Monetary Policy Unit 2.5. What is money?  Money is any object or record that is widely accepted as payment for goods and services.  3 Functions:  Money.

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Monetary Policy Unit 2.5

What is money?  Money is any object or record that is widely accepted as payment for goods and services.  3 Functions:  Money must be a medium of exchange  Money must serve as a unit of account  Money must be a store of value

Categories of Money  M1  All currency (paper and coin money)  Deposits, traveller’s checks  M2  All of M1  Less accessible money such as time deposits and short-term deposits

Online Videos  What is Money? rjVkB8&list=PLF2A3693D8481F442 rjVkB8&list=PLF2A3693D8481F442  Creating Money st=PLF2A3693D8481F442 st=PLF2A3693D8481F442  The Fed st=PLF2A3693D8481F442 st=PLF2A3693D8481F442

Intro to Money Market  Macroeconomics policymakers have 2 general tools to manage the level of aggregate demand  Fiscal Policy – changing the levels of taxes and government spending  Monetary Policy – changing the supply of money available in a nation  Carried out by the central bank of each country  Note the difference between central bank and commercial bank

Central bank vs. Commercial bank  Commercial banks  are financial institutions whose main functions are  to hold deposits for their customers (consumers and firms)  to make loans to their customers  to transfer funds by check & electronically from one bank to another  to buy government bonds

Role of Central Banks  Central bank  Is the monetary authority of a country, which performs the functions of issuing currency, managing the money supply, and controlling interest rates  2 largest economies  European Union – The European Central Bank (ECB)  United States – US Federal Reserve (the Fed)  Independent from politics  Head and governors are appointed by politicians to fixed terms

Central Bank’s Responsibilities  Banker to the government  Banker to commercial banks  Regulator of commercial banks  Conduct Monetary Policy

Central Bank’s Responsibilities  Banker to the government  Holds the government’s cash/deposits  Receives payments for the gov’t and makes payments for the gov’t  Manages the government’s borrowing by selling bonds to commercial banks and the public  Acts as an adviser to the gov’t on financial and banking matters

Central Bank’s Responsibilities  Banker to commercial banks  Holds deposits for commercial banks  Loans to commercial banks in times of need  Note: central bank does not act as a banker to consumers and firms

Central Bank’s Responsibilities  Regulator of commercial banks  Central bank regulates and supervises commercial banks, making sure they operate with appropriate levels of cash & according to rules that ensure the safety of the financial system  This is a very important function, because the funds that commercial banks use to make loans are the savings and other deposits that consumers and firms deposit with commercial banks

Central Bank’s Responsibilities  Conduct Monetary Policy  CB is responsible for monetary policy, based on changes in the supply of money or the rate of interest  Usually responsible for the determination of exchange rates because of the close relationship between interest rates and exchange rates

The Money Market  Money Demand  Includes the desire to hold money as an asset and the demand for money as a means to purchase goods and services  Inversely related to the interest rate  Increases / decreases with the overall level of national output  Money Supply  Is determined by the action of the central bank aimed at increasing or decreasing the overall supply of money available in a nation

Equilibrium in the Money Market Quantity of Money Interest Rate 0 Money Demand (Dm) Quantity fixed by the Central Bank Money Supply (Sm) r2r2 M2M2 d M d r1r1 Equilibrium interest rate

Monetary Policy and the Money Market Interest Rate Q of Loanable Funds S1S1 D Money Market Loanable Funds Market Interest Rate Q of Money M1M1 i0i0 D i1i1 M0M0 S0S0 i0i0 i1i1 Expansionary monetary policy leads to… … an increase in loanable funds The decline in interest rates increases investment spending, which shifts the aggregate demand curve out to the right 14-16

Monetary Policy Price level Real output AD 0 P0P0 AD 1 P1P1 Y0Y0 Y1Y1 SAS Monetary policy affects both real output and the price level AD 2 Expansionary monetary policy shifts the AD curve to the right Contractionary monetary policy shifts the AD curve to the left Y2Y2 P2P

Tools for changing the money supply  Central banks manage the money supply with the following monetary policy tools:  Changing the discount rate  Buying or selling bonds  Changing the reserve requirement

Tools for changing the money supply (1) Changing the discount rate  Discount rate is the rate charged by central banks when they make loans to big commercial banks  Central bank is typically the “lender of last resort”; commercial banks would try to borrow first from other commercial banks  Lower discount rate, increases money supply and lowering interest rates across the economy

Tools for changing the money supply (2) Buying and selling bonds (Open Market Operations – OMO)  Central bank buys bonds from private banks  Puts cash into banks’ reserves, increasing the funds available for banks to make loans  Incentive for banks to lower the interest rates they charge private borrowers  Increases the level of consumptions and investment in the economy – Expansionary monetary policy  Central bank sells bonds to private banks  Commercials banks’ reserves are taken out of the private banking system  Less money available for loans which increases interest rates  Decreases the level of consumption and investment in the economy – contractionary monetary policy

Tools for changing the money supply (3) Changing the reserve requirement  Reserve requirement is the % of deposits that banks are required to have available at all times  Amount held beyond the reserve requirement is called excess reserves  If the reserve requirement is lowered, bank will have more money to loan out. This increases money supply and lowers interest rate.

Tools for changing the money supply Additional info: 7/central-banks.asp

Expansionary Monetary Policy to Fight a Recessionary Gap

Contractionary Monetary Policy to Fight an Inflationary Gap

Monetary Policy  Expansionary monetary policy is a policy that increases the money supply and decreases the interest rate and it tends to increase both investment and output  Contractionary monetary policy is a policy that decreases the money supply and increases the interest rate, and it tends to decrease both investment and output M i IYM i IY 14-25

Online tools  Welker’s Wikinomics

Evaluation of Monetary Policy

Stimulating growth during recession  STRENGTHS  Speed  Control  No Politics  No crowding-out

Stimulating growth during recession  STRENGTHS  Speed  Can be enacted by the CB as soon as the problem is recognized  CB skips the process by which legislators debate fiscal policy and create compromises in order to get the policy passed

Stimulating growth during recession  STRENGTHS  Control  It is within the power of the CB to adjust the money supply more discretely and finely than legislators can with fiscal policy

Stimulating growth during recession  STRENGTHS  No Politics  CB is independent of politics and not involved in election processes  This should prevent the desires of voters from influencing CB policy

Stimulating growth during recession  STRENGTHS  No Crowding-Out  Monitary policy, by lowering interest rates, avoids crowding-out

Stimulating growth during recession  WEAKNESSES  Investors reluctant to borrow  Time lags  Changes in elasticity of demand for investment

Inflation Control  STRENGTHS  Direct action, speed and control  Apolitical nature of the bank

Inflation Control  WEAKNESSES  Time lags during high inflation  Ineffective against cost-push inflation

Test your understanding  Explain the functions of central banks and their role with respect to achieving macroeconomic objectives.  Explain the importance of the money supply in determining the rate of interest.  What is the government authority that is responsible for changing the supply of money and carrying out monetary policy?  Using a diagram, explain how equilibrium interest rates are determined.  What would a central bank do if it wanted to (i) lower interest rates, (ii) to increase interest rates?

Test your understanding  What are the objectives of monetary policy?  Distinguish between expansionary and expansionary monetary policy.  What are the components of AD that the monetary policy can influence?  Using diagrams, show how the government can use monetary policy when there is (a) a recessionary gap, and (b) an inflationary gap