Money and Monetary Policy
Meaning and Functions of Money • The functions of money – medium of exchange – means of storing wealth – means of evaluation – means of establishing value of future claims and payments
• What should count as money? – narrow definitions of money – broad definitions of money
Financial System in the UK • The key role of banks – deposits and loans – liabilities and assets – retail and wholesale deposits and loans
• Liabilities – sight deposits
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Financial System in the UK • The key role of banks – deposits and loans – liabilities and assets – retail and wholesale deposits and loans
• Liabilities – sight deposits – time deposits
Balance sheet of UK banks: February 2003
Financial System in the UK • The key role of banks – deposits and loans – liabilities and assets – retail and wholesale deposits and loans
• Liabilities – sight deposits – time deposits – certificates of deposit
Balance sheet of UK banks: February 2003
Financial System in the UK • The key role of banks – deposits and loans – liabilities and assets – retail and wholesale deposits and loans
• Liabilities – sight deposits – time deposits – certificates of deposit – repos
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Financial System in the UK • Assets – cash and balances with the Bank of England
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Financial System in the UK • Assets – cash and balances with the Bank of England – short-term loans
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Financial System in the UK • Assets – cash and balances with the Bank of England – short-term loans – longer-term loans
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Balance sheet of UK banks: February 2003
Financial System in the UK • Liquidity and profitability – profitability – liquidity • the liquidity ratio
Balance sheet of UK banks: February 2003
Financial System in the UK • The central bank – Bank of England, ECB, Fed, etc. – functions • note issue • acts as a bank – to the government – to overseas central banks
• overseas activities of banks • provides liquidity to the banks – lender of last resort
• operates monetary and exchange rate policy
Financial System in the UK • The London money market – the discount and repo markets • discounting • the repo market • last-resort facilities by Bank of England
– the parallel money markets • the inter-bank market • inter-companies deposit market • market for certificates of deposit, etc. • foreign currencies market
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK – definitions in the UK: M0, M4
UK monetary aggregates: (end February 2003) £ million Cash outside Bank of England + Banks’ operational deposits with Bank of England = M0
Cash outside banks (in circulation)
36 861 91 36 952
30 630
+ Private-sector retail bank and building society deposits
676 969
= Retail deposits and cash in M4 (also known as M2)
707 599
+ Private-sector wholesale bank and b.s. deposits + CDs
295 996
= M4
1 003 595
UK monetary aggregates: (end February 2003) £ million Cash outside Bank of England + Banks’ operational deposits with Bank of England = M0
Cash outside banks (in circulation)
36 861 91 36 952
30 630
+ Private-sector retail bank and building society deposits
676 969
= Retail deposits and cash in M4 (also known as M2)
707 599
+ Private-sector wholesale bank and b.s. deposits + CDs
295 996
= M4
1 003 595
UK monetary aggregates: (end February 2003) £ million Cash outside Bank of England + Banks’ operational deposits with Bank of England = M0
Cash outside banks (in circulation)
36 861 91 36 952
30 630
+ Private-sector retail bank and building society deposits
676 969
= Retail deposits and cash in M4 (also known as M2)
707 599
+ Private-sector wholesale bank and b.s. deposits + CDs
295 996
= M4
1 003 595
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK – definitions in the UK: M0, M4 – euro zone definitions: M1, M2, M3
UK monetary supply using ECB measures: (end February 2003) £ million Currency in circulation
31 351
+ Overnight deposits
513 292
= M1
544 643
+ Deposits with agreed maturity up to 2 years
81 696
+ Deposits redeemable up to 3 months' notice
296 518
= M2
922 857
+ Repos
88 978
+ Money market funds and paper
57 496
= M3
1 069 331
UK monetary supply using ECB measures: (end February 2003) £ million Currency in circulation
31 351
+ Overnight deposits
513 292
= M1
544 643
+ Deposits with agreed maturity up to 2 years
81 696
+ Deposits redeemable up to 3 months' notice
296 518
= M2
922 857
+ Repos
88 978
+ Money market funds and paper
57 496
= M3
1 069 331
UK monetary supply using ECB measures: (end February 2003) £ million Currency in circulation
31 351
+ Overnight deposits
513 292
= M1
544 643
+ Deposits with agreed maturity up to 2 years
81 696
+ Deposits redeemable up to 3 months' notice
296 518
= M2
922 857
+ Repos
88 978
+ Money market funds and paper
57 496
= M3
1 069 331
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK • The creation of credit
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK • The creation of credit – simple illustration
Credit creation: Banks' original balance sheet
Credit creation: Effect of a new deposit of £10bn
Credit creation: Full effect of a new deposit of £10bn
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK • The creation of credit – simple illustration – the bank multiplier
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK • The creation of credit – simple illustration – the bank multiplier • 1/L
