About money: supply,

demand, interest rates and

Central Banks
 Functions of money
 It is not the commodity or token used as money that
matters, but the social convention that it is accepted
without question as a means of payment.
 Money makes it easier for everyone to buy and sell
goods and services and economize on the use of scarce
resources.
 Money is defined by four important functions. It
provides:
 a. A means of payment as a medium of exchange
 b. A unit of account
 c. A store of value
 d. A standard of deferred payments
 As a means of payment money is involved in most
exchanges.
 We use money to pay for the goods and services – from
food and clothing to transportation, to rent, to fees and
taxes.
 People receive wages and salaries and other types of
income in money.
 Money is not consumed in these transactions. It is used
as a medium of exchange.
 A) Means of payment: a commodity or token generally
accepted in payment for goods and services or the
repayment of debt
 Money also serves as a unit of account.
 Prices are quoted in domestic currency. Europe prices
are in euros and in the United States, the U.S. dollar and
in Japan in yen.
 This reflects the convenience of using the same units for
the means of payment and the unit of account.
However, there are exceptions.
 Historically, in Canada, during the time of the fur trade,
books were kept in “currency” but actual currency never
changed hands in the barter of trade goods for furs.
 B) Unit of account: the standard in which prices are
quoted and accounts are kept.
 To serve as a medium of exchange, money must also
be a store of value.
 Money works as time machine allowing people to
separate the timing of their expenditures from the timing
of their incomes.
 Money is accepted today with confidence that it can be
used some time in the future to make payments when
buying goods and services.
 You would not accept money today that you thought
would be unacceptable when you offered it in payment
at some later date.
 Money is not a unique store of value.
 Other assets including real estate, financial assets like
corporate and government bonds, fine art and antiques all
serve as stores of value.
 These may be better ways to store value, but people still
choose to hold some of their wealth as money.
 This choice to hold money balances is very important to the
effects money balances have on financial markets and
aggregate expenditure.
 C) Store of value: an asset that carries purchasing power
forward in time for future purchases.
 Money provides a standard for deferred payments. If
you take out a student loan the amounts you will repay
in the future are measured in currency.
 Similarly, servicing and retiring a mortgage on a property
or a loan on a car calls for future payments specified in
currency.
 Individuals, businesses and governments often borrow
or lend in the money of other countries.
 In those cases the currency in which the loan
transaction takes place is usually the standard for
payments to settle the debt. The essential attribute of
money is its general acceptance as a means of payment.
For this money must also be a store of value. This works
well when money is also a unit of account and a
standard of deferred payments.
 D) Standard of deferred payments: the units in which
future financial obligations are measured.
 Money market
 2008: The worldwide financial system was in a
crisis and banks and other financial institutions
wanted to borrow more than $2 trillion. What
could be done?
 Studying this chapter we learn…
 What a central bank does and how it does it.

 What is meant by the money supply.

 How the central bank is able to influence the

money supply.
 How the Central Bank has more influence over
Agragte Demand than anyone else.
 What Is a national bank/central bank?
 As the Central Bank :
 Can issue and create money.
 Is a bank with two customers.

 It is the government’s bank.

 Maintains the bank account of country/zone.

 It manages government borrowing.

• Issuing, transferring, and redeeming treasury

bonds, bill, and notes.
 It is the banker’s bank.
 Banks keep their own accounts at the central bank.
 Banks can borrow from the central bank.
 And it also…
 Regulates other banks.

 Manages the nation’s payment system.

 Protects financial consumers with disclosure

regulations.
 Most important function: Regulating the money supply.
 The Money Supply
 Money is anything that is widely accepted as means of
payment.
 The most important assets that serve as money today
are:
1. Currency: Paper bills and coins.

