The monetary system
(Chapter 29 in Mankiw & Taylor)
• Return to inflation and consider money
The Meaning of Money
• What is money? £,$...
– Set of assets in an economy that people
regularly use to buy goods and services
from other people
– Liquid
• The three functions of money, which
distinguish it from other assets, like shares:
– Medium of exchange
– Unit of account
– Store of value 2
The Meaning of Money
• Medium of exchange
– Item that buyers give to sellers
• When they want to purchase goods and
services
• Unit of account
– Yardstick people use to post prices and
record debts
– Measure of economic value
3
The Meaning of Money
• Store of value
– Item that people can use to transfer purchasing
power
• From the present to the future
• Liquidity
– Ease with which an asset can be converted into
the economy’s medium of exchange
– Trade-off between the liquidity of an asset and
its return (store of value)
• e.g. inflation erodes value of your money
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The Kinds of Money
• Commodity money
– Money that takes the form of a commodity
with intrinsic value
• Intrinsic value
– Item would have value even if it were not
used as money
• Gold standard - Gold as money
– Or paper money that is convertible into
gold on demand
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The Kinds of Money
• Fiat money
– Money without intrinsic value
– Used as money because of government
decree
• Fiat
– From the Latin: “it shall be [money]”
– By government order or decree
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Money in the Economy
• What is the money stock?
– Quantity of money circulating in the economy
• Includes, currency
– Paper bills and coins in the hands of the public,
and also,
• Demand deposits
– Balances in bank accounts - depositors can access
on demand by writing a cheque or use their debit
cards. Effectively, these are as useful as currency
– What about credit cards? Be careful; they are a
means of deferring not simply transferring payment
7
Money in the Economy
• There are different measures of money stock
– M1 (in the US. Definitions vary slightly internationally)
• Currency in circulation
• Demand deposits, Traveler’s checks (US spelling)
• Other checkable deposits
– M2
• Everything in M1
• Savings deposits; Small time deposits
• Money market mutual funds
• A few minor categories 8 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Figure 1
9
Two Measures of the Money Stock for the U.S. Economy
The two most widely followed measures of the money stock are M1 and M2. This
figure shows the size of each measure in 2009.
Central Banks
• With fiat money, some agency must be
responsible for regulating it
• Central banks
– Bank of England (UK), Federal Reserve
(Fed, US) and European Central Bank
• Central bank
– Institution designed to
• Oversee the banking system
• Regulate the quantity of money in the
economy 10
Central Banks (CBs)
• Have the power to increase/decrease the amount
of currency in the economy
– Monetary policy
• Their primary policy tool: open-market operations
by the CB
– Purchase and sale of government bonds
• Increase the money supply
– CB: open-market purchase
• Decrease the money supply
– CB: open-market sale 11
Bank of England
• Founded in 1694
• Operationally independent since 1997
– Monetary Policy Committee (MPC)
– Sets interest rates
– To achieve 2% CPI inflation rate
• New powers for financial regulation, with
the abolition of FSA in the aftermath of
the global financial crisis
12
The U.S. and Europe
• The Federal Reserve
– Created in 1913
– After a series of bank failures in 1907
– Purpose: to ensure the health of the nation’s
banking system
• European Central Bank
– Created in 1998
– Comprises EMU countries
– Aim to achieve price stability
• Inflation rates below but close to 2% over the
medium run 13
Importance of monetary policy
• Prices rise when too much money is
printed
• The economy faces a short run trade-off
between inflation and unemployment
• So a CB’s actions affect:
– inflation in the long run (hence CBs are
often charged with protecting the value of
money → inflation target)
– an economy’s production and employment
in the short run 14 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Quantitative Easing (QE)
• Way of affecting the money supply
• http://www.bankofengland.co.uk/monetary
policy/assetpurchases.htm
• Between March 2009 and January 2010,
the MPC authorised the purchase of £200
billion worth of assets, mostly gilts
• Way to boost nominal demand and
generate inflation
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Banks also determine the Money Supply
• This is because your money comprises both cash and your
current account (deposits) at your bank
• Reserves
– Deposits that banks have received but have not loaned out
• The simple case of 100% reserve banking
– All deposits are held as reserves
• Banks do not influence the supply of money (money supply =
demand deposits plus currency. This sum is unchanged)
16
Fractional-Reserve Banking
• Fractional-reserve banking
– Banks hold only a fraction of their deposits as
reserves. Use the remainder to make loans and
earn a return on their assets
• Reserve ratio
– Fraction of deposits that banks hold as reserves
• in case depositors wish to withdraw their cash
• Reserve requirement
– Minimum amount of reserves that banks must
hold; set in some countries (by the Fed, ECB).
