Monetary Account and Money

Supply Process
 Money
Money is anything that is generally
accepted as a means of payment.

Functions of Money
Medium of Exchange
Unit of Account
Store of Value
 Measurement of Money

Narrow Money(M1) equals currency plus

demand deposit

Broad Money (M2) consists of currency

plus demand and time deposits
 The money supply process

• who determines the money supply?

–the central bank
–depositors
–borrowers
 The Central bank's balance sheet:

Assets Liabilities
Government Securities Currency in circulation
Discount Loans Reserves
 monetary base (MB)
• currency + reserves
• C+R
• also called “high-powered money”
Tk.1 increase in MB will cause
> Tk.1 increase in money supply
 Controlling MB
• open market operations
– CB buys and sells Gov. securities
– affect size of monetary base
• use T accounts to track the effect
 example

• open market purchase $100 million

– CB buys $100 million in T bonds
– CB buys from a bank
Banking System
Assets Liabilities
Securities - $100
Reserves $100

increase in bank reserves of $100 million

• if Fed buys Tbonds from public,
& public deposits in account

Banking System
Assets Liabilities
reserves $100 checking $100

increase in bank reserves of $100 million

• if Fed buys Tbonds from public,
& public keeps cash

Nonbank Public
Assets Liabilities
Securities - $100
currency $100

increase in currency of $100 million

• discount loans
– Fed loans to bank
– Fed credits bank’s reserve account
 Banking System
Assets Liabilities
Reserves $100 Discount Loans $100

• reserves increase
• MB increases
 open market purchase
or
discount loans
• increase in MB
– due to increase in reserves OR
– due to increase in currency
 III. Deposit creation
• Fed increases reserves by $1,
• deposits increase by > $1
– multiple deposit creation
• how?
 example
• Fed buys $100 securities from bank
– bank securities decrease $100
– bank reserves increase $100

First National Bank

Assets Liabilities
Securities - $100
Reserves $100
• $100 increase in reserves are excess reserves,
– banks lends them out by crediting checking account

First National Bank

Assets Liabilities
Securities - $100 Checking $100
Reserves $100
Loans $100
• borrower takes $100 loan and deposits in bank A
– reserves increase at bank A
– deposits increase at bank A

Bank A
Assets Liabilities
Reserves $100 Checking $100
• required reserve ratio = 10%
• bank A must keep $10
– free to lend $90

Bank A
Assets Liabilities
Reserves $10 Checking $100
Loans $90
• borrower at bank A takes $90 loan and deposits in
bank B

Bank B
Assets Liabilities
Reserves $90 Checking $90
• bank B must keep $9
– free to lend $81

Bank B
Assets Liabilities
Reserves $9 Checking $90
Loans $81
 where are we?
• initial $100 open market purchase
• checking deposits so far:
$100 + $90 + $81 = $271
• money has been created
 simple money multiplier
• how much money creation is possible?

change in = change in 1
x
deposits reserves reserve req.
change in = 1
$100 x = $1000
deposits .10

• $100 increase in reserves,

$1000 increase in deposits
 simple money multiplier
• leaves out 2 possibilities:
(1) borrowers take some of loan as cash
(2) banks hold some excess reserves
• need a more complex multiplier
 Money Creation

• Deriving the Money Multiplier

– The money multiplier is a multiplicative factor on the monetary base:

M  m* B
– Where:
M : Money Supply (we will use M 1  C  D)
m: Money Multiplier
B: Monetary Base
 Money Creation

• Deriving the Money Multiplier

– The multiplier tells us by how much the money supply is going to change if a
central bank increases the monetary base.

– By the nature of the money creation process it will generally be larger than 1. This is
where the name high-powered money for the monetary base is derived from:

• Each $1 of the monetary base leads to a money supply larger than $1.
 Money Creation

Deriving the Money Multiplier

c  {C / D}  currency ratio
e  {ER / D}  excess reserves

– Where ER indicates the level of excess reserves of the banking sector. Note that
this is technically a behavioral assumption. We assume that individuals and banks in
the aggregate always hold a certain fraction of their “money” in terms of currency
and excess reserves respectively.
 Money Creation

• Deriving the Money Multiplier

– Now the total level of reserves R in an economy is no longer identical to the

required level of reserves RR, instead R is given by:

R = RR + ER <1.>

– Further we know that the level of required reserves is equal to the reserve
requirement ratio r times the level of deposits D

RR=r*D <2.>
 Money Creation

• Deriving the Money Multiplier

– By substitution of <2.> into <1.> it follows that:

R = (r * D) + ER <3.>

– Further we know, that the monetary base equals reserves and currency, such that
B=R+C <4.>

– By substituting <3.> in <4.> it follows that

B = (r*D) + ER + C <5.>
 Money Creation

• Deriving the Money Multiplier

– In order to introduce our agents behavior into this discussion, we rewrite <5.> in
terms of c and e:

B = (r * D) + (e * D) + (c * D) = (r + e + c) * D <6.>

– Since: C=c*D
and ER = e * D

(by definition)
 Money Creation

• Deriving the Money Multiplier

– We can now rewrite <6.> as:

1
D *B
r ec <7.>

– Using our definition of M1 = C + D and C = c*D, we find that:

M = (c*D) + D = (1 + c)*D <8.>

1
or D *M
1 C
 Money Creation

• Deriving the Money Multiplier

– Substituting <8.> into <6.> it follows that:

M 1
 *B
1 c r  e  c

1 c
 M *B
r ec <9.>

1 c
– With m indicating the money multiplier as suggested initially.
r ec
 Money Creation

• Deriving the Money Multiplier

– An example:

• Let the required reserve ratio r be equal to 10%

• Let the currency in circulation C be $500 billion
• Let outstanding checkable deposits D be $1,000 billion
• Let excess reserves ER be $1 billion

• The money supply then is given by C + D = $1,500 billion

 Money Creation

• Deriving the Money Multiplier

– An example:

• The currency ratio c is given by:

$500 Billion
c  0.5  50%
$1, 000 Billion
• The excess reserve ratio e is given by:

$1 Billion
e  0.001  0.1%
$1, 000 Billion
 Money Creation

• Deriving the Money Multiplier

– An example:

• Plugging all these values into the expression for our money multiplier, we find
that:
1  0.5
m  2.5
0.1  0.001  0.5

• In other words, for each $1 Dollar of high-powered money, $2.5 Dollars of

M1 are created.
 Interest Rate and YTM
• Since interest rates are among the most closely
watched variables in the economy, it is imperative
that we understand exactly what interest rate means.