2. Total reserves held by banks at the central bank.

3. Checkable deposits: your checking or debit

account.
4. Savings deposits, money market mutual funds, and
small-time deposits.
 The following figure shows the magnitude and
proportions of these assets…
The U.S. Money Supplies
 Let’s look at each of these.
1. Total reserves: All major banks have accounts at
the central bank.
 Can be easily converted into currency.
2. Currency: .
• Currency can be held by others in unstable
countries to protect their wealth.
3. Checkable deposits—are deposits you can write
checks on or can access with a debit card.
4. Savings accounts, money market mutual
funds, small-time deposits.
 Not as liquid as the other means of payment.
• Each can be used to pay for goods and
services, but this requires a little extra effort.
 What is meant by a “liquid asset”?
 Definition liquid asset: An asset that can be used
for payments, quickly and without loss of value
 The money supply can be defined in different ways
depending on exactly what kinds of liquid assets are
included.
 The three most important definitions of the money
supply are:
1. The monetary base (MB): currency outstanding
and total reserves at the Central Bank.
2. M1: currency outstanding and checkable deposits.

3. M2: M1 plus saving deposits, money market mutual

funds ( Treasury bills, commercial papers, bankers
acceptances, repurchase agreements and certificates
of deposit), and small-time deposits.
 These definitions correspond to an inverted pyramid
of ever-expanding size shown in the next figure.(US
numbers)
 Difficulty of Central Banking
 The Central bank has direct control only over the
monetary base.
 the Central Bank uses control over MB to influence M1
and M2.
 Problems:

 M1 and M2 can shrink or grow independent of what

the central bank does.
 Aggregate demand can shrink or grow for other
reasons than changes in M1 and M2.
 Now we turn to how the central bank influences M1 and
M2.
Fractional Reserve Banking, Reserve Ratio,
Money Multiplier
 Fractional reserve banking—A system where banks do
not have to keep all of their deposits on reserve.
 Causes the banking system to create money “out of
thin air”.
 The amount of money created depends on…
 The reserve ratio (RR)—the fraction of deposits held
on reserve:
Value of Reserves
RR 
Value of Deposits
  The required reserve ratio is the fraction that
banks are required, by regulation, to keep as
reserves. Required reserves are the total amount
of reserves that banks are required to keep.
 The Central Bank sets a minimum RR (reserve
requirement).
 The money multiplier (MM)—the amount the
money supply expands with each dollar increase in
reserves:
1
MM 
RR

•Now let’s see how fractional reserve banking, RR, and

MM all work together to create money.
 Imagine the Fed creates $1,000 of new money by
crediting your banking account with an additional
$1,000. Total ↑M = $1,000.
 If your bank’s RR is 10%, they will loan out $900
(90%) of your increased deposit.
 Sam borrows the $900 and deposits it in his bank.
Total ↑MS = $1,900 ($1,000 + $900)
 Suppose Sam’s bank has the same RR (10%). They
will loan out $810 (90%) of his increased deposit.
 Total ↑M = $2,710 ($1,000 + $900 + $810)
 The rippling process continues until the total change in
the money supply is given by:
MS  Reserves MM  $1,00010  $10,000

.
 Ultimate change in the money supply equals the
original amount the Fed injected into the economy
($1,000) times the money multiplier.

 https://www.youtube.com/watch?v=93_Va7I7Lgg
How the Central Bank Controls the Money
Supply
 Three Major Tools control the Money Supply
1. Open market operations: buying and selling of
government bonds on the open market.
2. Discount rate lending : central bank lending to banks
and other financial institutions.
3. Required reserves and payment of interest on
reserves: Changing the minimum RR; paying interest
on any reserves held by banks at the central bank.
 Let’s look at each of these in turn…
1. Open Market Operations
 Because government bonds can be stored and
shipped electronically, and the market for
government bonds is liquid and deep, the central
bank can buy and sell billions of dollars worth of
government bonds in a matter of minutes.
 The central bank usually buys and sells short-term
bonds called Treasury bills or T-bills (sometimes
called Treasure securities or Treasuries).
 If the Fed wants to increase the
money supply, they will buy T-bills:

