Money and Banking

31,32,33

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Definition of Money

What is Money ?

Anything that performs the functions of money is money

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Functions of Money1- Medium of exchange

Used to buy/sell goods

2- Unit of accountGoods valued in dollars

3- Store of value- Transferring purchasing power from present to future. - Money is used to store value because it is the most liquid asset.

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Functions of Central Bank

1- Quasi Public BankNot deal with public only commercial banks

2- Bankers’ Banks- issuing a currency- acting as lender of last resort- accepting deposits from banks

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Components of Money Supply

• Supply of Money: Measuring Money in the Economy

• Money supply is measured in two ways;• The narrowest definition of money supply

is M1• The broader definition of money supply is

M2

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M1

M1= Currency + Checkable Deposit• Currency -Coins : All coins are “token money”

-Paper money• Checkable deposits

- Customers Deposits payable on demand- Checkable deposits are the largest component of M1

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M2

M2 = M1+ SD + TD + MMMF• M1• Saving deposits• Time deposits• Money market mutual funds (MMMF)

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Money Market

• Links the relationship between amount of money & interest rate in a graph.

• Why supply money (Ms)?- Central Bank only controls the Money Supply - Central Bank changes Money Supply when needed (using tools

of Monetary Policy)

• Why hold (Demand) money (Md)?1- Transactions demand(indicated by nominal GDP)2- Asset demand,(varies inversely with the interest rate)• Thus; Total money demand is function of GDP & interest rate

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Money MarketTotal demand for money (Md) and supply of money (Ms)

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5

50 100 150 200 250 300

Rat

e of

inte

rest

, i p

erce

nt

Amount of moneydemanded and supplied(billions of dollars)

Ms

Md

-Equilibrium i is 5%, -Equilibrium i changes with shifts in Md and Ms

Commercial Banks• Accept deposits from customers• Banks create money through lending• Banks lend excess reserves (How ??)

• Total Reserves consist of Required Reserves (at the central bank) & Excess Reserves ( available to banks)

• Required reserves= Checkable deposits x reserve required ratio

• Example:– Total Checkable deposits $1,000,000 at NBK, Reserve Required Ratio

= 20%, then NBK has to keep …….. at the central Bank of Kuwait, and lends up to ………

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Tools of Monetary Policy

First Tool: Open market operations–Buying and selling of government securities (or bonds)–Commercial banks and the general public–Used to influence the money supply

• When the Central Bank sells securities, commercial bank reserves are reduced (Money supply decreases…why?)

• When the Central Bank buys securities, commercial bank reserves are increased (Money supply increases ..why?)

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Tools of Monetary Policy

Second Tool : Reserve requirement Ratio (RRR)– part of the deposits at each commercial bank should

be kept at the central bank

• When the Central Bank increases RRR, commercial bank reserves are reduced (Money supply decreases…Why?)

• When the Central Bank decreases RRR, commercial bank reserves are increased (Money supply increases…Why?)

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Tools of Monetary Policy

Third Tool : Discount Rate (Rd)– is the interest rate that the central bank charges to

commercial banks that borrow from the central bank.

• When the Central Bank increases Rd, commercial bank reserves are reduced (Money supply decreases…Why?)

• When the Central Bank decreases Rd, commercial bank reserves are increased (Money supply increases… Why?)

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Monetary Policy• The monetary policy is the use of monetary

policy tools to affect the Aggregate Demand (AD).

• Expansionary monetary policy To increase AD, central bank aims to increase

Money Supply using:OMP, or lower RRR, or lower Rd• Restrictive(Contractionary)monetary policyTo increase AD, central bank aims to decrease

Money Supply using:OMS, or rise RRR, or rise Rd

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Expansionary Monetary Policy

• Used to face Recession or Unemployment

• When: GDP (or Y) < AE• Need to increase the level of AE• Central Bank uses OMP, or lower RRR,

or lower Rd• This increases the level of Y (through

shifting AD to the right)

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Expansionary Monetary Policy

Real GDP (billions)

Pric

e le

vel

AD2

AD1

increase inaggregate demand

AS

$510

P1

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Contractionary Monetary Policy

• Used to face the inflation• When: GDP (or Y) > AE• Need to reduce the level of AE• Central Bank uses OMS, or rise

RRR, or rise Rd• This decreases the level of Y

(through shifting AD to the left)

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Contractionary Monetary Policy

Real GDP (billions)

Pric

e le

vel

AD2

AD1

decrease inaggregate demand

AS

$522

P2a

bP1

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Expansionary Monetary PolicyProblem: Unemployment and Recession

Central Bank buys bonds, lowers reserve ratio, lowers the discount rate,

Excess reserves increase

Money supply rises

Investment spending increases

Aggregate demand increases

Real GDP risesLO4

CA

USE

-EFF

ECT

CH

AIN

33-19

Restrictive Monetary PolicyProblem: Inflation

Central Bank sells bonds, increases reserve ratio, increases the discount rate

Excess reserves decrease

Money supply falls

Investment spending decreases

Aggregate demand decreases

Inflation declines

CA

USE

-EFF

ECT

CH

AIN

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