Money, Central Banking, and Inflation

Chapter 13

Money

Aspects of Money

1. Medium of Exchange – Token that can be offered as a payment for goods.

2. Unit of Account – All goods will have a value in money and, thus, can be used to measure all goods

3. Store of Value – If money is to be accepted for goods today it must have durable value. (Money is an Asset).

Evolution of Money:

Money is a technology

• Commodity Money – Metals (ca.1400 B.C.).

• Minting coins for standardization (ca. 700 B.C.)

• Paper banknotes backed by precious metals (600 AD in China, 1650 in Sweden)

• Fiat Money Paper declared legal tender (800 AD in China, 1700 in France/USA)

Evolution of Money

In more advanced societies with sophisticated banking systems, broad money may be used for transactions.

• Checks: Paper promises to pay definitive money on demand.

• Electronic Transfers: Funds can be transferred from account to account in banking system.

• Debit Cards and ATM Cards can be used to transfer funds to definitive money or in direct exchange for goods.

Money Supply The stock of the medium of exchange.

Types of Financial Assets

M1 Currency in Hands of the Public [C] + Demand Deposits [D]

M2 M1 + Savings Deposits + “Small” Time Deposits +

[Liquid Money Market Instruments inc/ “Small” NCD’s]

M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Hong Kong Guide to Money and Banking Terms

M1 The sum of legal tender notes and coins held by the public plus customers' demand deposits placed with banks.

M2 M1 plus customers' savings and time deposits with banks plus negotiable certificates of deposit (NCDs) issued by banks held outside the banking sector.

M3 M2 plus customers' deposits with restricted licence banks and deposit-taking companies plus NCDs issued by these institutions held outside the banking sector.

Monetary Aggregates in HK

0

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8,000,000

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-85

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-87

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-89

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-91

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-93

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-95

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-97

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-99

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-01

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-03

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-05

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-07

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-09

HK

$ M

illio

n

M1 M2 M3

HKMA Monthly Statistical Bulletin

Real Balances

• Real balances are the purchasing power of monetary assets, i.e. the money supply divided by the price level.

• Taking the price level as given, real balances can be shifted by the central bank through changes in money supply.

• Taking the money supply as given, real balances can change through changes in the price level.

SMP

Real Balances and HK Deflation

3300000

3400000

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-00

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HK

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Money Supply Real Balances

Liquidity Theory

Money is part of the liquid end of the asset portfolio. We consider a theory of how this liquidity is divided up.

1. Liquid Assets (Currency, Checking Accounts, Savings Accounts) that are useful for transactions which pay zero or below market interest rates.

2. Money market assets (Government bills, commercial paper, jumbo CD’s) that pay a market rate, i, but which cannot be used for transactions.

Determinants of Holding Money

• Trade-off: The benefit of holding real balances is that doing so will make transactions more convenient. The cost is that you will earn interest income.

• The greater is the quantity of real transactions, Y, the more attractive is real balances.

• The greater is the real interest rate, i, the less attractive are real balances.

Money Demand

i

Money Demand

i*

MPSM

P

DMP

The greater is the market interest rate, the greater is the opportunity cost of holding money.

What shifts the money demand curve?

1. An increase in real spending (GDP) will increase the need for money for transactions shifting the demand curve out. A reduction in GDP will shift the demand curve in.

2. There are also large shifts in money demand due to liquidity preference (possibly related to risk level of financial assets).

Central Banks

What is a central bank?• Central banks have two main roles:

– Banker to the government• Manage many financial assets of the government.• Monopoly on the issue of banknotes/currency (true

almost everywhere, but not HK)• Arm of government policymaking

– Banker to commercial banks.• Operate the Payment System• Regulate Banking System• Lender of Last Resort during a crisis

• Central Bank: A special

governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

Economy Central Bank

HK ?

USA ?

Eurozone ?

PRC ?

UK, Canada, Japan, Korea

?

The Monetary Base

• The monetary base, also called “high powered money” consists of:

C Currency in the Hands of the Public

+ R + Reserves of the Banking System

=MB = Monetary Base

• Monetary base is typically the monetary liabilities of the central bank.

