Module 17 - Money, the central bank and monetary Policy

17.1
So far minimal focus on money.
We live in monetary economy and money is medium of exchange and used to
reflect value of goods.
Periods on rising prices inf, declining prices def.
Explanation required.
19th century many recessions due to financial crisis and loss of confidence in
banking sector.
Interwar period persistent depression Keynes argued that monetary policy could
not raise demand and corrective action had to be placed on fiscal policy. This
mentality inherited by capitalist societies focus on functional fianc and ignore
monetary policy - until 1970s. But accelerated inflation required rethinking of
strategy.

17.2 The function of money

Money is anything that is acceptable for settlement of debts ( eg cigarettes in
WW2).
Single most imp source commercial bank deposits debts of private financial
institutions not legal tender but are generally acceptable in settlement of debts.
3 types coins, banknotes and bank deposits. Coins and banknotes are legal tender.
Bank deposits , eg cheques, are not. But still commonly accepted and so bank
deposit, and their derivatives, are still part of the money supply.
Money has 3 main functions medium of exchange, unit of account and store of
wealth.

17.2.1 Money as medium of exchange

Convenient, compared to alternatives, barter (depends on coincidence of wants)
( common when exchanges are rare, eg in self-sufficient underdeveloped families
with little specialization). Specialization of labour frequent exchanges that need to
be efficient and cheap- require money.
Modern economy flow of goods/services and rewards for factors of production is
determined by flow of money.
it
it
it
it

must
must
must
must

be widely acceptable;
have a high value: weight ratio;
be divisible to settle debts of differing denominations; and
not be easily produced, counterfeited or debased in value.

17.2.2 Money as unit of account

Provides standard measure of value. $10 is $1 times 10.

17.2.3 Money as store of wealth

Stores wealth obtained from factor services until needed. Most common store.
Needs to be reasonably stable over time. If quick price rise other store needed metals,
art, land.
Inflation decreases the value of money. Movement out of money and into real good
actually further contributes to declining value.

17.3 A Brief History of Banking

Previous metal coins, in themselves valuable -> commodity value of coinage as acceptable
payment of debt -> importance of acceptability.
1) Goldsmiths safekeeping gold for merchants written receipt of evidence converted
back to money when needed - cloakroom banking only safekeeping of money - all
bank receipts backed by equivalent gold.
2) Increased confidence receipt became as good as gold receipts themselves
accepted as payment, rather than carrying gold.
3) Banks issues banknotes in excess of actual gold- became manufactures of money
fractional reserve banking bank liabilities exceed actual gold/cash. Pyramid of
credit

Based on confidence and convertibility. Both can fail and state regulation of
banknotes introduced.
Today still have reminders of statements on banknotes as convertibility into gold.
Value was tied to fixed rate of exchange to gold Gold standard , now abandoned.
Currency no longer carry any intrinsic value. But only as acceptable means of
settling debt, at current value.
Nowadays only central banks issue can issue notes and commercial banks only do
deposit banking. Still fractional reserve banking by creating deposits in excess of
the reserve. Still requite ability to convert to cash on demand but they know the
defined percentage of despite liabilities required.
Still can fail due to high loans to foreign countries or high risk industries. Or
speculation causing a higher than normal request for convertibility can crash a
bank.

17.4 The fractional reserve system, Credit creation and

credit multiplier
Commercial banks have 2 competing pulls;
Profitability cash earns no interest and the higher the proportion of interest
bearing assets the more profit
Liquidity need sufficient assets in liquid form to meet demands. So portion is kept
as cash or highly liquid ( low profit) assets.

In this assumption 10% if assets in cash will suffice to met liquidity needs.
Cash ratio r 10% = 0.1
Single monopoly commercial bank
Public doesnt want any more cash than currently has and so depots all
additional money. No cans leakage from bank.

Day 1 ; 100 deposit.

This is not equilibrium. Bank wishes only 0.1 cash so will create loans or buy bonds.
( bonds have redemption date, redemption value and yearly coupon payment +
bond market forces or demand and supply). Pays for these by drawing a cheque on
itself and will credit the seller. The banks assets will therefore increase in
equivalent to deposits liabilities.

Day 2

This is an equilibrium position and keep the required 0.1 cash ration. Any inc or dec
in deposit liabilities would result in r being too big or small.
Change in deposits = deposit or credit multiplier x change in cash
Deposit multiplier is reciprocal of cash ration ie

d= 1/r

therefore

The credit multiplier gives the change in deposits incurred by change in cash
reserves;

The smaller the cash ratio, the bigger the credit multiplier and volume of deposits.
Now assumptions can be relaxed;
In multibank case deposit creation will result in some cash drain as cheques are
cashed. Deposit creation reduced cash reserves. However the cash flows to other
banks and so overall reserves stays unchanged.
Other assumptions however do impact; if r is no longer 0.1 or cash flows to public
the deposit multiplier size is affected and deposit creation on a given cash base
changes.
A bank can decide to not create further deposits cash deposits increase by 100
and liabilities by 100. Credit multiplier will become 1. Central banks set the
minimum cash ratio.
Publics propensity to hold cash was zero since both cash and deposits are used to
settle debts this is likely to increase as demand for deposits increases. Ie theyll
want part of the new deposits in cash. This limits ability to create deposits.
The creation of bank deposits is therefore limited by two factors:
(a) the banks propensity to keep cash for liquidity purposes, as represented by the cash
ratio; and
(b) the publics propensity to hold additional cash.

