Money and Monetary Policy

1
Money and Monetary Policy
2
Meaning 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

3
Financial System in the UK

• The key role of banks
• deposits and loans
• liabilities and assets
• retail and wholesale deposits and loans
• Liabilities
• sight deposits

4
Balance sheet of UK banks February 2003
5
Balance sheet of UK banks February 2003
6
Financial 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

7
Balance sheet of UK banks February 2003
8
Financial 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

9
Balance sheet of UK banks February 2003
10
Financial 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

11
Balance sheet of UK banks February 2003
12
Balance sheet of UK banks February 2003
13
Balance sheet of UK banks February 2003
14
Balance sheet of UK banks February 2003
15
Financial System in the UK

• Assets
• cash and balances with the Bank of England

16
Balance sheet of UK banks February 2003
17
Balance sheet of UK banks February 2003
18
Financial System in the UK

• Assets
• cash and balances with the Bank of England
• short-term loans

19
Balance sheet of UK banks February 2003
20
Balance sheet of UK banks February 2003
21
Balance sheet of UK banks February 2003
22
Financial System in the UK

• Assets
• cash and balances with the Bank of England
• short-term loans
• longer-term loans

23
Balance sheet of UK banks February 2003
24
Balance sheet of UK banks February 2003
25
Balance sheet of UK banks February 2003
26
Balance sheet of UK banks February 2003
27
Balance sheet of UK banks February 2003
28
Financial System in the UK

• Liquidity and profitability
• profitability
• liquidity
• the liquidity ratio

29
Balance sheet of UK banks February 2003
30
Financial 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

31
Financial 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

32
The Supply of Money

• Definitions of the money supply
• monetary base
• broad money
• Definitions in the UK
• definitions in the UK M0, M4

33
UK monetary aggregates (end February 2003)
million
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
34
UK monetary aggregates (end February 2003)
million
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
35
UK monetary aggregates (end February 2003)
million
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
36
The 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

37
UK monetary supply using ECB measures (end
February 2003)
million
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
38
UK monetary supply using ECB measures (end
February 2003)
million
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
39
UK monetary supply using ECB measures (end
February 2003)
million
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
40
The Supply of Money

• Definitions of the money supply
• monetary base
• broad money
• Definitions in the UK
• The creation of credit

41
The Supply of Money

• Definitions of the money supply
• monetary base
• broad money
• Definitions in the UK
• The creation of credit
• simple illustration

42
Credit creation Banks' original balance sheet
43
Credit creation Effect of a new deposit of 10bn
44
Credit creation Full effect of a new deposit of
10bn
45
The 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

46
The 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

47
The 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

48
The 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

49
The 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

50
The supply of money curve (a) exogenous money
supply
Rate of interest
O
Quantity of money
51
The supply of money curve (b) endogenous money
supply
Rate of interest
O
Quantity of money
52
The 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

53
The demand for money (liquidity preference) curve
Rate of interest
O
Money
54
Monetary Equilibrium

• Equilibrium in the money market
• equilibrium interest rate where D and S of money
  are equal

55
Equilibrium in the money market
Rate of interest
re
O
Me
Money
56
Monetary Equilibrium

• Equilibrium in the money market
• equilibrium interest rate where D and S of money
  are equal
• Equilibrium in the foreign exchange market

57
Monetary 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

58
Monetary 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

59
Monetary Equilibrium

• Effects of changes in money supply on national
  income
• effect on interest rates
• Ms? ? r?

60
The demand for and supply of money
Rate of interest
O
Money
61
The demand for and supply of money
MS
Rate of interest
r1
Md
O
Q1
Money
62
Monetary 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?

63
Monetary 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?

64
Monetary 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?

65
Monetary 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

66
Monetary 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

67
Effectiveness 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

68
Effectiveness of Monetary Policy

• Effectiveness of controlling interest rates
• inelastic demand for loans
• problem of possibly high interest rates

69
An inelastic demand for loans
Rate of interest
r1
Demand for loans
O
Q1
Q2
Loans
70
An inelastic demand for loans
Rate of interest
r1
Demand for loans
O
Q1
Q2
Loans
71
Effectiveness 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

72
Effectiveness 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

73
Effectiveness 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

74
Effectiveness 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

75
Effectiveness 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

76
Effectiveness 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

77
Effectiveness 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