eco 101 ch.12 interest rates, money and inflation(1)
TRANSCRIPT
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Ch12. Interest rates, money and inflation
Dr.Agim Mamuti
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Money
Money Any generally accepted means of payment for delivery of goods or
settlement of debt. It is the medium of exchange.
Barter economy has no medium of exchange - goods are simply swapped for other
goods
Unit of account is the unit in which prices are quoted and accounts are kept
Store of value Money is available for future purchases.
Token money
has a value as money that greatly exceeds its cost of production orvalue in consumption.
IOU ("I owe you)money is a medium of exchange based on the debt of a private bank.
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Modern bankingBank reserves
cash in the bank to meet possible withdrawals by depositorsReserve ratio
ratio of reserves to deposits.
Banks assets mainly loans to firms and households, but also financial securities
such as bills and bonds, issued by governments and firms
Banks liabilities mainly sight and time deposits
Sight deposits
Where a depositor can withdraw money on sight with no notice (suchas cheque accounts)
Time deposits pay higher interest rates and need a period of notice before
withdrawing money
Banks make profits through the interest rate spreadthe amount by
which interest rates on loans exceed interest rates on deposits
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Measures of money
Liquidity is the ease with which an asset canbe turned into money
The money supply consists of a spectrum ofliquidity: M0 (wide monetary base)= all cash + banks deposits
with the Bank of England
M1 = M0 + sight deposits of banks
M3 = M1 + other bank deposits
M4 (broad money) = M3 + building society deposits
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Interest rates and monetary policy
Central bank
responsible for:
printing money
setting interest rates
acting as banker to commercial banks and the
government
In the UK, the Bank of England fulfils these
roles
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Three ways in which the central bank MAYinfluence money supply:
Reserve requirements
central bank sets a minimum ratio of cash reserves todeposits that commercial banks must meet
Discount rate
the interest rate that the central bank charges when thecommercial banks want to borrow
setting this at a penalty rate may encourage commercialbanks to hold more excess reserves
Open market operations
actions to alter the monetary base by buying or sellingfinancial securities in the open market
The bank and the money supply
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Lender of last resort
The lender of last resort lends to bankswhen financial panic threatens the financialsystem.
The Bank will therefore always lend to thebanking system if the financial system is underthreat
this function can be used by the Bank when
the financial system is not under threat toaffect the money supply
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The demand for money
Focus on three determinants of desired money holdings
interest rates price level
real income
Assume that money pays no interest and bonds are all
the other assets that pay interest How do people split their assets between money and bonds?
Holding money means not earning interest from holding bondsinstead
The cost of holding money is the interest given up by holding
money rather than bonds.
People hold money only if there is a benefit to offset thiscost
So what is the benefit?
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The demand for money
The demand for money is a demand for real money
balances M/P.
Transactions motive
payments and receipts are not perfectly synchronized:
so money is held to finance known transactions
depends upon income and payment arrangements
Precautionary motive
because of uncertainty:
people hold money to meet unforeseen contingencies
depends upon the (nominal) interest rate
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The demand for money
Asset motive
In deciding in which assets to hold wealth to bespent at some distant date, a wise portfolio ofassets will include
some high-earning assets such as company shares
but are potentially risky
Plus some safer assets with a return that is lower
on average but less volatile
Holding some wealth in interest-bearing bankaccounts is part of a well-diversified portfolio
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In summary, the demand for money
depends upon the motive for holding money
people want money for purchases - transactions
demand
people want money as a precaution -
precautionary demand
people want money to buy assets - asset demand
The demand for money
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How much money will
people hold?
People will equate the MC and MBof holding moneyE
Higher prices
If all prices and wages doublewith interest rates unaltered - MCstays the same
Real income unaltered so MBschedule is unaffected
Desired holding of real moneyremains L
People hold twice as muchnominal money M when prices Pdouble.
Real income and real money M/Pare unaffected.
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Money market equilibrium
Real money holdings
MD
Other things being equal,the demand for real moneybalances will be lower when
the opportunity cost (the rateof interest) is relatively high.
The position of thisschedule depends uponreal income and the pricelevel.
When money supply is L0, money market equilibriumoccurs when the rate of interest is at r0.
L0
r0
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Monetary policy
Interest rates are the instrument of monetarypolicy
The monetary instrument is the variable over
which a central bank exercises day-to-day control
The Bank of England has operationalindependence from government to set interest
rates But the Chancellor has decided the Banks ultimate
objective is to set interest rates to try to keep inflationclose to 2 per cent a year
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InflationThe rate at which the generallevel of prices for goods andservices is rising, and,subsequently, purchasing poweris falling.
As inflation rises, every dollar will
buy a smaller percentage of agood. For example, if the inflationrate is 2%, then a $1 pack of gumwill cost $1.02 in a year.
Most countries' central banks willtry to sustain an inflation rate of2-3%.
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Committing to low inflation
Central Bank independence is a usefulcommitment to tight monetary policy and
low inflation
Institutional commitment has succeeded in
keeping inflation in many countries in
recent years.