17.5 The central bank and monetary policy

All economies have a central bank.
It controls commercial banks as to support the monetary policy of the economy.
Acts as bankers bank and lender of last resort
Also government bank and manager of publics debt.
Responsible for conduct and operation of monetary policy -> attempts to influence
the level of economic activity by regulation supply of money and cost of credit.
Has the following powers and instruments monopoly to issue notes, dictate cash
ratio and reserve requirements for commercial banks, credit control ( initial
payments and repayment periods for hire purchase contracts) and power to issue
direct instructions to commercial banks and financial institutions.

Most important is the open marker operations central bank buying/selling gov
bonds in open market
-

Buy bonds -> increase supply or money and reduced cost of borrowing
Sell bonds -> reduced supply of money and inc cost of borrowing.

Buy bond with cheque onto itself -> deposited into commercial bank -> central
bank credits the common bank -> bankers balance increase by value of cheque and
since these can be turned into cash they are considered part of cash reserve. ->
deposits are created -> expansion of money supply that is a multiple of the initial
increase in cash reserve depend on deposit/credit multiplier.
This also affects cost of borrowing as increase of money supply, by normal supply
and demand analysis -> the cost of borrowing ( interest rates) must fall as long as
there is no shift in demand for money.
If sells it reced money supply, which becomes more scares and cost of borrowing
increases.
Monetary policy influence on aggregate demand and therefore level of
income, output and employment.
An expansionary monetary policy , by buying bonds, will inc money supply, dec
rates and this should increase level of aggregate demand. If private investment is
interest elastic -> dec rates will make some investment more profitable ->
movement along marginal efficiency of investment curve and investment would
rise.
Also the dec rates could also cause increase in consumer component of agg
demand eg cars and households, central and local governments would also find
borrowing cheaper. Even exporters could encourage trade by offering easier credit
terms.
Hence, open market operations, through increasing the supply of money and lowering
the structure of interest rates, may increase aggregate demand by raising private and
public
investment, consumption (particularly of consumer durables), and even exports, and this, in
turn, will raise the level of income, output and employment. Conversely, open market
operations, when they reduce the supply of money and raise the structure of interest rates,
may reduce aggregate demand by lowering private and public investment, consumption
and
even exports; and this, in turn, will lower the level of income, output and employment. In
general, investment, particularly private investment, is likely to be more sensitive to
changes
in interest rates, but other components of aggregate demand may also be affected through
monetary policy.
The manner in which monetary policy can influence the level of aggregate demand, and
therefore the level of economic activity, can be summarized as having five sequential
stages:
1. The central bank acts on the cash reserves of the commercial banks.
2. Commercial banks act to change bank deposits and therefore the money supply.
3. A change in the money supply influences the cost of borrowing.
4. A change in the availability and cost of credit influences aggregate demand.
5. A change in aggregate demand leads, through the multiplier process, to some multiple
change in income, output and employment.

Let us now consider these steps in greater detail.

1. The central bank influences the activities of the commercial banks through open market
operations, or through changing the cash ratio and reserve requirements of the commercial
banks. In open market operations, the central bank, if it wishes to engage in an
expansionary monetary policy, will buy bonds, the effect of which is to increase the cash
reserves of the commercial banks. If the central bank wishes to follow a restrictive
monetary
policy, it will sell bonds, the effect of this being to reduce the cash reserves of the
commercial banks.
2. The change in the cash reserves of the commercial banks will have, through the credit
multiplier, a multiple impact on the volume of bank deposits. A reduction in cash reserves
will lead to a multiple contraction of bank deposits and therefore to a multiple
contraction of the money supply. An increase in cash reserves will lead to a multiple
expansion of bank deposits and therefore to a multiple expansion of the money supply.
3. Changes in the money supply will influence the ease and cost of borrowing. An increase
in the money supply will make it easier to obtain credit and also make it less expensive,
and so interest rates will fall. Conversely, a reduction in the money supply will make
borrowing more difficult and hence more expensive, and interest rates will rise.
4. Changes in the availability and the cost of credit will influence the level of aggregate
demand. If the money supply is increased so that credit is more easy to obtain and interest
rates are lower, this will have a favorable effect on the volume of private and public
investment, consumption and even exports. Conversely, if the money supply falls, so that
it is more difficult and costly to obtain credit, this will have the effect of lowering the
level of private and public investment, consumption and even, possibly, exports. As
private investment is likely to be more sensitive to changes in interest rates, the effect on
aggregate demand in terms of this component of demand can be analyzed in terms of the
previous discussion of investment decisions, i.e. a change in interest rates causes a
movement along a given marginal efficiency of investment curve, so that a fall in interest
rates results in an increase in private investment and vice versa.
5. The change in the volume of aggregate demand will cause national income, output and
employment to change in the same direction. An initial increase in aggregated demand
will lead to a multiple process and vice versa. An expansionary monetary policy, by
lowering
interest rates and raising aggregate demand, will lead to a multiple expansion in
national income, and a contractionary monetary policy will have the reverse effect. The
difference between expansionary and contractionary monetary policies is shown in Figure
17.1.