academic year 2015/16 Introduction to Economics Augusto Ninni

So far we have assumed that the money supply is completely controlled by the Central Bank and that it was the only instrument of monetary policy. To what extent does the Central Bank control the supply of money? What is the role of private banks in determining the supply of money? What are the other policy instruments used by the Central Bank? Money supply and the instruments of monetary policy

 The role of private banks in the creation of money  Re-examine the equilibrium in financial markets  Instrument of monetary policy Money supply and the instruments of monetary policy

So far we assumed that the money supply was entirely control by the Central Bank. In reality in economic systems there exist different financial intermediaries(e.g., private banks) that: Receive funds from firms and individuals (bank deposit) Give loans and purchase financial assets The activities of private banks affect the money supply.

Let’s examine the relationships among households, firms and private banks a)Let’s assume that households and firms are endowed with a certain amount of cash (K) K is split in two parts Part kept at home in form of cash Bank deposit Part that is saved in a bank account Cash flow

b)Banks receive the sum that is saved in deposits This sum can be used in any moment by their owners (withdrawal, payments, etc.) -> Banks should keep an amount of cash equal to the total amount of deposits In reality, however, only a fraction of deposit is available for withdrawal -> banks keep less cash than the value of their deposits.

This amount of cash is called: Bank reserves (e.g. 10% of deposits). The Central Bank set the minimum value of the reserves(mandatory reserves) The bank can keep a higher amount if she wish (voluntary reserves) Bank reserve= Mandatory reserves + Voluntary reserves

c) Once fixed the reserves, what happens to the remaining part of deposits? Two alternatives: i) loans (e.g. mortgage); ii) purchase of financial assets Deposits Loans and purchase of financial assets have very similar effects -> for simplicity we consider only the purchase of financial assets. Reserve Loans+Assets

d) Purchase of financial assets Banks purchase assets from firms and households. Those who sell assets receive cash in exchange. How is this cash spent? Cash Circulating Deposits e) … and the previous mechanism starts again…

In conclusion we have: Cash k Circulating Deposits Reserves Assets Cash Circulating Deposits and so on…

At each “step” a smaller quantity of cash is reintroduced in the system. The cash that is reintroduced can be used to make transactions: each introduction of cash “create” new money -> the interaction among banks, firms and household “create” new money.

Given this mechanism, let’s now go back to the determination of equilibrium in financial markets Components used to determine the equilibrium: a) Demand of money M D =$YL(i) (Chapter 4)

b) Firm and household behaviour Demand of money M D Demand of circulating units Demand of deposits CU D = cM D D D = (1-c)M D with 0 < c < 1 c) Bank behaviour Demand of reserve -> fraction of deposits R D = rD D with 0< r  <1

Let’s introduce a new variable: Money issued by the Central Bank (cash) -> Monetary Base (H). The monetary base is not the total supply of money (there is also money “created” by private banks). The monetary base is equal to the overall cash owned in the economy. Which form does this cash take? Households and firms -> Circulating units Banks -> Reserves

H = Circulating units + Reserves = CU D + R D By substituting the preceding equations H = CU D + R D = cM D + rD D = cM D + r(1-c)M D = [c + r(1-c)] M D = [c + r(1-c)] $YL(i) Equilibrium of financial markets

From previous equation we know that H = [c + r(1-c)] $YL(i) Equilibrium condition in financial markets is M S = $YL(i) By substituting the second equation in the first we get H = [c + r(1-c)] M S from which we get M S = H /[c + r(1-c)] Equilibrium of financial markets

Let’s examine the money supply:  H -> controlled by the Central Bank  1 /[c + r(1-c)] -> depends on (i) c -> behaviour of households and ii) r -> behaviour of banks The Central Bank controls only part of the Money Supply. Equilibrium of financial markets

Moreover, it can be shown that 1/[c + r(1-c)]>1 It follows that: Money supply > monetary base 1/[c + r(1-c)] Money multiplier Equilibrium of financial markets

What happens if the Central Bank want ↑ M S ? The CB impact on the Money Supply by increasing the monetary base ( ↑ H). The effect of ↑ H is amplified by the actions of banks. The overall effect is only partially under CB’s control (if banks and households change their behaviour the money multiplier changes too) The effect of the intervention can be only approximately forecasted by the CB. Equilibrium of financial markets

We conclude the analysis of monetary policy examining the set of instruments that is used by the Central Bank. The main instruments are three: Monetary base Coefficient of mandatory reserves Interest rate

1) Monetary base The Central Bank can affect the short-period equilibrium by changing the monetary base H. It is the mechanism that we have been considering so far: ↑ H -> ↑ M S -> ↓ i -> ↑ Y These effect (as we saw before) depend on the value of the money multiplier and thus on the behaviour of households, firms and banks.

2) Coefficient of mandatory reserve. Money multiplier 1/[c + r(1-c)] contains the reserve coefficient  This coefficient depends on the value of mandatory reserve set by the Central Bank:  -> 1/[c + r(1-c)] If the Central Bank ↓ r -> ↑ multiplier -> ↑ M S -> ↓ i -> ↑ Y

The effect depends also on the behaviour of banks It is possible that ↑ mandatory reserve but banks ↓ voluntary reserve -> r does not change

3) Reference interest rate Another way of affecting the short period equilibrium is the one of changing the reference interest rate i R. i R - rate of banks’ re-financing (very short term). What happens when i R vary?

Premise: So far we have assumed that there exist only one asset and one interest rate. In reality there exist different financial assets (bonds, shares, short-term assets, long-term assets, etc.) There exist substitutability among the different assets: those who purchase one asset compare the return of alternative assets and decides consequently -> the interest rate of the different assets are linked one another.

The link among the different assets imply that if i R changes also the other interest rate change in the same direction For instance if the Central Bank ↓ i R -> ↑ I The relation between i and i R is not stable so that the overall effects of the intervention cannot be determined with certainty.

In conclusion: The Central Bank has three instruments: monetary base, reserve coefficient and interest rate Each of these three instruments allow one to impact on the short period equilibrium The effects obtained are influenced by the behaviour of individuals and by financial intermediaries.

Given that behaviour can change over time the effects are foreseen with some errors. For this reason the choice of the instruments depend also on the greater or smaller stability of the effects that are obtained.