1 النقود والبنوك والسياسة النقدية Money, Banking System, Central Bank and Monetary Policy الجزء الثامن

2 Recall, there are many policies that can applied to change a GDP gap or to generally change the real GDP and the price level. One of these policies is the Fiscal Policy. The other policy is monetary policy. Monetary policy: policy by the central Bank to adjust and control the quantity of money in circulation (money supply) through different tools to influence GDP growth, the general price level and other macroeconomics variables. السياسة النقدية : سياسة يتبعها البنك المركزي للتحكم في عرض ( كمية ) النقود في الاقتصاد باستخدام أدوات مختلفة للتأثير على النمو الاقتصادي ومستوى الأسعار ومتغيرات اقتصادية كلية أخرى

3 To understand the operation of the monetary policy, we need to understand the definition and function of money, commercial banks, and the central bank. لفهم السياسة النقدية نحتاج تعريف وفهم وظائف كل من النقود ، و البنوك التجارية و البنك المركزي.

4 Q: What is money ? Money: anything that is generally accepted as a means of payment (in the exchange of goods & services) النقود : أي وسيلة تستخدم للتبادل السلعي والخدمات و تتمتع بالقبول العام First: Money

5 Functions of Money: 1- Medium of exchange 2- Unit of account 3- Store of value 4- Standard of deferred payment ( وسيلة للدفع الآجل ) Q1: What is meant by money illusion? Q2: What is meant by currency substitution?

6 (1) Narrow definition: financial assets that are the most liquid : M1 = currency in circulation (coins & papers in the hands of the public ) + Demand deposits (+ traveler's checks) (2) Broad definition: M2 = M1 + Saving and time deposits (in commercial banks (3) Broad definition: M3 = M2 + time deposits in other financial institutions Q: What is meant by quantity of money (money supply)? And how to measure it ?

7 Note: part of the quantity of money is held by commercial banks as demand and time deposits. In Kuwait (2000): M1: KD m M2: KD m M3: KD m

8 Functions of Commercial Banks 1- Accepting deposits 2- Lending money 3- Other banking services 4- Money creation ( خلق النقود ) Second: Commercial Banks

9 Required reserve ratio ملاحظة : جزء كبير من أرباح البنوك التجارية هو فرق أسعار الفائدة على القروض عن أسعار الفائدة على الودائع. إذن من صالح البنوك التجارية إقراض أكبر قدر من حجم الودائع لديها. لتنظيم هذه العملية بما يحافظ على حقوق المودعين، يقوم البنك المركزي بفرض ما يعرف بنسبة الاحتياطى القانوني. (Required reserve ratio) Required reserve ratio (RRR): percentage of deposits that is required by the central bank to keep as reserves. نسبة الاحتياطي القانوني : نسبة يفرضها البنك المركزي على البنوك التجارية يحتفظ بها من كل وديعة كاحتياطى.

10 Example: if RRR=10%, of an initial deposit = KD100 Required reserves = 100 * 10% =10 ( الاحتياطى القانوني ) Excess reserves = = 90 ( الاحتياطى الفائض ) Note: If the bank was able to lend KD 60 of its excess reserves, what is the total reserve this bank has ? Total Reserve = Required reserves + Excess reserves ( الاحتياطى الفائض ) ( الاحتياطى القانوني ) ( الاحتياطى الكلي ) = = 40

11 Money creation is based on the process of deposits & loans and the RRR. To explain this process we assume: 1- All Commercial Banks will apply the RRR 2- All banks will lend their excess reserves 3- No currency leakage out of the banking system Money Creation لشرح عملية خلق النقود نفترض : التزام البنوك التجارية بنسبة الاحتياطى القانوني، وقيام البنوك بإقراض جميع الفوائض النقدية لديها، وعدم وجود أي تسرب من الجهاز المصرفي

A 90B Required Reserves Excess Reserve DepositsBank E D C Example: RRR= 10%, an initial deposit = KD 100

13 Money Multiplier (Deposit expansion multiplier): ( مضاعف النقود / مضاعف الائتمان ) M m = 1 RRR The multiplier: maximum possible change in total deposits out of any new deposit created by a multi-bank system. Potential money creation = initial deposit x M m

14 Q: What will happen to the effect M m when : A: there is a leakage (money drain) from the banking system? B: Banks were not able to lend all their excess reserves? C: Banks fail to apply the RRR?

