Principles of Macroeconomics Lecture 3 MONEY AND COMMERCIAL BANKS CENTRAL BANKING AND MONETARY POLICY

Money  Money is anything that is generally accepted as a medium of payment.  Money is not income, and money is not wealth.  Money has the following functions:  Medium of payment  Store of value  Unit of account

Money: Medium of Payment  Barter system: direct exchange of goods and services for other goods and service  Barter system requires a double coincidence of needs for trade to take place.  Money eliminates the barter problem.  Money facilitates market transactions.

Money: Store of Value  Money is as an asset that can be used to transport purchasing power from one time period to another.  Money is easily portable across time and space.

Liquidity  The liquidity property of money makes money the best medium of exchange as well as a good store of value.  Money is the most “liquid” asset. Currency Debasement: The decrease in the value of money that occurs when its supply is increased rapidly.

Money: Unit of Account  Money serves as a unit of account for  quoting prices  keeping books  calculating debts

Types of Money  Commodity Money: an item used as money that also has intrinsic value in some other use (e.g., gold & silver).  Fiat or Token Money: money that is basically worthless (e.g., coins & bills).  Legal Tender: money that a government requires to be accepted in settlement of debts (e.g., bills).

Supply of Money  M1 or Transactions Money is money that can be directly used in transactions.  M1 = currency held outside banks + demand deposits + plus traveler’s checks + other checkable deposits

Supply of Money  M2 or Broad Money includes near monies that are close substitutes for transactions money.  M2 = M1 + savings accounts + money market accounts + other near monies

Central Banking System  The Central Bank regulates the private banking system  the Central Bank requires a fraction of any deposit at a bank to be held at the bank’s account at the Central Bank; this fraction is called the Required Reserve Ratio

Functions of the Central Bank  Clearing interbank payments  Regulating the banking system  Assisting banks in difficult financial times  Managing the nation’s foreign exchange rates and foreign exchange reserves

Functions of the Central Bank  Control of mergers between banks  Examination of banks to ensure that they are financially sound  Setting the short-term interest rate  Lender of last resort

Commercial Banking: Bank Reserves  Total Reserves = Total deposits at a bank  Required Reserves: A fraction of Total Reserves a bank must hold at the Central Bank by law  Excess Reserves: The rest of Total Reserves that a bank can use for loans

Commercial Banking: Money Creation  Banks usually use up their Excess Reserves to make loans.

Commercial Banking: Money Creation  Assume Jim deposits €100 of newly printed money in his checking account in Bank 1. Also assume the Central Bank requires 20% in Required Reserves. Bank 1 can increase its loans by €80.  Total Reserves = 100  Required Reserves = 20  Excess Reserves = 80

The Creation of Money Bank 1 makes an €80 loan and deposits it in the checking account of a borrower, Andrew, who uses the loan to buy a good and pays by a check. The seller, John, deposits the check in his account in Bank 2:  Total Reserves = 80  Required Reserves = 16  Excess Reserves = 64

The Creation of Money Now, Bank 2 makes a €64 loan and deposits it in the checking account of a borrower, Peter, who uses the loan to buy a good and pays by a check. The seller, Steven, deposits the check in his account in Bank 3:  Total Reserves = 64  Required Reserves =  Excess Reserves = 51.20

The Creation of Money  Now, Bank 3 makes a €51.20 loan and deposits it in the checking account of a borrower, Neithan, who uses the loan to buy a good and pays by a check. The seller, Jennifer, deposits the check in her account in Bank 4:  Total Reserves =  Required Reserves =  Excess Reserves = 40.96

The Creation of MoneySummary:Deposits Bank Bank 2 80 Bank 3 64 Bank Total500.00

The Money Multiplier  The multiple by which deposits can increase for every monetary unit increase in excess reserves: In this example where the required reserve ratio is 20%, the money multiplier is 1/0.20 = 5. It means a €1 increase in excess reserves could cause an increase in deposits of €5 if there were no leakage out of the system.In this example where the required reserve ratio is 20%, the money multiplier is 1/0.20 = 5. It means a €1 increase in excess reserves could cause an increase in deposits of €5 if there were no leakage out of the system.

Monetary Policy the Central Bank uses three instruments to manage the money supply and interest rates:  The Required Reserve Ratio  The Discount Rate  Open Market Operations

The Required Reserve Ratio  If the Central Bank wants to increase the money supply, it lowers the Required Reserve Ratio.  As a result, banks will have to hold less money in RR and keep more money in ER. To lend the additional ER, banks will lower the rate of interest on business loans.

The Discount Rate  Banks can borrow from the Central Bank. The interest rate they pay to the Central Bank is the Discount Rate.  If the Central Bank wants to increase the money supply, it would lower the discount rate, which encourages banks to borrow from the Central Bank. To lend these additional reserves, banks will lower the interest rate on business loans.

Open Market Operations These are defined as the Central Bank’s purchases and sales of government bonds to member banks.  If the Central Bank wants to increase the money supply, it would buy government bonds from private banks. Banks receiving additional reserves from the Central Bank will lower the interest rate on business loans.

Open Market Operations These are the C entral Bank’s preferred means of controlling the money supply because:  They can be used with some precision.  They are extremely flexible and fairly predictable.

Easy Monetary Policy  To increase the money supply and reduce the interest rate, the Central Bank could  Lower the required reserve ratio  Lower the discount rate  Buy government securities from member banks

The Supply of Money  A vertical money supply curve says the Central Bank sets the money supply independent of the interest rate. MdMd

Increase in Money Supply MsMs MdMd An increase in money supply causes interest rate to fall and investment to rise. An increase in money supply causes interest rate to fall and investment to rise.

Tight Monetary Policy  To decrease the money supply and reduce the interest rate, the Central Bank could  Increase the required reserve ratio  Raise the discount rate  Sell government securities from member banks Any or a combination of these actions will reduce the money supply and increased the rate of interest.

Tight Monetary Policy  To decrease the money supply and reduce the interest rate, the Central Bank could  Increase the required reserve ratio  Raise the discount rate  Sell government securities from member banks Any or a combination of these actions will reduce the money supply and increase the rate of interest.

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: Factors affecting investment and consumption expenditure such as: income, interest rate, expectation..etc. Factors affecting supply of money: Factors affecting saving decisions and central bank policy such as: income, interest rate, macroeconomic conditions

Now assuming all factors are constant except interest rate, then money demand is inversely related to interest rate, while money supply is positively related to interest rate Qm i Md Ms i q

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 output (other things equal) Ms 2 i2i2 q2q2 Note: This is an expansionary monetary policy that can be applied to increase output (e.g in case of a deflationary gap)

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 output (other things equal) Ms 2 i2i2 Note: This is a contractionary monetary policy that can be applied to reduce output (e.g in case of an inflationary gap) q2q2

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

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

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

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

Effect of Money Demand on Output

Helpful Reading Economics. Samuelson, & Nordhaus (2005) Ch