The meaning of money
Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
The money supply
Total money in the economy includes not only
currency but also deposits in banks and other
financial institutions that can be readily accessed to
buy goods and services.
Different measures of the stock of money
(narrow...broad).
The money supply (2)
The money supply is the quantity of money available in the economy
- M1: currency, demand deposits
-M2: M1 plus "near-money" (savings accounts)
-M3: M2 plus other financial assets (repurchase agreements, money market fund shares, debt securities up to two
The role of Central Banks
A central bank is an institution designed to regulate the quantity of money in the economy (economic objective) and to oversee the banking system (financial objective).
Economic objective (ECB: control inflation; FED: stabilize the economy) = Monetary pol
Costs of inflation
International competitiveness.
Uncertainty and investment.
Time.
Non anticipated inflation is more distortive. Redistribution of rents from creditors to debtors.
But anticipated inflation can accelerate inflation.
Deflation is also very dangerous.
Both, h
Inflation in the euro-area, the harmonized index of
consumer prices (HICP)
Equilibrium in the money market
A monetary injection (expansive monetary policy)
Banks and the money supply
Central Banks have mechanisms to control the
money supply in the economy (we are going to
analyze them next...).
But Commercial Banks can also affect the money
supply in the economy.
Banks and the money supply (2)
In a fractional-reserve banking system, banks hold a
fraction of the money deposited as reserves and lend out the rest.
Reserves are deposits that banks have received but have not loaned out.
The reserve ratio is the fraction of deposits that banks hold a
Banks and the money supply (3)
This T-Account shows a bank that...
accepts deposits,
keeps a portion as reserves,
and lends out the rest.
It assumes a reserve ratio of 10%.
Banks and the money supply (4)
When one bank loans money, that money is
generally deposited in another bank.
This creates more money to be lent out.
As a result the money supply increases.
...how much money is eventually created in
this economy? The money multiplier.
The money multiplier
The money multiplier is the reciprocal of the reserve
ratio:
M = 1/R
With a reserve requirement, R = 10% or 1/10, the
multiplier is 10.
From an initial deposit of 100 euros, the financial
system can create 1000 euros.
If individuals and business decide to
Excess reserves in the U.S. banking system, 2008-2010
Balance Sheet of a Commercial Bank Balance sheet (commercial bank)
Implementing monetary policy
Monetary policy tools (conventional):
Reserve ratio
- % of total demand deposit liabilities that commercial banks must maintain in a special reserve account with the central bank
Discount rate
- interest rate charged by central bank to commercial banks
Op
Balance sheet changes after borrowing from the Central Bank
Effects of an open-market purchase of T-bills on the
balance sheets of commercial banks and the Central
Bank
In recessionary gap (GDPe< GDPp) authorities use an
expansive policy ("easy money")
IMPLEMENTING MONETARY POLICY
Reduce reserve ratio (rarely used)
Cut discount rate
Buy bonds in the open market
Objective: bring GDPe closer to GDPp
In inflationary gap (GDPe> GDPp), authorities use a
restrictive policy ("tight money")
IMPLEMENTING MONETARY POLICY
Raise reserve ratio (rarely used)
Raise discount rate
Sell bonds in the open market
Objective: bring GDPe closer to GDPp
How monetary policy works?
Expansionary monetary policy
Lower interest rates (r)
Encourage investment (I)
Higher total spending
Multiplier effect on aggregate demand
Increases aggregate quantity demanded
- At any given price level
Causes some inflation
- Depends on slope of aggrega
Which interest rate?
Some can be controlled by the Fed:
- Discount rate / Federal funds rate
- Treasury bills rate
Some cannot be controlled by the Fed
- Credit card balances
- Automobile loans
- Home mortgages
- Corporate bonds
Under normal conditions
- All interest rates mo
Limits of monetary policy
Unconventional monetary policies
Once the federal funds rate is zero
- And yet the economy still needs more stimulus
-Use unconventional monetary policies
Massive lending to banks, or even to companies other
than banks
- The Fed did it in 2008 and 2009
Open-market purchases of assets oth
Balance Sheet of a Central Bank Balance sheet (Central Bank)
A central bank's control of the money supply is not
precise.(unconventional monetary policy)
- The central bank does not control the amount of money that bankers choose to lend.
- The central bank does not control the amount of money that households choose to hold as deposits in banks.
Pros and cons of monetary policy
Control over the money supply is imperfect
Usually conducted by technical experts who are not
subject to political pressures
Decision lag can be very short
Problem: monetary policy can take 12-18 months to
affect aggregate demand, and therefore GDPe
Monet
How low is too low? (Or does anything happen when
interest rates turn negative in real terms?)