CHAPTERS

The Monetary System & Monetary Policy

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After studying this chapter you will be able to: Define money and describe its functions Explain the economic functions of banks and other financial institutions Describe the functions of the central bank Explain how the banking system creates money Explain what determines the demand for money Explain how the quantity of money and the interest rate are determined

What is Money?

What is Money?
Medium of Exchange

Money is any commodity or token that is generally acceptable as a means of payment. Money has three other functions: Medium of exchange Unit of account Store of value

A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. Unit of Account A unit of account is an agreed measure for stating the prices of goods and services.

What is Money?
Store of Value As a store of value, money can be held for a time and later exchanged for goods and services. Money Today Money today consists of: Currency Deposits at banks and building societies

What is Money?

Currency is the general term for notes and coins. Narrow money is currency in circulation plus the current account deposits in banks banks. Broad money is narrow money plus the time deposits (include both savings deposits and fixed deposits).

What is Money?
Cheques, Debit Cards and Credit Cards are not Money Cheques are not money. A cheque is an instruction to your bank to move some funds from your account to someone elses account. Debit cards are not money. Using a debit card is like writing a cheque except the transaction takes place in an instant. Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.

Financial Intermediaries
A financial intermediary is a firm that takes deposits from households and firms and makes loans to other households and firms. The main financial intermediaries are: Commercial banks Building societies

Financial Intermediaries

Financial Intermediaries
Building Societies A building society is a private firm, licensed to accept deposits and make loans. Difference between building societies and banks is: A building society is usually owned by its depositors whereas banks are not

Commercial Banks A commercial bank is a private firm, licensed to take deposits and make loans.

Central Banking

Central Banking
The Bank of England

A central bank is the public authority that provides banking services to governments and commercial banks, p g supervises and regulates financial institutions and markets and conducts monetary policy. Monetary policy is the attempt to control inflation and moderate the business cycle by changing the quantity of money, interest rates and the exchange rate.

The Bank of England is the central bank of the United Kingdom. Central Banking in the Eurozone The European Central Bank (ECB) is the central bank of the Eurozone. The ECB was established in 1998. Bangladesh Bank is the Central bank of Bangladesh

Central Banking
The Functions of a Central Bank A central bank performs the following functions: Governments bank Bankers Bankers bank A central bank provides banking services to the government and the commercial banks similar to those that the commercial banks provide to individuals and firms.

Central Banking
Central Banks Policy Tools Central Bank uses two tools to influence the supply of money and the interest rate. They are: Bank Rate Open market operations

Central Banking
Bank Rate Bank Rate is the Central Banks official interest rate. It applies to transactions between the central bank and the commercial banks. Central Bank pays interest to commercial banks on their reserve deposits and commercial banks pay interest on loans of reserves from the Central Bank. Bank Rate influences the supply of money higher bank rate increases commercial banks reserves with the central bank reduces the reserves held by the commercial banks themselves reduces money supply. As a result market rate of interest rate rises.

Central Banking

Open Market Operations An open market operation is the purchase or sale of government bonds by the central bank in the open market market. The term open market refers to commercial banks and the general public but not the government.

How Banks Create Money

Creating Deposits by Making Loans When a bank receives a deposit, its reserves increase by the amount deposited, but it doesnt keep all of the deposit as reserves. The bank lends some of the amount f deposited. These loans end up as deposits. The increase in deposits is an increase in money.

How Banks Create Money

What limits the amount of money that the banking system can create? Three factors that limit the quantity of loans and deposits that the banking system can create are: The monetary base Desired reserves Desired currency holdings

How Banks Create Money

How Banks Create Money

Desired Reserves

The Monetary Base The monetary base is the sum of notes and coins and banks banks deposits at the central bank bank. The monetary base limits the total amount of money that the banking system can create because banks have a desired level of reserves.

The fraction of a banks total deposits held as reserves is the reserve ratio. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Excess reserves equal actual reserves minus desired reserves.

How Banks Create Money

Desired Currency Holdings People hold money in the form of currency and deposits. People have a definite view about the proportion of money they want to hold as currency based on expenditure plans. When the total quantity of money increases people will increases, want to hold more currency. So currency drains from the banking system. The currency drain ratio is the ratio of currency to deposits. The greater the currency drain ratio, the smaller is the quantity of money that the banking system can create.

How Banks Create Money

The Money Creating Process The money creating process begins when the monetary base i b increases and the b ki system h excess d h banking has reserves.

Creation of Money Creation of Money

Dynamics:
Bank 1 receives a deposit of 100 It keeps 10% (i.e., 10) as required reserves and lends the rest (i.e., 90) to Borrower 1 Bank 2 receives the deposit of 90 from Borrower 1 It keeps 10% (i.e., 9) as required reserves and lends the rest (i.e., 81) to Borrower 2 The banker can continue making loans of excess reserves until total deposits equal 1,000. At that point, the bankers actual reserves (100) equal the required reserves (100 = 10% of 1,000) 13-23 Dynamics: The total amount of money in the economy is increased in the following way: = 100 + 90 + 81 + .... to infinity = 100 [1 + 0.9 + 0.81 + . to infinity] = 100[1 + 0.9 + (0.9)2 + . to infinity] = 100 x 1/(1 0.9) geometric progression = 100 x 1/0.1 = 100 x 1/b 100 x 1/0.1 =100 x 10 = 1,000 Where b is the commercial banks reserve ratio
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How Banks Create Money

The Money Multiplier: Money multiplier is the ratio of the change in the quantity of money (money supply) to the change in monetary base. y y , If the monetary base increases by 100,000 and the quantity of money increases by 250,000 then the money multiplier is: 250,000 100,000 = 2.5 The magnitude of the multiplier depends on desired reserve ratio and the currency drain ratio.

