(chapter 29 in mankiw & taylor) · the monetary system (chapter 29 in mankiw & taylor)...

The monetary system

(Chapter 29 in Mankiw & Taylor)

• Return to inflation and consider money

The Meaning of Money

• What is money? £,$...

– Set of assets in an economy that people

regularly use to buy goods and services

from other people

– Liquid

• The three functions of money, which

distinguish it from other assets, like shares:

– Medium of exchange

– Unit of account

– Store of value 2


• Medium of exchange

– Item that buyers give to sellers

• When they want to purchase goods and

services

• Unit of account

– Yardstick people use to post prices and

record debts

– Measure of economic value

3


• Store of value

– Item that people can use to transfer purchasing

power

• From the present to the future

• Liquidity

– Ease with which an asset can be converted into

the economy’s medium of exchange

– Trade-off between the liquidity of an asset and

its return (store of value)

• e.g. inflation erodes value of your money

4 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

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The Kinds of Money

• Commodity money

– Money that takes the form of a commodity

with intrinsic value

• Intrinsic value

– Item would have value even if it were not

used as money

• Gold standard - Gold as money

– Or paper money that is convertible into

gold on demand



The Kinds of Money

• Fiat money

– Money without intrinsic value

– Used as money because of government

decree

• Fiat

– From the Latin: “it shall be [money]”

– By government order or decree



Money in the Economy

• What is the money stock?

– Quantity of money circulating in the economy

• Includes, currency

– Paper bills and coins in the hands of the public,

and also,

• Demand deposits

– Balances in bank accounts - depositors can access

on demand by writing a cheque or use their debit

cards. Effectively, these are as useful as currency

– What about credit cards? Be careful; they are a

means of deferring not simply transferring payment

7

Money in the Economy

• There are different measures of money stock

– M1 (in the US. Definitions vary slightly internationally)

• Currency in circulation

• Demand deposits, Traveler’s checks (US spelling)

• Other checkable deposits

– M2

• Everything in M1

• Savings deposits; Small time deposits

• Money market mutual funds

• A few minor categories 8 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Figure 1

9

Two Measures of the Money Stock for the U.S. Economy

The two most widely followed measures of the money stock are M1 and M2. This

figure shows the size of each measure in 2009.

Central Banks

• With fiat money, some agency must be

responsible for regulating it

• Central banks

– Bank of England (UK), Federal Reserve

(Fed, US) and European Central Bank

• Central bank

– Institution designed to

• Oversee the banking system

• Regulate the quantity of money in the

economy 10

Central Banks (CBs)

• Have the power to increase/decrease the amount

of currency in the economy

– Monetary policy

• Their primary policy tool: open-market operations

by the CB

– Purchase and sale of government bonds

• Increase the money supply

– CB: open-market purchase

• Decrease the money supply

– CB: open-market sale 11

Bank of England

• Founded in 1694

• Operationally independent since 1997

– Monetary Policy Committee (MPC)

– Sets interest rates

– To achieve 2% CPI inflation rate

• New powers for financial regulation, with

the abolition of FSA in the aftermath of

the global financial crisis

12

The U.S. and Europe

• The Federal Reserve

– Created in 1913

– After a series of bank failures in 1907

– Purpose: to ensure the health of the nation’s

banking system

• European Central Bank

– Created in 1998

– Comprises EMU countries

– Aim to achieve price stability

• Inflation rates below but close to 2% over the

medium run 13

Importance of monetary policy

• Prices rise when too much money is

printed

• The economy faces a short run trade-off

between inflation and unemployment

• So a CB’s actions affect:

– inflation in the long run (hence CBs are

often charged with protecting the value of

money → inflation target)

– an economy’s production and employment

in the short run 14 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Quantitative Easing (QE)