But, unusually, not imposed by law in the UK 17
Fractional-Reserve Banking
• Excess reserve
– Banks may hold reserves above any legal
minimum
• Example: First National Bank
– Reserve ratio 10%. Consider their balance sheet
18
Fractional-Reserve Banking
• Banks hold only a fraction of deposits in
reserve
– Banks create money
• Assets
• Liabilities
– Increase in money supply, from $100 to
$190
– Does not create wealth (a stock); since loans
from the bank are debt for the borrower and
therefore do not make them richer 19
Money creation
• But the process of money creation
continues
– Suppose the borrower from First National
Bank uses the $90 to buy some goods,
the proceeds of which are then deposited
in Second National Bank
– Second National Bank then holds 10% in
reserves ($9) and lends out a further $81
– and so on…
20
… The Money Multiplier
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The Money Multiplier
• The money multiplier
– Original deposit = $100.00
– First National lending = $ 90.00 [= .9 ×
$100.00]
– Second National lending = $ 81.00 [= .9 ×
$90.00]
– Third National lending = $ 72.90 [= .9 ×
$81.00]
– … (to infinity)
– Total money supply = $1,000.00
22
The Money Multiplier
• The money multiplier
– Amount of money the banking system
generates with each dollar of reserves
– Reciprocal of the reserve ratio = 1/R
– Equals 1/0.1 = 10 in our example
• The higher the reserve ratio
– The smaller the money multiplier
– Money multiplier = 0 when R=1
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Financial Crisis of 2008–2009
• Bank capital
– Resources a bank’s owners have put into
the institution
– Used to generate profit
24
Financial Crisis of 2008–2009
• Leverage
– Use of borrowed money to supplement
existing funds for purposes of investment
• Leverage ratio
– Ratio of assets to bank capital = 20 here
• Capital requirement
– Government regulation specifying a
minimum amount of bank capital
– Basel Accords set international standards
25
Financial Crisis of 2008–2009
• If bank’s assets – rise in value by 5%
– Because some of the securities the bank
was holding rose in price
– $1,000 of assets would now be worth
$1,050
– Bank capital rises from $50 to $100
– So, for a leverage rate of 20
• A 5% increase in the value of assets
• Increases the owners’ equity by 100%
26
Financial Crisis of 2008–2009
• If bank’s assets – reduced in value by 5%
– Because some people who borrowed from
the bank default on their loans
– $1,000 of assets would be worth $950
– Value of the owners’ equity falls to zero
– So, for a leverage ratio of 20
• A 5% fall in the value of the bank assets
• Leads to a 100% fall in bank capital
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Financial Crisis of 2008–2009
• Banks in 2008 and 2009
– Shortage of capital
• After they had incurred losses on some of
their assets
– Mortgage loans
– Securities backed by mortgage loans
– Reduce lending (credit crunch)
• Contributed to a severe downturn in
economic activity
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Financial Crisis of 2008–2009
• U.S. Treasury and the Fed
– Put many billions of dollars of public funds
into the banking system
• To increase the amount of bank capital
– It temporarily made the U.S. taxpayer a
part owner of many banks
– Goal: to recapitalise the banking system
• Bank lending could return to a more normal
level
– Occurred by late 2009
– Ongoing in the UK… 29
The Central Bank’s Tools of Monetary
Control
• Three main tools:
– Open market operations
– The refinancing rate
– Reserve requirements
• Influences the quantity of reserves
• Influences the reserve ratio
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1. Open-market operations (OMOs)
• (Outright) purchase and sale of
government bonds by the Central Bank
– To increase the money supply
• The Central Bank buys government bonds
from the public
– To reduce the money supply
• The Central Bank sells government bonds to
the public (and the currency it receives is now
out of the hands of the public)
31
2. The Refinancing Rate
• The interest rate at which the Central
Bank will lend to commercial banks on a
short-term basis
– Called the refinancing rate in Europe; repo rate
in the UK; discount rate in the US
– Central banks tend not to undertake outright
OMOs these days
– Instead they buy bonds from the public but
promise to sell them back later
– Effectively, they have made a loan and taken
the bond as collateral
32
The refinancing rate (cont.)