MS↑ as the
Fed
With more money creation
To pay for electronically
reserves, bank process ripples
the T-bills ↑reserves of the
↑ loans through the
seller
economy

 If the Fed wants to decrease the money

supply, they will sell T-bills: MS↓ as the
With fewer money creation
Fed sells ↓reserves of
reserves, bank process ripples
T-bills the buyer
↓ loans in reverse through
the economy
1. Open Market Operations (cont.)
 Recall: the change in the money supply
is given by:
1
MS  Reserves  MM, where MM 
RR
 A complicating factor:
 When banks are eager to lend, they keep
reserves low, and MM will be high.
 Changes in MB will have a larger effect on the
money supply.
 When banks are reluctant to lend, they hold
reserves high, and MM will be low.
• Changes in MB will have a smaller effect.
Summary
a) The Fed can increase or decrease the money
supply by buying and selling government bonds.
b) The increase in reserves boosts the money
supply through a multiplier process.
c) The size of the multiplier is not fixed but
depends on how much of their assets banks
want to hold as reserves.
1. Open market operations and interest
rates.
 Buying and selling government bonds
rather than apples has another
advantage.
 Not only the monetary base changes but
interest rates change as well:
Fed buys ↑Demand ↑Price of ↓Interest
bonds for bonds bonds rates

Fed sells ↓Demand ↓Price of ↑Interest

bonds for bonds bonds rates
1. Open Market Operations (cont.)
 Buying bonds stimulates the economy in two ways:
 Step 1 Increased money supply → increased
supply of loans.
 Step 2 Lower interest rates → increased
demand for loans.
 The Fed doesn’t “set” interest rates.
 Interest rates are determined by the supply
and demand for loans.
 The Fed works through supply and demand.
1. Open Market Operations (cont.)
 A central bank controls a real rate of interest only in
the short run.
 Why is this important?

 Lending and borrowing decisions depend on

the real interest rate.
 The FED has greatest influence over the short-
term interest rate called the Federal Funds rate.
 Federal Funds rate—is the overnight lending
rate that banks charge each other.
 For the European Central Bank it is called
marginal lending rate.
1. Open Market Operations (cont.)
 Monetary policy is usually conducted in terms of the
Federal Funds rate.
 It is a convenient signal of monetary policy.

 It responds quickly to actions by the Fed.

 It can be monitored on a day-to-day basis.

 M1 and M2 are more difficult to measure and

monitor.
 Finally, don’t forget that the Fed controls the
Federal Funds rate through its control of the
monetary base.
2. Discount Rate Lending
 Discount Rate Lending
 Because the Fed can create money at will, it is the
lender of last resort.
 Discount rate: the interest rate the Fed charges
banks for loans.
 These loans increase the monetary base.

 When the banks repay the loans the monetary

base shrinks back.
 Market traders read the discount rate as a signal of
the Fed’s willingness to allow the money supply to
increase.
 The discount window is intended to help banks that
are in financial stress.
  Banks in good health usually borrow from other
banks.
 There is a stigma to borrowing from the Fed.

 The very existence of the discount window makes

private bank loans work more smoothly.
 Two financial problems banks can get into:
1. Solvency crisis: when the value of the bank’s
loans falls and the bank can no longer pay back its
depositors.
 To avoid this, banks hold “capital”.

• “capital” in this sense— assets in relatively

safe forms (e.g., T-bills).
• Regulations impose capital requirements.
  2008—the U.S. treasury acted to “recapitalize” parts of
the U.S. banking system by investing additional money
into these banks.
2. Liquidity crisis: When enough depositors want their
money back at the same time.
 Banks may be solvent with lots of good loans, but they
can’t meet depositors demands at the moment.
 Fear and panic can turn solvent banks into illiquid
banks.
 What if a bank is insolvent?
 Usually, depositors are paid off by the FDIC (Federal
Deposits Insurance Corporation-US) and the bank is
closed.
 An exception to this occurred in 2008.
 Because too many banks might be insolvent for the
economy to survive widespread bank closures, the
treasury decided to offer aid to banks instead.
Required Reserves and Payment of Interest on Reserves
 Spring 2009 minimum reserve requirements were:
• 0% for liabilities under $10.3 million.

