Money, Central Banks and Monetary Policy With money in your pocket, you re wiser, you re more handsome and you sing better, too 1of 29
The Meaning of the Money (I) What s money? Money is any asset that can easily be used to purchase goods and services. It is the most liquid asset, sometimes only currency in circulation and checkable bank deposits, or other assets that t are highly hl liquid. Currency in circulation is cash held by the public. Checkable Bank Deposits (CBD) are bank accounts on which people p can write checks. These are often considered the money supply, which is the total value of financial assets in the economy that are considered money. But not always it depends on how wide the definition of money is. Cash + CBD is the narrowest one. 2of 29
The Meaning of the Money (II) Roles of Money Money plays 3 main roles in an economy: Medium of Exchange A medium of exchange is an asset that individuals acquire for the purpose of trading rather than for their own consumption. Store of Value A store of value is a means of holding gpurchasing gpower over time. Unit of Account A unit of account is a measure used to set prices and make economic calculations. 3of 29
The Meaning of the Money (III) Types of Money: History Money has been in use for thousands of years. For long time people used commodity money, which h is a good used as a medium of exchange that has other uses. Later, nations started to use a commodity-backed money, which is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. This kind of money reduced the amount of real resources used by society to provide the functions of money. Nowadays, neither commodity money nor commodity-backed money is used in developed countries. We use fiat money, which is a medium of exchange whose value derives entirely from its official status as a means of payment. 4of 29
The Meaning of the Money (III) Measuring the Money Supply (I) The most common definitions of the money supply are 3 different aggregates: M1, M2 and M3. M1 is the narrowest definition: currency in circulation + Checkable Bank Deposits M2 adds several other kind of assets AKA near-moneys. Nearmoneys are financial assets that can t be directly used as a medium of exchange but can be readily converted into cash or CBD. M3 also includes some harder-to-convert-into-cash cash assets as deposits with to come with penalties for early withdrawal. Obviously, from the most liquid to the less we have M1, M2 and M3. 5of 29
The Meaning of the Money (III) Measuring the Money Supply (II) M 2 includes M 1, plus a range of M 1 is equally split between een other deposits and deposit-like currency in circulation and assets, making it about three times checkable bank deposits. as large. You can now check your understanding 13-1 (p. 326) 6of 29
The Monetary Role of Banks (I) What Banks Do (I) As money monetary aggregates include bank deposits, banks have a major role in the evolution of money supply. A bank is a financial intermediary that uses liquid assets in form of bank deposits to finance the illiquid investments of borrowers. To avoid a bank run, they are legally bound to held what is called, bank reserves. Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve. Because bank reserves are held by banks and the Federal Reserve, and not by the public, they are not considered part of currency in circulation (nor money supply). 7of 29
The Monetary Role of Banks (II) What Banks Do (II) Assets and liabilities of a commercial bank. The reserve ratio is the fraction of a bank deposits that a bank holds as reserves. 8of 29
The Monetary Role of Banks (III) The Problem of Bank Runs What would happen to a bank if all or at least a large fraction of its depositors tried to withdraw all their funds during a short period of time? This is called a bank run. The bank should sell its assets (loans) quickly (and badly), so it can occur that it does not have enough money to face the withdrawals. What might start this process? A rumor that the bank is in financial trouble Depositors that simply think that others are going to panic Fortunately, there is regulation to try to avoid this bank runs. 9of 29
The Monetary Role of Banks (IV) Bank Regulation The system has 3 main features to avoid this bank run: 1. Deposit insurance guarantees that t a bank s depositors will be paid even if the bank can t come up with the funds (up to a maximum amount per account). 2. To reduce the incentive for excessive risk taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits (Capital requirements). 3. Reserve requirements are rules set by the Federal Reserve that determine the minimum reserve ratio for a bank. You can now check your understanding 13-2 (p. 329) 10 of 29
Determining the Money Supply (I) How Do Banks Create Money? If banks didn t exist the money supply would be equal to the currency in circultation. ti But banks exist and: 1. Take some currency out of circulation 2. Create money allowing the money supply to be larger than the quantity of currency in circulation. The process of money creation is quite similar to the multiplier process we saw in fiscal policy. In fact, it is called the money multiplier. 11 of 29
Determining the Money Supply (II) The Money Multiplier in Reality (I) The determination of the money supply is more complicated than the previous model suggests. Mainly because it depends not only on the ratio of reserves to bank deposits but also o the fraction of the money hold in currency. The monetary base is the sum of currency in circulation and bank reserves. In practice, most of the monetary base actually consists of currency in circulation, which also makes up about half of the money supply. 12 of 29
Determining the Money Supply (III) The Money Multiplier in Reality (II) We can now formally define the money multiplier as the ratio of the money supply to the monetary base. So, the money multiplier is quite smaller than the ratio 1/(reserve ratio). The reason is that about a half of money supply is hold as cash. 13 of 29
