money and monetary policy. meaning and functions of money the functions of money –medium of...
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Money and Monetary
Policy
Money and Monetary
Policy
Meaning and Functions of MoneyMeaning and Functions of Money
• The functions of money
– medium of exchange
– means of storing wealth
– means of evaluation
– means of establishing value of future claims and payments
• What should count as money?
– narrow definitions of money
– broad definitions of money
Financial System in the UKFinancial System in the UK
• The key role of banks
– deposits and loans
– liabilities and assets
– retail and wholesale deposits and loans
• Liabilities
– sight deposits
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• The key role of banks– deposits and loans
– liabilities and assets
– retail and wholesale deposits and loans
• Liabilities– sight deposits
– time deposits
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• The key role of banks– deposits and loans
– liabilities and assets
– retail and wholesale deposits and loans
• Liabilities– sight deposits
– time deposits
– certificates of deposit
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• The key role of banks– deposits and loans
– liabilities and assets
– retail and wholesale deposits and loans
• Liabilities– sight deposits
– time deposits
– certificates of deposit
– repos
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• Assets
– cash and balances with the Bank of England
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• Assets
– cash and balances with the Bank of England
– short-term loans
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• Assets
– cash and balances with the Bank of England
– short-term loans
– longer-term loans
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• Liquidity and profitability
– profitability
– liquidity
• the liquidity ratio
Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003
Financial System in the UKFinancial System in the UK
• The central bank– Bank of England, ECB, Fed, etc.
– functions• note issue
• acts as a bank– to the government
– to overseas central banks
• overseas activities of banks
• provides liquidity to the banks– lender of last resort
• operates monetary and exchange rate policy
Financial System in the UKFinancial System in the UK
• The London money market
– the discount and repo markets• discounting
• the repo market
• last-resort facilities by Bank of England
– the parallel money markets• the inter-bank market
• inter-companies deposit market
• market for certificates of deposit, etc.
• foreign currencies market
The Supply of MoneyThe Supply of Money
• Definitions of the money supply
– monetary base
– broad money
• Definitions in the UK
– definitions in the UK: M0, M4
UK monetary aggregates: (end February 2003)UK monetary aggregates: (end February 2003)
Cash outside Bank of England
+ Banks’ operational deposits with Bank of England
= M0
Cash outside banks (in circulation)
+ Private-sector retail bank and building society deposits
= Retail deposits and cash in M4 (also known as M2)
+ Private-sector wholesale bank and b.s. deposits + CDs
= M4
36 861
91
36 952
30 630
676 969
707 599
295 996
1 003 595
£ million
UK monetary aggregates: (end February 2003)UK monetary aggregates: (end February 2003)
Cash outside Bank of England
+ Banks’ operational deposits with Bank of England
= M0
Cash outside banks (in circulation)
+ Private-sector retail bank and building society deposits
= Retail deposits and cash in M4 (also known as M2)
+ Private-sector wholesale bank and b.s. deposits + CDs
= M4
36 861
91
36 952
30 630
676 969
707 599
295 996
1 003 595
£ million
UK monetary aggregates: (end February 2003)UK monetary aggregates: (end February 2003)
Cash outside Bank of England
+ Banks’ operational deposits with Bank of England
= M0
Cash outside banks (in circulation)
+ Private-sector retail bank and building society deposits
= Retail deposits and cash in M4 (also known as M2)
+ Private-sector wholesale bank and b.s. deposits + CDs
= M4
36 861
91
36 952
30 630
676 969
707 599
295 996
1 003 595
£ million
The Supply of MoneyThe Supply of Money
• Definitions of the money supply
– monetary base
– broad money
• Definitions in the UK
– definitions in the UK: M0, M4
– euro zone definitions: M1, M2, M3
UK monetary supply using ECB measures:(end February 2003)
UK monetary supply using ECB measures:(end February 2003)
Currency in circulation
+ Overnight deposits
= M1
+ Deposits with agreed maturity up to 2 years
+ Deposits redeemable up to 3 months' notice
= M2
+ Repos
+ Money market funds and paper
= M3
31 351
513 292
544 643
81 696
296 518
922 857
88 978
57 496
1 069 331
£ million
UK monetary supply using ECB measures:(end February 2003)
UK monetary supply using ECB measures:(end February 2003)
Currency in circulation
+ Overnight deposits
= M1
+ Deposits with agreed maturity up to 2 years
+ Deposits redeemable up to 3 months' notice
= M2
+ Repos
+ Money market funds and paper
= M3
31 351
513 292
544 643
81 696
296 518
922 857
88 978
57 496
1 069 331
£ million
UK monetary supply using ECB measures:(end February 2003)
UK monetary supply using ECB measures:(end February 2003)
Currency in circulation
+ Overnight deposits
= M1
+ Deposits with agreed maturity up to 2 years
+ Deposits redeemable up to 3 months' notice
= M2
+ Repos
+ Money market funds and paper
= M3
31 351
513 292
544 643
81 696
296 518
922 857
88 978
57 496
1 069 331
£ million
The Supply of MoneyThe Supply of Money
• Definitions of the money supply– monetary base
– broad money
• Definitions in the UK
• The creation of credit
The Supply of MoneyThe Supply of Money
• Definitions of the money supply– monetary base
– broad money
• Definitions in the UK
• The creation of credit– simple illustration
Credit creation: Banks' original balance sheetCredit creation: Banks' original balance sheet
Credit creation: Effect of a new deposit of £10bn Credit creation: Effect of a new deposit of £10bn
Credit creation: Full effect of a new deposit of £10bn Credit creation: Full effect of a new deposit of £10bn
The Supply of MoneyThe Supply of Money
• Definitions of the money supply– monetary base
– broad money
• Definitions in the UK
• The creation of credit– simple illustration
– the bank multiplier
The Supply of MoneyThe Supply of Money
• Definitions of the money supply– monetary base
– broad money
• Definitions in the UK
• The creation of credit– simple illustration
– the bank multiplier• 1/L
The Supply of MoneyThe Supply of Money
• Definitions of the money supply– monetary base
– broad money
• Definitions in the UK
• The creation of credit– simple illustration
– the bank multiplier• 1/L
– the real world
The Supply of MoneyThe Supply of Money
• Definitions of the money supply– monetary base
– broad money
• Definitions in the UK
• The creation of credit– simple illustration
– the bank multiplier• 1/L
– the real world• no precise bank multiplier
The Supply of MoneyThe Supply of Money
• Causes of increases in money supply
– banks reduce liquidity ratio
– inflow of funds from abroad
– PSNCR and its financing
• Money supply: exogenous or endogenous?