• A part of the monetary liabilities of a central bank. The Monetary Base is defined, at the minimum, as the sum of the currency in circulation (banknotes and coins) and the balance of the banking system held with the central bank (the reserve balance or the clearing balance). In Hong Kong, the Monetary Base comprises Certificates of Indebtedness (for backing the banknotes issued by the note-issuing banks), government-issued currency in circulation, the balance of the clearing accounts of banks kept with the HKMA (the Aggregate Balance), and Exchange Fund Bills and Notes.

Hong Kong Guide to Money and Banking Terms

Interbank Payment Systems• Commercial banks keep accounts at the

central bank for interbank payments. referred to generally as reserves, specifically as clearing balances in Hong Kong.

• These accounts, along with cash, constitute the monetary base.

Hong Kong Interbank Clearing Limited

Interbank Market

• Individual banks will face a short-fall in reserves if they have too many outflows and borrow funds from other banks facing a surplus.

• Banks will keep an inventory of reserves to meet their own liquidity needs but the interest rate is the opportunity cost of holding reserves.

• Desire to hold reserves is a declining function of the interest rate.

• Central bank controls the total supply of reserves available to banks.

Interbank Market

S

D

iIBR

Reserves

i*

Equilibrium in the Interbank Market

• If interest rates are too low, banks will want to hold more reserves than available. Banks facing a shortfall of reserves will be willing to bid up interest rates until all banks are content with reserves available.

• If interest rates are too high, banks will want to lend out their excess reserves. To do so in a liquid market, they must lower interest rates.

Equilibrium

S

D

iIBR

Reserves

i

i

Monetary Base and Money Supply

Money Supply vs. Monetary Base

Monetary

Base

Money

Multiplier

Money

Supply* =

Fractional Reserve Banking• Banks keep only a fraction of any deposits

they receive on hand in the form of vault. The rest is used to acquire other assets, especially loans.

• Reserves- Deposit Ratio:

The fraction of deposits kept as reserves is the Reserves-Deposit Ratio.– D = Deposits (for M1 this is Demand

Deposits; for M2 this is a broader category of deposits).

RD

Liquidity Portfolio

• Savers keep some of their asset portfolio in liquid assets.

• We can divide up liquid assets into currency and deposits

• Currency-Deposit Ratio: – Bank deposits and currency are both assets which will

be part of the portfolios of savers.

CD

Money Supply Multiplier

• The money multiplier can be derived by the ratio of aggregate money to the monetary base.

• As long as the reserve ratio is less than 1, the money multiplier is greater than 1.

• Multiplier is decreasing in reserve-deposit ratio and decreasing in cash-deposit ratio.

1S

CM C D DmmC RMB C RD D

Determinants of Reserve Ratio

1. Regulatory Requirements – Some regulatory regimes have minimum reserve levels.

Reserve Ratio = Required Reserves Ratio + Excess Reserves Ratio

(R/D) = rr + ER/D 2. Volatility of Deposit Outflows – If deposit outflows

are likely to be large, banks hold more reserves.

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral BankReservesReserves

rdrd

CashCash

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

CashCash

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

CashCash

Central Bank and Money Supply

• The central bank can adjust the stock of reserves through transactions with commercial banks.

• An increase in reserves will increase the deposits that banks can accept and will have a multiple impact on overall money supply.

Money Demand

i

Money Demand

i*

MPSM

P

DMP

Equilibrium in the Money Market

• If interest rates are too high, excess supply of money: – people will want to buy interest paying assets like

bank accounts or treasury bills.– Bond dealers and banks can reduce the interest

rates they are willing to offer

• If interest rates are too low, excess demand for money:– people will want to sell interest paying assets like

bank accounts or treasury bills to get more liquidity.

– Bond dealers and banks must raise interest rates.

Open Market Operations

• In an Open Market PURCHASE, the central bank purchases government securities from banks and credits their reserve accounts. This increases the aggregate supply of reserves.