Central Banks System (I) The Fed: America s Central Bank (I) () A central banks is an institution that oversees and regulates the banking system and controls the monetary base. Its board of directors is usually appointed for a longer term than polititians (government) to avoid political pressures. Central banks usually have 3 main policy tools at its disposal: reserve requirements, the discount rate and the open-market operations. When a private bank has no enough reserves to fulfill the central bank requirement, it borrows in the federal funds market. 14 of 29
Central Banks System (II) The Fed: America s Central Bank (II) Alternatively, banks can borrow reserves from the Fed at a discount rate (which is usually +1 point the federal funds rate). The target federal funds rate is the Federal Reserve s desired federal funds rate. Open-Market Operations: An open-market operation is a purchase or sale of government debt. The central bank goes to the open market to buy a financial asset. To pay for this, bank reserves in the form of new base money (newly printed cash) is transferred to the sellers bank. Thus, the total amount of fbase money in the economy has increased. Conversely, if the central bank sells these assets in the open market, the amount of base money that the buyer's bank holds decreases, destroying base money. You can now check your understanding 13-4 (p. 338) 15 of 29
The Demand for Money (I) The Opportunity Cost of Holding Money There is an opportunity cost of holding money, which can be measured by the difference between the interest rate on assets that aren t money and the interest rate on assets that are money. Short-term interest rates are the interest rates on financial assets that mature within six months or less. Long-term interest rates are the interest rates on financial assets that mature a number of years in the future. Even if in reality they have different structures, for our current purposes we will assume that there is only one interest rate. 16 of 29
The Demand for Money (II) The Money Demand Curve The money demand curve shows the relationship between the quantity of money demanded and the interest rate. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. 17 of 29
The Demand for Money (III) Prices and the Demand for Money However, economists often focus on the real quantity of money: the nominal quantity of money (M) divided by the aggregate price level (P). The real quantity of money (M/P) measures the purchasing power of the nominal quantity of money. 18 of 29
The Demand for Money (IV) Shifts of the Real Money Demand Curve Factors that can change the real money demand curve: Changes in Real Aggregate Spending The larger the quantity of goods and services households and firms plan to buy the larger the quantity of money they will want to hold. Changes in Banking Technology Changes in Tech have reduced the real demand for money by making it easier to get it or to purchase without cash. Changes in Institutions Changes in legislation (US bank legislation 1980s). 19 of 29
The Demand for Money (V) The Velocity Approach to Money Demand The velocity of money is nominal GDP divided by the nominal quantity of money. That is, V = (P x Y) / M or M x V = P x Y which is called the quantity equation. The velocity is the number of times the average unit of money is spent in a year. The Aggregate Spending is equal to the nominal quantity of money, M, times the velocity, V, and nominal GDP is equal to Aggregate Spending. You can now check your understanding 14-1 (p. 349) 20 of 29
Money and Interest Rates (I) The Equilibrium Interest Rate Liquidity preference model of the interest rates 21 of 29
Money and Interest Rates (II) Monetary Policy and the Interest Rate (I) 22 of 29
Money and Interest Rates (III) Monetary Policy and the Interest Rate (II) You can now check your understanding 14-2 (p. 354) 23 of 29
Monetary Policy and Aggregate Demand (I) Expansionary Monetary Policy y( (with multiplier) Expansionary monetary policy is monetary policy that increases aggregate demand. It occurs through a decrease of the interest rate which stimulated investment and consumer spending. 24 of 29
Monetary Policy and Aggregate Demand (II) Contractionary Monetary Policy y( (with multiplier) Contractionary monetary policy is monetary policy that reduces aggregate demand. It occurs through an increase of the interest rate which discourage investment and consumer spending. 25 of 29
Monetary Policy and Aggregate Demand (III) The Short-Run Determination of the Interest Rate In the short run, the interest rate is determined in the money market, where an increase in the money supply from M1 to M2 pushes the equilibrium interest rate down from r1 to r2. The fall in the interest rate in the money market leads, through the multiplier effect, to an increase in GDP and savings; to a rightward shift of the supply curve of loanable funds, from S1 to S2; and to a fall in the interest rate, from r1 to r2. 26 of 29
Money, Output and Prices in the Long Run (I) Short-Run and Long-Run Effects of an Increase in the Money Supply 27 of 29
Money, Output and Prices in the Long Run (II) Monetary Neutrality There is monetary neutrality when changes in the money supply have no real effects on the economy no effects on real GDP or components. The only effect on an increase in the money supply is to raise the aggregate g price level by an equal percentage. It is then said that money is neutral in the long term. Show what happens in the long run if, from a LRME, the money supply multiplies by 1.25. 28 of 29
Money, Output and Prices in the Long Run (III) The Interest Rate in the Long Run 29 of 29
K E Y T E R M S Money Currency in circulation Checkable bank deposits Money supply Medium of exchange Store of value Unit of account Commodity money Commodity-backed money Fiat money Monetary aggregate g Near-moneys Bank Financial intermediary Bank deposit Bank reserves Asset Liability Reserve ratio Bank run Deposit insurance Reserve requirements Excess reserves Central bank Federal funds market Federal funds rate Discount rate Open-market operation Target federal funds rate Expansionary monetary policy Contractionary monetary policy 30 of 29