How Banks Create Money

The Money Multiplier: Bank reserves = R Bank deposits = D Currency held by public = C Monetary base = MB = R + C Quantity of money = M = C + D Ratio of currency to deposits = a Ratio of reserves to deposits = b M=D+C M = D + aD M = (1 + a)D MB = C + R MB = aD + bD MB = (a + b)D M = (1 + a)D MB = (a + b)D M (1 + a) MB = (a + b)

The Demand for Money

So, the money multiplier: (1 + a)/(a + b) M (1 + a) ------- = ---------MB (a + b) It follows from the above equation that change in money supply (M ) = change in monetary base (MB) money multiplier

The Demand for Money

If a = 0.5 b = 0.1 Money multiplier is: (1 + a)/ (a + b) (1 + 0.5)/(0.5 + 0.1) = 1.5/0.6 = 2.5 So the magnitude of the multiplier depends on desired reserve ratio (b) and the currency drain ratio (a).

The Demand for Money

The Influences on Money Holding The quantity of money that people plan to hold depends on four main factors: The price level The interest rate Real GDP (Y) Financial innovation

The Demand for Money

Demand for money is the demand for money to hold: Transactions demand (+ Y) Speculative demand Overall: O ll (M/P)d = aY lr Supply of money: Fixed by central bank (- r)

The Demand for Money

Figure 27.4 illustrates the demand for money curve. A rise in the interest rate brings a decrease in the quantity of money demanded. d d d A fall in the interest rate brings an increase in the quantity of money demanded. The interest rate is the opportunity cost of holding money.

The Demand for Money

Shifts in the Demand for Money Curve The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs. Figure 27.5 illustrates a change in the demand for money.

The Demand for Money

A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve l ft d d leftward. d An increase in real GDP increases the demand for money and shifts the demand curve rightward.

Interest Rate Determination

The Supply of Money

The supply of money is the relationship between the quantity of money supplied and the interest rate. The higher the interest rate, the greater the percentage of deposits the banks want to lend and the smaller the percentage they want to hold as reserves And the smaller the desired reserve ratio, the greater the quantity of money supplied.

Money Market Equilibrium Money market is in equilibrium when the demand for money and the supply of it are equal and the equilibrium rate of interest is determined at that equilibrium equilibrium.

Figure 4-3 Money Market Equilibrium

Interest rate Ms /P

r*

If income rises, demand for real money balances curve shifts to the right and with fixed Ms., equilibrium occurs at higher interest rate and vice versa.
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Md Money

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Monetary Policy Objectives and Framework

Monetary policy-making involves two activities: 1 Setting the policy objectives 2 A hi i th policy objectives Achieving the li bj ti In most countries, the government sets the monetary policy objectives and the central bank decides how to achieve them.

Monetary Policy Objectives and Framework

Government Economic Policy Objectives The governments economic policy objectives as they relate to monetary policy are to achieve hi h and stable l li hi high d bl levels of economic growth and employment.

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The Conduct of Monetary Policy

Monetary Policy Transmission

Quick Overview

Bank Rate The interest rate that the Bank sets is Bank Rate, which is linked li k d to the i h interest rate that b k earn or pay on h banks reserves lent or borrowed from other banks.

When the Central Bank lowers the Bank Rate: 1 Other short-term interest rates and the exchange rate fall. 2 The quantity of money supply increases. 3 Other interest rates falls. 4 Consumption expenditure, investment and net exports increase.

Pearson Education 2008

Pearson Education 2008

Monetary Policy Transmission

Monetary Policy Transmission

Expenditure Plans

5 Aggregate demand increases. 6 R l GDP growth and th i fl ti rate i Real th d the inflation t increase. When the Central Bank raises Bank Rate, the ripple effects go in the opposite direction.

Bank Rate change three components of aggregate expenditure: 1 Consumption expenditure 2 Investment 3 Net exports The change in aggregate expenditure plans changes aggregate demand, real GDP and the price level.

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Pearson Education 2008

Monetary Policy Transmission

Expansionary monetary policy Money supply increases Rate of interest falls Consumption expenditure increases Investment expenditure increases AD increases Real GDP increases through multiplier effect
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Monetary Policy Transmission

Contractionary monetary policy Work it out yourself

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Monetary Policy Transmission

Exchange Rate Fluctuations The exchange rate responds to changes in the interest rate relative to the interest rates in other countriesthe interest rate differential differential.

Exchange Rate and Interest Rate

When domestic interest rate increases, while foreign interest rate remains the same, domestic securities become more attractive to foreigners. Demand for domestic currency rises exchange rate of domestic currency rises appreciation (increase in the value of domestic currency relative to foreign currency).
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Exchange Rate and Interest Rate

A decrease in domestic interest rate causes depreciation (decrease in the value of domestic currency relative to foreign y g currency) Interest rate affects exchange rate through flows of capital between countries.

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