• In an Open Market SALE, the central bank sells government securities from banks and debits their reserve accounts. This increases the aggregate supply of reserves.

Money Supply and Interest Rates

• If the central bank engages in an open market PURCHASE, they will increase the reserve holdings of counter-party commercial banks.

• This will increase liquidity in the reserve funds market.

• Banks with excess reserves can lend them out creating more liquid bank deposits.

• Increase in liquid bank deposits will increase money supply. More liquid money market reduces interest rates.

Reserve Market/Money Market

i

Money Market

i*

MP

SMP

DMP

iIBR

i*

i**

i**

S S'

D

Reserves

SMP

Reserve Market

Fed Funds & Money Market Rates

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Fed Funds NCD CP-Fincl CP-NonFincl Tbill

Money Markets and Interest Rate Policy

Money Market: GDP Rises

i

i*

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i**

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2

Y↑SMPDM

P

/DMP

Money Demand and Reserve Markets

• If demand for money rises, households will want to hold more money. They will pull funds from non-liquid instruments (like jumbo CD’s) and convert them into cash or liquid deposits.

• Banks will need to hold more reserves to backup the liquid deposits. This will increase the demand for reserves.

Inflation

Quantity Theory

• Simplest monetary theory is the Quantity Theory of Money.– Purchasing power of money is equal to the

quantity of money (Mt) times the speed of circulation (V, # of transactions)

– Purchasing power means # of goods (Yt) multiplied by price per good (Pt)

Moneyt * Velocity = Pt * Yt

Rule of Thumb

• Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

Z X Yt t t t t tZ X Y g g g

1

1

Z t tt

t

Z Zg

Z

Money and Inflation

• Assuming stable velocity

• Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

M Y Pt t t t tg g g

Money & Inflation: 1975-1994

Inflation & Money OECD Countries

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Average Money Growth

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Ex Ante Rate and the Fisher Effect• Savings and investment decisions must be

made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

• Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.

1EA FORECAST

t t ti r

Great Inflation of the 1970’sUS Inflation Rates & Interest Rates

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ar-5

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-67

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-82

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%

Interest Rates

Inflation

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

Great Inflation Download

Fisher Effect: OECD Economies Great Inflation of 1970’s

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Average Inflation 1970-1984

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Loanable Funds MarketFisher Effect

S

D

LF

r*

LF*

1Et

1Et

i*

Ex Ante vs. Ex post

• We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation.

• The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return.

1ExP ACTUALt t tr i

1 1ExP ExA FORECAST ACTUALt t t tr r

Unexpected Inflation Winners and Losers

– Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers.

– Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are winners/borrowers are losers.

Inflation Risk

• When inflation is variable, lenders will demand some premium for inflation risk. This will put cost on borrowers.

• High inflation rates tend to be associated with unpredictable inflation.

Costs of Anticipated Inflation

• Shoe Leather Costs – Money is a technology for engaging in transactions. The greater is inflation, the greater the cost for individuals of holding money. Individuals must make efforts as a substitute for the convenience of holding money.

• Menu Costs – Firms must engage in costs of changing posted prices. More generally, when prices change rapidly over time, more time and effort must be put into calculating relative prices.

The Inflation Tax

• Banknotes do not pay interest. • The real interest rate on banknotes is

• If inflation is high, currency has sharply negative returns. People will avoid holding money leading to society losing the convenience of money transactions.

1CASHt tr

•Zimbabwe Inflation Download

Causes of Extremely Rapid Inflation

• Government generates revenues by printing new money (referred to as seignorage).

• Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money.

• Explain the link between deficits and inflation.

Israel 1970-1990

Inflation

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Israel 1970-1990Surplus (% of GDP)

-30.00%

-25.00%

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-10.00%

-5.00%

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5.00%

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Money Market at ZIRP

0

r

-πt+1

DMP

When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

MP

Learning Outcomes

Students should be able • Calculate the relationship between

expected inflation, real and nominal interest rate.

• Calculate the relationship between the money supply, multiplier and base.

• Use the model of money market to describe the impact of events on equilibrium outcomes.