• The interest rate the Central Bank
charges on this loan is the refinancing
rate
• Since the seller has agreed to buy back
the bonds from the Central Bank in the
future at an agreed price this type of
OMO is called a repo (repurchase
agreement)
33
How repos are used to control the money supply
• Banks carry enough reserves to cover
their lending – the reserve ratio
• At the end of a given working day,
commercial banks’ reserves may be
greater than or less than this reserve
ratio, due to random shocks
• Banks lend this excess to each other,
overnight or short-term
• This all takes place in the “money market”
34
• If, across banks, there is a general shortage of liquidity
in the money markets, then the short-run interest rate
charged will rise; and vice-versa
• The Central Bank monitors the money market and may
intervene
– to affect the supply of liquidity to banks and, in turn,
their lending and the money supply
– by manipulating their refinancing rate and effectively
lending to the banks or not renewing these (short-
term) loans if it wants to reduce the money supply
– In practice, the Central Bank sets the refinancing rate
and conducts OMO near it
35
Tools of Monetary Control
• The refinancing rate
– Interest rate on the loans that the Central
Bank makes to banks
– Higher refinancing rate
• Reduce the money supply
– Smaller refinancing rate
• Increase the money supply
36
Tools of Monetary Control
• Reserve requirements
– Regulations on minimum amount of reserves
• That banks must hold against deposits
– An increase in reserve requirement
• Decrease the money supply (multiplier ↓)
– A decrease in reserve requirement
• Increase the money supply (multiplier ↑)
– Used rarely – disrupts business of banking
• Since changes require banks to alter their lending
to achieve the reserve requirement
• Basel III increases reserve ratio
37
Problems
• The Central Banks’s control of the money
supply
– Not precise; money multiplier can vary
– Due to fractional reserve banking
• The Central Bank
– Does not control the amount of money that
households choose to hold as deposits in
banks
– Does not control the amount that bankers
choose to lend rather than keep as reserves 38
Bank runs and the money supply
• Bank runs
– Depositors suspect that a bank may go
bankrupt
• “Run” to the bank to withdraw their deposits
• Northern Rock bank run in 2007
– Problem for banks under fractional-
reserve banking
• Cannot satisfy withdrawal requests from all
depositors
39
Bank runs and the money supply
• When a bank run occurs
– The bank - is forced to close its doors
– Until some bank loans are repaid
– Or until some lender of last resort
provides it with the currency it needs to
satisfy depositors
• In 2008 government took Northern Rock into
state ownership
– Complicate the control of the money
supply
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Bank runs and the money supply
• Great Depression, early 1930s
– Wave of bank runs and bank closings
– Households and bankers - more cautious
– Households
• Withdrew their deposits from banks
– Bankers - responded to falling reserves
• Reducing bank loans,
• Increased their reserve ratios
• Smaller money multiplier
• Decrease in money supply
41
Bank runs and the money supply
• Bank runs today
– Not a major problem if the government
guarantees the safety of deposits at
most banks
• Federal Deposit Insurance Corporation
(FDIC) in the US
• Financial Services Compensation Scheme
in the UK guarantees full compensation up
to £85,000 per saver, per authorised
institution
– But only implemented in the aftermath of the
Northern Rock bank run/crisis
42
Bank runs and the money supply
• No bank runs
– Depositors are confident
– Government will make good on the
deposits
• Government deposit insurance
– Cost:
• Bankers - little incentive to avoid bad risks
– Benefit:
• A more stable banking system
43