Money and Monetary Policy

The Money Market

“Behind everything is money”. (Milton Friedman)

Money: What it does?

Three main functions of money. 1. Unit of account. Everything in

economic life can be measured by money.

2. Store of value. You can hold your wealth as money.

3. Medium of exchange. Money allows us to carry on purchasing transactions.

Money: What it Is?Money = everything used as a tool for

exchange

Historical development: Natural exchange. Commodity money: Many things have been money

over the centuries: cattle, stones, beads, iron, copper, zinc, cigarettes, silver and gold, ... Gold and silver hold a place of special importance.

Why? Because they have qualities which are important for any useful commodity money: are relatively scarce, have a high value for unit of mass, are easily divisible, are durable and easily worked, are considered rather valuable themselves.

Gold standard

Up until quite recently, gold was money. 1933 - the United States went off the

domestic gold standard. Gold was stored in government vaults, and in it's place people were issued paper money which was "backed" by gold or silver on a one for one basis.

1973 - the U.S. left off the international gold standard. This meant that gold and silver no longer had any

monetary role whatever. They became (and remain) „normal” industrial commodities.

If money is no longer gold or silver--or even "backed" by gold or silver, what is it?

The main feature of money is that money have a certain level of liquidity.

Liquidity is a measure of how quickly an assets can turn into cash.

Liquid asset - asset which can be turned into cash quickly and without capital loss or interest loss.

Money groups according to liquidityMoney aggregates Transaction money M1:

Currency (paper bills and coins) is obviously the most liquid of all assets.

Checking accounts (current accounts) are nearly as liquid as currency. With the advent of debit (or check) cards, it is simple to spend from the balances in you checking account.

Broad money M2: M1 (currency and checking accounts) + deposits in saving accounts (short time)

Aggregate M3: M2 + shares of money market, deposits in

saving accounts (long time) …, etc. Low

High

Liquid

ity

Monetary Policy

Monetary policy is the process of managing a nation's money supply to achieve specific goals.

Main participant: Central Bank (Czech National Bank, Federal Reserve Bank, the Bank of Canada, State Bank of Namibia….) Who controls central banks and determines

their actions? What motivates their behavior?

Central Bank – “Bank of banks”Functions: Fights against inflation. Promotes the efficiency of finance system. Ensures financial system stability.

Main Central Bank’s clients: Commercial banks:

Transaction execution between banks. Control of their assets and their performance.

The government: Keeps it’s accounts. Accumulates tax-income.

Other central banks.

Monetary Policy Goals Steady economic growth: Goal of steady economic

growth closely related to high employment goal, as firms will invest more when unemployment is low.

High employment: If unemployment is high, economy has unused workers and unused resources which results in loss of output and lower GDP levels.

Price stability: Price stability increasingly viewed as the most important goal of monetary policy. Inflation (increasing price level) creates uncertainty in an economy and leads to slowdowns in economic growth.

Interest rate stability: Fluctuations in interest rates can create uncertainty in the economy, making it harder to plan for future (for households or firms).

Monetary Policy Goals5. Stability of financial markets: financial crisis causes

recessions. Financial crises decreasing investment opportunities, therefore

decreasing real GDP, Stability of financial markets also support by interest rate

stability… as interest rate uncertainty is a main concern for financial institutions.

6. Stability of foreign exchange: value of CZK (Euro, US dollar) affects competitiveness of Czech (European, US) goods and services in the international economy. Value of the CZK relative to other currencies is also a major

consideration for the Czech National Bank. Rise in value of CZK makes Czech firms less competitive. Decline in value of CZK stimulates inflation in the CR.

Demand for money

The demand for money is related with peoples intensions to hold (save) or spend the money.

There are three reasons why people wish to save/spend: Transactions demand: demand for day-to-day money by

firms and households for buying goods and services. Precautionary demand: demand for money by firms and

households caused by the wish to save money in case of unexpected.

Speculative demand: this is demand for money as financial asset for investment opportunities.

Demand for money Changes in the money

supply will result is shifts in the supply of money in the money market, changing the interest rate.

An increase in the money supply will cause the interest rate to go down.

A decrease in the money supply will result in an increase in the interest rate.

i

M0

How much money should be in the economy?

The theory by Irving Fischer:

M-money in circulation, V-velocity of circulation, P-average price level in transactions made, T-number of transactions.

PTMV

Two types of Monetary Policy

Expansive Restrictive

i

M

Dm

Sm2Sm1 Sm

E2

E

E1

Q2QQ1

0

Monetary Policy and Real GDP

A change in the interest rate would affect both investment and consumption expenditures. The higher interest rate is, the more

economical agents tend to save money, either to spend them.

Recall that: Agg. Exp. =C+Ig+G+Xn

Tools of the monetary policy

Direct and Indirect tools Long-term and Short-term tools Current and Exceptional tools etc.

A. Direct (administrative) tools= tools limiting and influencing market banking sector

market.

These tools are used as exceptional and short term:

Mandatory structure of assets and liability for commercial banks.

Credits, loans limits. One of the most tough direct tool.

Obligatory deposits – obligation for state institutions to have account at the central bank (for example revenues authorities, ministries, etc.).

Gentleman's agreements between central bank commercial banks

B. Indirect tools of the Central Bank

Tools are influencing all participants of financial market; they could be used without time limitation.

Basic tools: Setting the Discount Rate Reserve Requirements Open Market Operations Foreign exchange market operations

Discount Rate This is the interest rate the CB charges to banks that

borrow funds from the CB (bank rate). Serves as a signal to the public about its intentions over monetary policy.

↑ discount rate > raise price of money > commercial banks are lending lower amount of money > money are „suck out“ from economy > money circulation slow down – (anti-inflation) restrictive monetary policy;

↓ discount rate > reduce price of money > commercial banks are lending higher amount of money > money are „suck in“ economy > money circulation speed up – expansive monetary policy

Required Reserves (RR) This is the ratio of reserves to deposits required by law.

RR is very powerful and affects all banks equally (as small change results in a large change in money supply). So, cannot be used for fine tuning (small changes in MS – money supply).

↑ RR raise price of money > money are „suck out“ from economy > money circulation slow down – (anti-inflation) restrictive monetary policy;

↓ RR > reduce price of money > money are „suck in“ economy > money circulation speed up – expansive monetary policy

Open Market OperationsCentral national bank buying and selling of bonds (e.g.

government securities) in the open market. NB sells bonds, commercial banks pay money to the NB,

decreasing the bank’s reserves. This is called an open market sale.

CB´s buy bonds > raise price of money > money are „suck out“ from economy > money circulation slow down – (anti-inflation) restrictive monetary policy;

NB buys bonds, the NB pays money to the commercial banks, increasing the bank’s reserves. This is called an open market purchase (OMP).

CB´s sells bonds > reduce price of money > money are „suck in“ economy > money circulation speed up – expansive monetary policy

Foreign exchange market operations

National Bank influences the national currency exchange rate by using the direct market interventions.

When the market experiences the lack of foreign currency > the exchange rate tend to rise > the national currency becomes cheaper > the CB enters the market and sells it’s foreign currency reserves therefore supporting the exchange rate.

When the exchange rate of national currency tend to become very high due to the excess of foreign currency or due to market agent’s expectations > the CB enters the market and buys the foreign currency, increasing the demand and therefore the price for foreign currency.

Questions

What would be the effect on the demand for money M1 of each of the following:

An increase in real GDP An increase in the price level A rise in the interest rate on savings

accounts Allowing banks to pay interest on

checking deposits