• 3% for liabilities under $44.4 million.

• 10% for liabilities greater than $44.4 million.

 How it works:
• ↑reserve requirement → ↓ lending → ↓ MS

• ↓reserve requirement → ↑ lending → ↑ MS

 The Demand for money

 The influences on money holding:

 The price level
 The interest rate
 Real GDP (inflation-adjusted gross
domestic product)
 The price level
 A rise in the price level increases the nominal quantity of
money but doesn’t change the real quantity of money that
people plan to hold. Nominal money is the amount of money
measured in dollars. The quantity of nominal money
demanded is proportional to the price level-a 10 percent rise
in the price level increases the quantity of nominal money
demanded by 10 percent.
 The interest rate
 The interest rate is the opportunity cost of holding wealth in
the form of money rather than an interest-bearing asset. A
rise in the interest rate decreases the quantity of money that
people plan to hold.
 Real GDP
 An increase in real GDP increases the volume of expenditure,
which increases the quantity of real money that people plan
to hold.
 The demand for money Curve
 The demand for money curve is the relationship
between the quantity of real money demanded
(M/P) and the interest rate when all other
influences on the amount of money that people
wish to hold remain the same.
A rise in the interest rate
brings a decrease in the
Interest rate

quantity of money
demanded

A fall in the interest

rate brings an increase
in the quantity of
money demanded

MD

Real money
Shifts in the Demand for Money
Curve
 The demand for money changes if real
GDP changes.
Interest rate

Effect of increase in real

GDP

Effect of
decrease in real
GDP

Real money
 Interest rate determination
 An interest rate is the percentage yield on a financial
security such as bond or stock.
 The price of a bond and the interest rate are inversely
related.
 If the price of a bond falls, the interest rate on the bond
rises. If the price of a bond rises, the interest rate on the
bond falls.
 Money market equilibrium
 The Central Bank determines the quantity of money
supplied on any given day, that quantity obviously is fix.
 The supply of money curve is vertical at a given
quantity of money supplied. The equilibrium determines
the interest rate.
Money market equilibrium
interest rate
Interest rate

MS

i*

MD

Real money
Interest rate
Interest rate determination

Interest rate
MS
MS
Excess supply of
money. People
buy bonds and
interest rate falls

i* i
*
Excess demand of
money. People sell
MD bonds and interest
rate rises MD

Real money
Real money
 Influencing the Interest Rate
Change in the supply of

Interest rate
money

MS MS’
Interest rate

An increase in the
supply of money MS
An increase in the
lowers the interest
rate.
i’ demand of money
increases the
interest rate.

i*
i*

MD MD’
i’
MD
Real money
Real money
 The interest rate application
 Influencing the Exchange rate
 The exchange rate is the price at which the
Romanian leu exchanges for another currency
 The exchange rate is determined by demand
and supply in the global foreign exchange
market.
 A rise in the Romanian interest rate increases
the demand for our currency and also the
exchange rate rises.
 A fall in the Romanian interest rate decreases
the demand for our currency and the exchange
rate falls.
 Nominal interest rate and real interest rate
 The nominal interest rate is the percentage
return on an asset such as a bond expressed in
terms of money
 The real interest rate is the percentage return
on an asset such as a bond expressed in terms
of what money will buy.
 The two interest rates are linked by the inflation
rate in the relationship:
 Real interest rate=nominal interest rate-inflation
rate
 Interest rate and the
opportunity cost
 The nominal interest rate is the opportunity cost of
holding money so it influences the quantity of money
demanded.
 The real interest rate is the opportunity cost of spending.
 Among the two, the real interest rate influences the
consumption and investment components.
 Consumption expenditure- other things remain the same
(caeteris paribus)- the lower the real interest rate, the
greater is the amount of consumption expenditure and
the smaller is the amount of savings.