• In this session, we will see that a concept known as

yield to maturity (YTM) is the most accurate
measure of interest rates.
 Present Value Introduction
• Different debt instruments have very different
cash flows with very different timing.
• To value a debt instrument’s cash flows, we use
present value analysis.
• Present value analysis also allows us to measure the
instrument’s yield to maturity or interest rate.
 Present Value
• Present discounted value is based on the
commonsense notion that one taka tomorrow is
worth less to you than a taka today.
• WHY?
Because one could put the taka in a savings
account that earns interest and have more than a
taka in one year.
 Present Value
To determine the future value of a single amount

FV = PV(1+i)n
Here, FV = Future Value
PV = Present Value
i = Interest Rate
n = Number of Period
 Present Value
Sample problem:
One invest Tk. 10,000 for four years at 10% interest. What is
the value at the end of the fourth period?

FV = Tk. 10,000 (1 + 0.10)4

= Tk. 10,000 (1.10)4
= Tk. 10,000 X 1.464
= Tk. 14,640.
So, the value at the end of the fourth year is Tk. 14,640.
 Present Value Applications
• Four different types of debt instruments:
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond
 Present Value Concept:
Simple Loan Terms
• Loan Principal: the amount of funds the lender provides to the
borrower.
• Maturity Date: the date the loan must be repaid; the Loan Term is
from initiation to maturity date.
• Interest Payment: the cash amount that the borrower must pay the
lender for the use of the loan principal.
• Simple Interest Rate: the interest payment divided by the loan principal;
the percentage of principal that must be paid as interest to the
lender. Convention is to express on an annual basis, irrespective of
the loan term.
 Present Value Concept:
Fixed-Payment Loan Terms
• Simple Loans require payment of one amount which
equals the loan principal plus the interest.
• Fixed-Payment Loans are loans where the loan
principal and interest are repaid in several
payments in equal taka amounts over the loan
term.
 Yield to Maturity: Loans
• Yield to maturity = interest rate that equates today's
value with present value of all
future payments
1. Simple Loan Interest Rate

$100  $110 1  i  

$110  $100 $10

i   .10  10%
$100 $100
 Yield to Maturity: Loans
2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126

$1000   2  3  ... 
1 i  1  i 1 i  1 i 25

FP FP FP FP
LV   2  3  ... 
1  i  1  i  1 i  1 i n
 Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
$100 $100 $100 $100 $1000
P  2  3  ...  10 
1 i  1  i 1 i  1 i  1  i 10
C C C C F
P  2  3  ...  n 
1 i  1  i 1 i  1 i  1  i n

Consol: Fixed coupon payments of $C forever

C C
P i
i P
 Yield to Maturity: Bonds
4. One-Year Discount Bond (P = $900, F = $1000)

$1000
$900  
1  i
$1000  $900
i  .111  11.1%
$900
FP
i
P
 Relationship Between Price
and Yield to Maturity

• Three interesting facts in Table 1

1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price
is below par value
 Other Measures of Interest Rate
• Current Yield
• Yield on a discount basis
 Distinction Between Real
and Nominal Interest Rates
• Real interest rate
1. Interest rate that is adjusted for expected changes in
the price level

ir  i   e

2. Real interest rate more accurately reflects true

cost of borrowing
3. When real rate is low, greater incentives to
borrow and less to lend
 Distinction Between Real
and Nominal Interest Rates (cont.)
• If i = 5% and πe = 0% then

ir  5% 0%  5%
• If i = 10% and πe = 20% then

ir  10%  20% 10%

 Distinction Between Interest Rates
and Returns
• Rate of Return
C  Pt 1  Pt
RET   ic  g
Pt
C
where ic   current yield
Pt
pt 1  Pt
g  capital gain
Pt
 Behavior of Interest Rates
Loanable Funds Framework
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds
 Wealth
 ER
 Risk
 Liquidity
 Shifts in the Supply of Bonds
Expected Profitability
Expected Inflation
Government Activities

Liquidity Preference Framework

 Shifts in the Demand for Money
 Income Effect
 Price Level Effect

Shifts in the Supply of Money

Money and Interest Rate

 Income Effect
 Price-level Effect
 Expected-Inflation Effect
 Risk Structure of Interest Rates
 Default Risk
 Liquidity Risk
 Income Tax Consideration

Term Structure of Interest Rates

 The Expectation Hypothesis
 The Segmented Market Theory
 The Liquidity Premium Theory
 Conduct of Monetary Policy: Tools, Goals and Targets

 Market for Reserve and the Call Money Rate

 Supply and Demand in the market for reserve
 How changes in the tools of monetary policy affect the
federal funds rate
 Tools of Monetary Policy
 Goals of Monetary Policy
 Central Bank strategy: Use of targets
 Choosing the Targets
 Criteria for choosing Intermediate Targets
 The Money Markets

 Money Market Definition and its Features

- They are sold in large denominations
- Low default risk
- Maturity period is less than one year

• Why money market is needed?

• Money Market cost Advantage