15 Example1: IF RRR= 20%, and an initial deposit = KD 7000 was deposited at Alnoor Bank. What is the maximum Value of loans can this bank lend ? What is the maximum value of loans can the banking system create out of this deposit ? Alnoor Required Reserves Excess Reserve Deposits Since M m = 1/20% = 5 Total loans (by the banking system) = 5600 x 5 = Answer :

16 Example2: IF RRR= 10%, and a commercial bank has deposits = KD 50,000 and total reserves = KD 7000 What is the value of excess reserves this bank has ? Required reserves = deposit x RRR = 50,000 x (10/100) = 5000 Excess reserves = Total reserves - Required reserves = 7000 – 5000 = 2000 Answer :

17 Third: Central Bank Functions of the Central Bank 1- Issuing the national currency 2- Banker’s Bank (maintain cash deposits, reserves, transferring funds and checks between banks, imposes regulations on banks, lender of last resort). 4- Implementing monetary policy (through monitoring and controlling money supply) 3- Government bank (handling payroll accounts, financial consultant & representative)

18 وظائف البنك المركزي 1 - اصدار العملة الوطنية 2 - بنك البنوك : الاحتفاظ بالودائع والاحتياطي، إدارة عمليات المقاصة، الملجأ الأخير للإقراض 3 - بنك الحكومة : إدارة و سداد الالتزامات المالية الداخلية والخارجية للحكومة ، مستشار الحكومة وممثلها في تعاملاتها النقدية الخارجية ، الاحتفاظ بالودائع الحكومية. 4 - رسم وتنفيذ السياسة المالية ( التحكم في عرض النقود (

19 Tools of Monetary Policy 1- Discount rate ( سعر الخصم ): the interest rate that the central bank charges the commercial banks. 3- Open market operation: the purchase and sale of government securities (bonds) by the central bank ( بيع وشراء السندات الحكومية ) 2- Required reserve ratio.

20 Note: To understand how these tools can affect macro economic activities, we first view the impact of changes in money supply. Factors affecting demand for money: ( العوامل المؤثرة على الطلب على النقود ) Factors affecting investment and consumption expenditure such as: income, interest rate, expectation..etc. Factors affecting supply of money: ( العوامل المؤثرة على عرض النقود ) Factors affecting saving decisions and central bank policy such as: income, interest rate, macroeconomic conditions

21 Now assuming all factors constant except interest rate, then money demand is inversely related to interest rate, while money supply is positively related to interest rate بافتراض ثبات جميع العوامل الأخرى، فإن العلاقة بين سعر الفائدة والطلب على النقود هي علاقة عكسية ، وعلاقة سعر الفائدة بعرض النقود علاقة طردية Qm i Md Ms i q

22 Qm i Md Ms i q If the central bank increases the money supply lower interest rate stimulate consumption and investment expenditure, i.e increases AE (other things equal) Ms 2 i2i2 q2q2 Note: This is an expansionary monetary policy that can be applied to increase AE (e.g in case of a deflationary gap)

23 Qm i Md Ms i q If the central bank reduces the money supply raise interest rate reduced consumption and investment expenditure, i.e reduce AE (other things equal) Ms 2 i2i2 Note: This is a contractionary monetary policy that can be applied to reduce AE (e.g in case of an inflationary gap) q2q2

24 First: If an economy is facing a deflationary gap, the central bank can increase money supply, i.e applying an expansionary monetary policy ( سياسة نقدية توسعية ) An expansionary monetary policy tools: 1- Reducing discount rate : reduce interest rate stimulate consumption & investment expenditure increase AE

25 An expansionary monetary policy tools: 2- Reducing RRR : increase money supply lower interest rate stimulate consumption & investment expenditure increase AE 3- Buying government securities : increase money supply lower interest rate stimulate consumption & investment expenditure increase AE

26 Second: If an economy is facing an inflationary gap, the central bank can reduce money supply, i.e applying a contractionary monetary policy ( سياسة نقدية إنكماشية a contractionary monetary policy tools: 1- increasing the discount rate : increase interest rate lower consumption & investment expenditure lower AE

27 A contractionary monetary policy tools: 2- Raising RRR : reduce money supply raise interest rate reduce consumption & investment expenditure reduce AE 3- Selling government securities : lower money supply raise interest rate reduce consumption & investment expenditure reduce AE

28 Possible obstacles to effective fiscal & monetary policies: 1- Possible time lags in policy implementation (more for fiscal policy) 2- Possible crowding out effect (as the government borrows to finance the deficit, interest rates increases and crowds out investment expenditure 3- Possible fiscal & monetary coordination problems

29 4- Lack of full control over some domestic and international economic variables. (e.g lack of control over international money movement, investors & consumers expectations, social & political changes) 5- Limitations of accurate economic forecasting of dynamic economic variables. Q: What policies should be applied in case of stagflation?