– Relationship between money supply and the rate of interest
The supply of money curve: (a) exogenous money supplyThe supply of money curve: (a) exogenous money supply
O
Ra
te o
f in
tere
st
Quantity of money
MS
The supply of money curve: (b) endogenous money supplyThe supply of money curve: (b) endogenous money supply
O
Ra
te o
f in
tere
st
Quantity of money
MS
The Demand for MoneyThe Demand for Money
• The motives for holding money– transactions and precautionary motive– assets or speculative motive– the total demand for money
• Determinants of demand for money– money national income– frequency with which people are paid– financial innovations– speculation about future return on assets– rate of interest
The demand for money (liquidity preference) curveThe demand for money (liquidity preference) curve
O
Ra
te o
f in
tere
st
Md
Money
Monetary EquilibriumMonetary Equilibrium
• Equilibrium in the money market– equilibrium interest rate where D and S
of money are equal
Equilibrium in the money marketEquilibrium in the money market
O
Ra
te o
f in
tere
st
Md
Money
MS
re
Me
Monetary EquilibriumMonetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal
• Equilibrium in the foreign exchange market
Monetary EquilibriumMonetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal
• Equilibrium in the foreign exchange market
– increased money supply leads to lower interest rates
Monetary EquilibriumMonetary Equilibrium
• Equilibrium in the money market
– equilibrium interest rate where D and S of money are equal
• Equilibrium in the foreign exchange market
– increased money supply leads to lower interest rates
– lower interest rates lead to a lower exchange rate
Monetary EquilibriumMonetary Equilibrium
• Effects of changes in money supply on national income– effect on interest rates
• Ms r
The demand for and supply of moneyThe demand for and supply of money
O
Money
Ra
te o
f in
tere
st
MS
Md
r1
Q1
O
Money
Ra
te o
f in
tere
st
Md
r1
Q1
r2
Q2
MS' MS
The demand for and supply of moneyThe demand for and supply of money
Monetary EquilibriumMonetary Equilibrium
• Effects of changes in money supply on national income– effect on interest rates
• Ms r– effects of changes in interest rates on
investment• r I
Monetary EquilibriumMonetary Equilibrium
• Effects of changes in money supply on national income– effect on interest rates
• Ms r– effects of changes in interest rates on
investment• r I
– effects of changes in interest rates on the exchange rate, and imports and exports
• r er X, M
Monetary EquilibriumMonetary Equilibrium
• Effects of changes in money supply on national income– effect on interest rates
• Ms r– effects of changes in interest rates on
investment• r I
– effects of changes in interest rates on the exchange rate, and imports and exports
• r er X, M– effects of changes in investment, imports
and exports on national income• I, X, M Y
Monetary PolicyMonetary Policy
• The significance of monetary policy
• The policy setting
– relationship between the government and the central bank
– degree of central bank independence
• Medium- and long-term policy
– control of banks’ liquidity ratio
– restricting size of PSNCR
Monetary PolicyMonetary Policy
• Short-term monetary control– techniques to control money supply
• open-market operations
• reduced central bank lending to the banks
• funding
• variable minimum reserve ratios
– techniques to control interest rates• announcing changes in interest rates
• backing up announcements– operations in the discount and repo markets
– credit rationing
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Medium and long-term control over the money supply: reducing PSNCR– automatic fiscal stabilisers– the desire to cut taxes– difficulty in cutting government
expenditure
• Short-term control of the money supply– use of money supply targets– ways in which banks resist attempts to
restrict the growth in the money supply– demand-determined money supply
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
O
Demand for loans
Q1Q2
Assume that the authoritieswant to reduce the
demand for money to Q2
r1
Loans
Rat
e of
inte
rest
An inelastic demand for loansAn inelastic demand for loans
r2
O
Demand for loans
r1
Q1Q2
A large rise in therate of interest (to r2)
will be necessary
Loans
Rat
e of
inte
rest
An inelastic demand for loansAn inelastic demand for loans
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
– unstable demand for money
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
– unstable demand for money• problem of changing expectations
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
– unstable demand for money• problem of changing expectations• speculation
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
– unstable demand for money• problem of changing expectations• speculation
– possible conflict between domestic goals and exchange-rate goals
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
– unstable demand for money• problem of changing expectations• speculation
– possible conflict between domestic goals and exchange-rate goals
• Using monetary policy
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy
• Effectiveness of controlling interest rates– inelastic demand for loans
• problem of possibly high interest rates• reasons for an inelastic demand for loans
– unstable demand for money• problem of changing expectations• speculation
– possible conflict between domestic goals and exchange-rate goals
• Using monetary policy– use of interest rates to meet inflation
target
Effectiveness of Monetary PolicyEffectiveness of Monetary Policy