Money and Banking 31,32,33 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Definition of Money What is Money ? Anything that performs the functions of money is money LO1 30-2

Functions of Money 1- Medium of exchange Used to buy/sell goods 2- Unit of account Goods valued in dollars 3- Store of value - Transferring purchasing power from present to future. - Money is used to store value because it is the most liquid asset. LO1 30-3

Functions of Central Bank 1- Quasi Public Bank Not deal with public only commercial banks 2- Bankers’ Banks - issuing a currency - acting as lender of last resort - accepting deposits from banks LO1 30-4

Components of Money Supply Supply of Money: Measuring Money in the Economy Money supply is measured in two ways; The narrowest definition of money supply is M1 The broader definition of money supply is M2 LO1 30-5

M1 M1= Currency + Checkable Deposit Currency -Coins : All coins are “token money” -Paper money Checkable deposits - Customers Deposits payable on demand - Checkable deposits are the largest component of M1 LO1 30-6

M2 M2 = M1+ SD + TD + MMMF M1 Saving deposits Time deposits Money market mutual funds (MMMF) LO1 30-7

Money Market Links the relationship between amount of money & interest rate in a graph. Why supply money (M s )? - Central Bank only controls the Money Supply - Central Bank changes Money Supply when needed (using tools of Monetary Policy) Why hold (Demand) money (M d )? 1- Transactions demand(indicated by nominal GDP) 2- Asset demand,(varies inversely with the interest rate) Thus; Total money demand is function of GDP & interest rate LO1 30-8

Money Market Total demand for money (M d ) and supply of money (M s ) LO Rate of interest, i percent Amount of money demanded and supplied (billions of dollars) MsMs MdMd - Equilibrium i is 5%, - Equilibrium i changes with shifts in M d and M s

Commercial Banks Accept deposits from customers Banks create money through lending Banks lend excess reserves (How ??) Total Reserves consist of Required Reserves (at the central bank) & Excess Reserves ( available to banks) Required reserves= Checkable deposits x reserve required ratio Example: – Total Checkable deposits $1,000,000 at NBK, Reserve Required Ratio = 20%, then NBK has to keep …….. at the central Bank of Kuwait, and lends up to ……… LO

Tools of Monetary Policy First Tool: Open market operations – Buying and selling of government securities (or bonds) – Commercial banks and the general public – Used to influence the money supply When the Central Bank sells securities, commercial bank reserves are reduced (Money supply decreases…why?) When the Central Bank buys securities, commercial bank reserves are increased (Money supply increases..why?) LO

Tools of Monetary Policy Second Tool : Reserve requirement Ratio (RRR) – part of the deposits at each commercial bank should be kept at the central bank When the Central Bank increases RRR, commercial bank reserves are reduced (Money supply decreases…Why?) When the Central Bank decreases RRR, commercial bank reserves are increased (Money supply increases…Why?) LO

Tools of Monetary Policy Third Tool : Discount Rate (Rd) – is the interest rate that the central bank charges to commercial banks that borrow from the central bank. When the Central Bank increases Rd, commercial bank reserves are reduced (Money supply decreases…Why?) When the Central Bank decreases Rd, commercial bank reserves are increased (Money supply increases… Why?) LO

Monetary Policy The monetary policy is the use of monetary policy tools to affect the Aggregate Demand (AD). Expansionary monetary policy To increase AD, central bank aims to increase Money Supply using: OMP, or lower RRR, or lower Rd Restrictive(Contractionary)monetary policy To increase AD, central bank aims to decrease Money Supply using: OMS, or rise RRR, or rise Rd LO

Expansionary Monetary Policy Used to face Recession or Unemployment When: GDP (or Y) < AE Need to increase the level of AE Central Bank uses OMP, or lower RRR, or lower Rd This increases the level of Y (through shifting AD to the right) LO

Expansionary Monetary Policy Real GDP (billions) Price level AD 2 AD 1 increase in aggregate demand AS $510 P1P1 LO

Contractionary Monetary Policy Used to face the inflation When: GDP (or Y) > AE Need to reduce the level of AE Central Bank uses OMS, or rise RRR, or rise Rd This decreases the level of Y (through shifting AD to the left) LO

Contractionary Monetary Policy Real GDP (billions) Price level AD 2 AD 1 decrease in aggregate demand AS $ 522 P2P2 a b P1P1 LO

Expansionary Monetary Policy Problem: Unemployment and Recession Central Bank buys bonds, lowers reserve ratio, lowers the discount rate, Excess reserves increase Money supply rises Investment spending increases Aggregate demand increases Real GDP rises LO4 CAUSE-EFFECT CHAIN 33-19

Restrictive Monetary Policy Problem: Inflation Central Bank sells bonds, increases reserve ratio, increases the discount rate Excess reserves decrease Money supply falls Investment spending decreases Aggregate demand decreases Inflation declines CAUSE-EFFECT CHAIN LO