• Way of affecting the money supply

• http://www.bankofengland.co.uk/monetary

policy/assetpurchases.htm

• Between March 2009 and January 2010,

the MPC authorised the purchase of £200

billion worth of assets, mostly gilts

• Way to boost nominal demand and

generate inflation



http://www.bankofengland.co.uk/monetarypolicy/assetpurchases.htm

http://www.bankofengland.co.uk/monetarypolicy/assetpurchases.htm

Banks also determine the Money Supply

• This is because your money comprises both cash and your

current account (deposits) at your bank

• Reserves

– Deposits that banks have received but have not loaned out

• The simple case of 100% reserve banking

– All deposits are held as reserves

• Banks do not influence the supply of money (money supply =

demand deposits plus currency. This sum is unchanged)

16

Fractional-Reserve Banking

• Fractional-reserve banking

– Banks hold only a fraction of their deposits as

reserves. Use the remainder to make loans and

earn a return on their assets

• Reserve ratio

– Fraction of deposits that banks hold as reserves

• in case depositors wish to withdraw their cash

• Reserve requirement

– Minimum amount of reserves that banks must

hold; set in some countries (by the Fed, ECB).

But, unusually, not imposed by law in the UK 17


• Excess reserve

– Banks may hold reserves above any legal

minimum

• Example: First National Bank

– Reserve ratio 10%. Consider their balance sheet

18


• Banks hold only a fraction of deposits in

reserve

– Banks create money

• Assets

• Liabilities

– Increase in money supply, from $100 to

$190

– Does not create wealth (a stock); since loans

from the bank are debt for the borrower and

therefore do not make them richer 19

Money creation

• But the process of money creation

continues

– Suppose the borrower from First National

Bank uses the $90 to buy some goods,

the proceeds of which are then deposited

in Second National Bank

– Second National Bank then holds 10% in

reserves ($9) and lends out a further $81

– and so on…

20

… The Money Multiplier



The Money Multiplier

• The money multiplier

– Original deposit = $100.00

– First National lending = $ 90.00 [= .9 ×

$100.00]

– Second National lending = $ 81.00 [= .9 ×

$90.00]

– Third National lending = $ 72.90 [= .9 ×

$81.00]

– … (to infinity)

– Total money supply = $1,000.00

22

The Money Multiplier

• The money multiplier

– Amount of money the banking system

generates with each dollar of reserves

– Reciprocal of the reserve ratio = 1/R

– Equals 1/0.1 = 10 in our example

• The higher the reserve ratio

– The smaller the money multiplier

– Money multiplier = 0 when R=1



Financial Crisis of 2008–2009

• Bank capital

– Resources a bank’s owners have put into

the institution

– Used to generate profit

24


• Leverage

– Use of borrowed money to supplement

existing funds for purposes of investment

• Leverage ratio

– Ratio of assets to bank capital = 20 here

• Capital requirement

– Government regulation specifying a

minimum amount of bank capital

– Basel Accords set international standards

25


• If bank’s assets – rise in value by 5%

– Because some of the securities the bank

was holding rose in price

– $1,000 of assets would now be worth

$1,050

– Bank capital rises from $50 to $100

– So, for a leverage rate of 20

• A 5% increase in the value of assets

• Increases the owners’ equity by 100%

26


• If bank’s assets – reduced in value by 5%

– Because some people who borrowed from

the bank default on their loans

– $1,000 of assets would be worth $950

– Value of the owners’ equity falls to zero

– So, for a leverage ratio of 20

• A 5% fall in the value of the bank assets

• Leads to a 100% fall in bank capital




• Banks in 2008 and 2009

– Shortage of capital

• After they had incurred losses on some of

their assets

– Mortgage loans

– Securities backed by mortgage loans

– Reduce lending (credit crunch)

• Contributed to a severe downturn in

economic activity




• U.S. Treasury and the Fed

– Put many billions of dollars of public funds

into the banking system

• To increase the amount of bank capital

– It temporarily made the U.S. taxpayer a

part owner of many banks

– Goal: to recapitalise the banking system

• Bank lending could return to a more normal

level

– Occurred by late 2009

– Ongoing in the UK… 29

The Central Bank’s Tools of Monetary

Control

• Three main tools:

– Open market operations

– The refinancing rate

– Reserve requirements

• Influences the quantity of reserves

• Influences the reserve ratio



1. Open-market operations (OMOs)

• (Outright) purchase and sale of

government bonds by the Central Bank

– To increase the money supply

• The Central Bank buys government bonds

from the public

– To reduce the money supply

• The Central Bank sells government bonds to

the public (and the currency it receives is now

out of the hands of the public)

31

2. The Refinancing Rate

• The interest rate at which the Central

Bank will lend to commercial banks on a

short-term basis

– Called the refinancing rate in Europe; repo rate

in the UK; discount rate in the US

– Central banks tend not to undertake outright

OMOs these days

– Instead they buy bonds from the public but

promise to sell them back later

– Effectively, they have made a loan and taken

the bond as collateral

32

The refinancing rate (cont.)

• The interest rate the Central Bank

charges on this loan is the refinancing

rate

• Since the seller has agreed to buy back

the bonds from the Central Bank in the

future at an agreed price this type of

OMO is called a repo (repurchase

agreement)

33

How repos are used to control the money supply

• Banks carry enough reserves to cover

their lending – the reserve ratio

• At the end of a given working day,

commercial banks’ reserves may be

greater than or less than this reserve

ratio, due to random shocks

• Banks lend this excess to each other,

overnight or short-term

• This all takes place in the “money market”

34

• If, across banks, there is a general shortage of liquidity

in the money markets, then the short-run interest rate

charged will rise; and vice-versa

• The Central Bank monitors the money market and may

intervene

– to affect the supply of liquidity to banks and, in turn,

their lending and the money supply

– by manipulating their refinancing rate and effectively

lending to the banks or not renewing these (short-

term) loans if it wants to reduce the money supply

– In practice, the Central Bank sets the refinancing rate

and conducts OMO near it

35

Tools of Monetary Control

• The refinancing rate

– Interest rate on the loans that the Central

Bank makes to banks

– Higher refinancing rate

• Reduce the money supply

– Smaller refinancing rate

• Increase the money supply

36

Tools of Monetary Control

• Reserve requirements

– Regulations on minimum amount of reserves

• That banks must hold against deposits

– An increase in reserve requirement

• Decrease the money supply (multiplier ↓)

– A decrease in reserve requirement

• Increase the money supply (multiplier ↑)

– Used rarely – disrupts business of banking

• Since changes require banks to alter their lending

to achieve the reserve requirement

• Basel III increases reserve ratio

37

Problems

• The Central Banks’s control of the money

supply

– Not precise; money multiplier can vary

– Due to fractional reserve banking

• The Central Bank

– Does not control the amount of money that

households choose to hold as deposits in

banks

– Does not control the amount that bankers

choose to lend rather than keep as reserves 38

Bank runs and the money supply

• Bank runs

– Depositors suspect that a bank may go

bankrupt

• “Run” to the bank to withdraw their deposits

• Northern Rock bank run in 2007

– Problem for banks under fractional-

reserve banking

• Cannot satisfy withdrawal requests from all

depositors

39


• When a bank run occurs

– The bank - is forced to close its doors

– Until some bank loans are repaid

– Or until some lender of last resort

provides it with the currency it needs to

satisfy depositors

• In 2008 government took Northern Rock into

state ownership

– Complicate the control of the money

supply




• Great Depression, early 1930s

– Wave of bank runs and bank closings

– Households and bankers - more cautious

– Households

• Withdrew their deposits from banks

– Bankers - responded to falling reserves

• Reducing bank loans,

• Increased their reserve ratios

• Smaller money multiplier

• Decrease in money supply

41


• Bank runs today

– Not a major problem if the government

guarantees the safety of deposits at

most banks

• Federal Deposit Insurance Corporation

(FDIC) in the US

• Financial Services Compensation Scheme

in the UK guarantees full compensation up

to £85,000 per saver, per authorised

institution

– But only implemented in the aftermath of the

Northern Rock bank run/crisis

42


• No bank runs

– Depositors are confident

– Government will make good on the

deposits

• Government deposit insurance

– Cost:

• Bankers - little incentive to avoid bad risks

– Benefit:

• A more stable banking system

43

(chapter 29 in mankiw & taylor) · the monetary system (chapter 29 in mankiw & taylor)...

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