Money and Stabilization Policy

KW Chapter 30

Money

• Money is a tool for conducting transactions and, like all tools, is subject to technological advance.

• Barter was replaced by commodity money, precious metal with intrinsic value. (China ca. 1400 B.C.).

• Commodity money was replaced by commodity-backed paper notes like gold certificates. (600 AD in China, 1650 in Sweden)

• Commodity-backed paper notes are replaced by fiat money whose only value comes from the governments declaration of it as legal tender. (China 800 AD.; France, USA 1700’s)

Role of Money

• Money has 3 roles

1. Medium of Exchange – Money is a technology for engaging in transactions.

2. Unit of Account – Value of most goods and assets is measured in money.

3. Store of Value – Money is an asset. It can be exchanged for goods in the future.

Two categories of money

1. Monetary Base: Money that can be used immediately for transactions without conversion to more basic forms of money.

– Currency+ Reserve accounts

2. Broad Money Supply: A set of assets, typically some form of bank deposit, which can be easily converted to definitive money.

– Checking Accounts, Savings Accounts, Liquid Time Deposits and CD’s

Money Supply The stock of the medium of exchange

supplied by the central bank. Types of Financial Assets

M1 Currency in Circulation [C] + Demand Deposits [D]

M2 M1 + Savings Deposits + “Small” Time Deposits +

[Liquid Money Market Instruments inc/ “Small” NCD’s]

M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Categories of Broad Money

M1

M2

M3

M1 Currency + Checking Acct.

M2 +Savings Acct.

+ “More Liquid” Time Deposit

M3 + “Less Liquid” Time Deposit

Mpney Types in HK

M1

M2

M3

Incremental M3 is trivial in HK Source: HKMA, 2006

HK$ Money CategoriesSource: HKMA http://www.info.gov.hk Million HK$ 2006

Legal tender notes

and coins in hands of public

Demand deposits

with licensed

banks M1

145,852 207,444 353,297

Savings deposits

with licensed

banks

Time deposits

with licensed

banks

NCDs issued by licensed

banks and held

by public M2

788,211 1,288,193 76,342 2,506,043

Central Bank• Governments in most countries create quasi-

governmental semi-independent organization called Central Bank – Hong Kong: Hong Kong Monetary Authority– USA: Federal Reserve Bank– Bank of England, Bank of Japan, Bank of Canada etc. – European Central Bank

• Central Bank will typically print banknotes • Central Bank accepts deposits (clearing balances)

by private sector banks. These accounts are used to clear

The Central Bank controls Monetary Base

Changing the Monetary Base

• Monetary Base is changed by the central bank through transactions which change the level of liabilities and assets of central bank.

1. Open Market Operations: Central Bank buys or sells securities in financial markets.

2. Currency Market Intervention: Central Bank buys or sells currency.

T-Accounts

• T-Accounts are a handy tool for examining the effects that any transaction has on balance sheets.

• A bank transaction will change both liabilities and assets (and possibly net worth). The total change in liabilities plus net worth must always equal the total change in assets.

Open Market Purchase: The Fed Purchases $100 of T-Bills from Bank A

• Fed credits the reserve accounts of Bank A which increases its liabilities and takes possession of an equal value of securities as assets.

• Bank A gets an extra amount of reserves and loses an equal amount of securities.

Assets Liabilities

+100 T-Bills + 100 Reserves

Assets Liabilities

+100 Reserves

-100 T-Bills

Fed Balance Sheet

Bank A Balance Sheet

Open Market Operations

• Central banks typically (though not in HK) change the money supply through open market operation (OMO). An OMO is the purchase or sale of government bonds by the central bank.

• In an open market purchase, the central bank prints new money and uses it to buy bonds from banks. This increases the supply of money in the short run.

• In an open market sale, the central bank sells some of its stock of bonds and receives existing money in exchange. This reduces the supply of money in the short run.