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK • The creation of credit – simple illustration – the bank multiplier • 1/L
– the real world
The Supply of Money • Definitions of the money supply – monetary base – broad money
• Definitions in the UK • The creation of credit – simple illustration – the bank multiplier • 1/L
– the real world • no precise bank multiplier
The Supply of Money • Causes of increases in money supply – banks reduce liquidity ratio – inflow of funds from abroad – PSNCR and its financing
• Money supply: exogenous or endogenous? – Relationship between money supply and the rate of interest
The supply of money curve: (a) exogenous money supply
Rate of interest
MS
O Quantity of money
The supply of money curve: (b) endogenous money supply
Rate of interest
MS
O Quantity of money
The Demand for Money • The motives for holding money – transactions and precautionary motive – assets or speculative motive – the total demand for money
• Determinants of demand for money – money national income – frequency with which people are paid – financial innovations – speculation about future return on assets – rate of interest
Rate of interest
The demand for money (liquidity preference) curve
Md O Money
Monetary Equilibrium • Equilibrium in the money market – equilibrium interest rate where D and S of money are equal
Equilibrium in the money market
Rate of interest
MS
re
Md O
Me
Money
Monetary Equilibrium • Equilibrium in the money market – equilibrium interest rate where D and S of money are equal
• Equilibrium in the foreign exchange market
Monetary Equilibrium • Equilibrium in the money market – equilibrium interest rate where D and S of money are equal
• Equilibrium in the foreign exchange market – increased money supply leads to lower interest rates
Monetary Equilibrium • Equilibrium in the money market – equilibrium interest rate where D and S of money are equal
• Equilibrium in the foreign exchange market – increased money supply leads to lower interest rates – lower interest rates lead to a lower exchange rate
Monetary Equilibrium • Effects of changes in money supply on national income – effect on interest rates • Ms↑ → r↓
The demand for and supply of money
Rate of interest
MS
r1
Md O
Q1 Money
Rate of interest
The demand for and supply of money MS ' MS
r2
r1
Md O
Q2
Q1 Money
Monetary Equilibrium • Effects of changes in money supply on national income – effect on interest rates • Ms↑ → r↓
– effects of changes in interest rates on investment • r↓ → I↑
Monetary Equilibrium • Effects of changes in money supply on national income – effect on interest rates • Ms↑ → r↓
– effects of changes in interest rates on investment • r↓ → I↑
– effects of changes in interest rates on the exchange rate, and imports and exports • r↓ → er↓→ X↑, M↓
Monetary Equilibrium • Effects of changes in money supply on national income – effect on interest rates • Ms↑ → r↓
– effects of changes in interest rates on investment • r↓ → I↑
– effects of changes in interest rates on the exchange rate, and imports and exports • r↓ → er↓→ X↑, M↓
– effects of changes in investment, imports and exports on national income • I↑, X↑, M↓ → Y↑
Monetary Policy • The significance of monetary policy • The policy setting – relationship between the government and the central bank – degree of central bank independence
• Medium- and long-term policy – control of banks’ liquidity ratio – restricting size of PSNCR
Monetary Policy • Short-term monetary control – techniques to control money supply • open-market operations • reduced central bank lending to the banks • funding • variable minimum reserve ratios
– techniques to control interest rates • announcing changes in interest rates • backing up announcements – operations in the discount and repo markets
– credit rationing
Effectiveness of Monetary Policy • Medium and long-term control over the money supply: reducing PSNCR – automatic fiscal stabilisers – the desire to cut taxes – difficulty in cutting government expenditure
• Short-term control of the money supply – use of money supply targets – ways in which banks resist attempts to restrict the growth in the money supply – demand-determined money supply
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates
An inelastic demand for loans
Rate of interest
Assume that the authorities want to reduce the demand for money to Q2
r1 Demand for loans O
Q2
Q1
Loans
Rate of interest
An inelastic demand for loans
A large rise in the rate of interest (to r2) will be necessary
r2
r1 Demand for loans O
Q2
Q1
Loans
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
– unstable demand for money
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
– unstable demand for money • problem of changing expectations
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
– unstable demand for money • problem of changing expectations • speculation
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
– unstable demand for money • problem of changing expectations • speculation
– possible conflict between domestic goals and exchange-rate goals
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
– unstable demand for money • problem of changing expectations • speculation
– possible conflict between domestic goals and exchange-rate goals
• Using monetary policy
Effectiveness of Monetary Policy • Effectiveness of controlling interest rates – inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans
– unstable demand for money • problem of changing expectations • speculation
– possible conflict between domestic goals and exchange-rate goals
• Using monetary policy – use of interest rates to meet inflation target