Currency Board• Central bank in HK adjusts the monetary base

automatically through a currency board. • When banks want to hold more HK dollars, the

central bank will sell them as many clearing balances as they would like at fixed exchange rate. (S = 7.85)

• When banks want to hold fewer HK dollars, the central bank will buy clearing balances from them in exchange for HK dollars. (S = 7.75)

Convertibility Undertaking HK

• Whenever the price of US dollars goes above 7.85, the central bank will sell US dollars at S = 7.85.– No one will ever pay more than 7.85HK$ per US$

• Whenever the price of US dollars goes below 7.75, the central bank will buy US$ at S = HK$7.75.– No one will ever sell for less than 7.75HK$ per

US$.

Currency Market Intervention Central Bank buys 100/S foreign currency from Bank.

• Central Bank credits Bank A reserves with 100 of domestic currency.

• This will increase Central Banks asset holdings of foreign reserves of 100/S.

• Bank A has 100 extra in reserve assets but loses 100/S in foreign currency

Assets Liabilities

+100 Foreign Reserves* + 100 Reserves

Assets Liabilities

+100 Reserves

-100 Foreign Currency*

Central Bank Balance Sheet

Bank A Balance Sheet

*100/S when measured in foreign currency

Fractional Reserve Banking• Money supply is a multiple of monetary base.• Money supply mostly consists of bank deposits

while monetary base includes only bank reserves. • Bankers keep only a fraction of deposits on reserve.

Reserve to deposit ratio:

• Regulations may require some minimum fraction of reserve holdings per dollar of deposits, rr.

Reserves

Depositsrd

Excess Reservesrd rr

Deposits

Monetary Expansion Hong Kongrd = .1

• Bob opens HK$1000 bank account at Bank of China by depositing US$128.

• Bank of China buys additional clearing balances from HKMA.

• Bank has $1000 extra deposits and needs only $100 in extra reserves. Bank makes $900 loan to Jim.

• Jim deposits $900 at HSBC. HSBC keeps 90 on reserves and lends out 810 in additional reserves.

• This money will then be lent out again and money will be returned to the banking system. The feedback loop will repeat ad infinitum

Money Multiplier Process

Step Deposits Reserves

# 1 Bank of China Increase

By 1000

Increase by 100

# 2 HSBC Increase

By 900

Increase by 90

# 3 Bank of East Asia

Increase

By 810

Increase by 81

……

Each dollar in bank reserves leads to increase in deposit

1rd

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanksCentral BankCentral Bank

ReservesReserves

rdrd

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral BankReservesReserves

rdrd

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

Money Supply vs. Monetary Base

Monetary

Base

Money

Multiplier

Money

Supply* =

Money Multiplier

• Money multiplier tends to be smaller than 1/rd because some of any additional money holdings will be held in terms of cash rather than in bank deposits.

• Money held as cash does not circulate back into the banking system and slows down the money multiplier process.

• The greater is cash holdings relative to deposits, the greater than the money multiplier.

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral BankReservesReserves

rdrd

CashCash

Balance Sheet of Bank of China.

• Commercial Bank has $10,000 in deposits which are there liabilities. The bank has $1000 in reserves and 10,000 in loans.

• Net worth is $1000

Assets Liabilities

1000 Clearing Balances

10000 Loans

10000 Deposits

1000 Net Worth

Bank of China Balance Sheet

Monetary Contraction Hong Kongrd = .1

• Bob closes HK$1000 bank account at Bank of China by withdrawing US$128.

• Bank of China cashes in clearing balances to get US$ from HKMA

• Bank has $9000 in deposits and no reserves. Need to call in $900 in loans from Jim to top up reserves.

• Jim withdraws $900 at HSBC. HSBC had only 90 in reserves backing up that loan and must call loans of $810. ….Etc.

• For every $1 in reserves that the central bank cashes in, a multiple of broad money contracts.

Learning Outcomes

• Distinguish the monetary base from the money supply and explain two methods that the central bank adjusts the monetary base.

• Identify 3 roles of money, 3 monetary aggregates, and 3 advances in monetary technology

• Explain the impact of reserve holdings and cash holdings on the money multiplier.