Econ 220: Saudi Economy – Topic 5

Monetary Policy:
the art of controlling money
supply
1
 Content of this lectuer
 Definition of Money
 Banks As Financial Intermediaries
 Measuring Money in the Economy
 The Process of Money Creation
 The Deposit Creation Formula
 The Money Multiplier
 The Role of Central bank Reserve in the Money Creation
Process
 Central Bank Independence
 Expansionary Monetary Policy
2
 Content of this lectuer
 SAMA
 SAMA Main Roles
 The Key Object of SAMA
 The History of SAMA Roles
 SAMA relies on four policy instruments

3
 Definition of Money

 Money is anything that is regularly used in

exchange.
 People are willing to accept money as a medium of
exchange because we trust that the money we
receive will also be accepted by others.
 Regardless of what money is “Precious metals,
stones, and gold bars”, money serves several
functions, all related to making economic
exchanges easier.
4
 Definition of Money

 There are 4 functions of Money:

1. Money Serves as a Medium of Exchange.
2. Money Serves as a Unit of Account.
3. Money Serves as a Store of Value.
4. Money Serves as a tool for future payments

5
 Banks As Financial Intermediaries

 Balance Sheet for a Commercial Bank:

 Liabilities are the sources of funds. The bank is
“liable” for returning funds to depositors.
 Assets are the uses of funds. Assets generate
income for the bank. Loans are assets for the
bank because a borrower must pay interest to
the bank.
 Net worth is the difference between assets and
liabilities.

6
 Banks As Financial Intermediaries

 Commercial Bank Reserves:

 Reserves are the fraction of banks’ deposits that
are set aside in either vault cash or as deposits at
the State Reserve.
 Required reserves are the fraction of banks’
deposits that banks are legally required to hold in
their vaults or as deposits at the State Reserve.
 Excess reserves are any additional reserves
that a bank holds above its required reserves.

7
 Money supply in the Economy
M0 + M1 + M2 + M3 + M4 + M5
 M0 and M1, also called narrow money, normally
include coins and notes in circulation and other
money equivalents that are easily convertible into
cash.
 M2 includes M1 plus short-term time deposits in
banks and 24-hour money market funds.
 M3 includes M2 plus longer-term time deposits and
money market funds with more than 24-hour
maturity.
 M4 includes M3 plus other deposits.
8
 Measuring Money in the Economy
 The most basic measure of money in the United
States is called M1:
M1 = Currency held by the public + Demand deposits +
Other checkable deposits + Travelers’ checks
 A broader definition of money, known as M2,
includes assets that can be readily turned into M1,
such as deposits in money market mutual funds and
savings accounts.
 M3 = M2 + Other Quasi-Money

9
 The Process of Money Creation
• Currency and checking deposits are included in the money
supply.
• When a customer makes a SR1,000 cash deposit, currency
held by the public decreases and checking deposits increase.
The money supply remains unchanged, but the bank’s
reserves increase.
• Assume that the bank holds no excess reserves and the
required reserve ratio equals 10% of deposits. Then the
liability side of the bank’s balance sheet will increase by
SR1000 and the asset side will increase by SR100 as reserve
and SR900 as loans.

10
 The Process of Money Creation

• Now, suppose that the First Bank makes a

SR900 loan which is used to open a checking
account in the Second Bank.
• Liability side of the balance sheet of the
Second Bank will increase by SR900 and the
asset side will increase by SR90 as reserve
and SR810 as loans.

11
 The Deposit Creation Formula
 The original SR1,000 cash deposit has
created checking account balances equal to:
SR1,000 + SR900 + SR810 + SR729 + SR656.10 + … = SR10,000
 The general formula for deposit creation is:

 The increase in the money supply resulting from

the increase in the $1,000 deposit equals
$10,000 - $1,000 = $9,000
12
 The Money Multiplier
 This term in the deposit creation formula is called
the money multiplier.

 The money multiplier shows the total increase in

checking account deposits for any initial cash
deposit.

13
 The Money Multiplier
 The initial cash deposit triggers additional rounds of
deposits and lending by banks, which leads to a
multiple expansion of deposits.

 The money multiplier, in reality, is much smaller than

the value in our example because people hold part of
their loans as cash. This cash is not available for the
banking system to lend.
14
 The Money Multiplier

 It is important to note that when one

individual writes a check to another, and
the other deposits the check in the
bank, the money supply will not change.
Instead, the expansion in one bank’s
reserves will offset the contraction in
the reserves of the other.

15
 The Role of Central bank Reserve
in the Money Creation Process
 The central bank has the power to change the
total amount of reserves in the banking system.
 The most important tool to change the total
amount of reserves in the banking system, and
therefore the money supply, is called Open
Market Operations: the central bank purchase
and sale of government securities to the public in
order to change the size of the monetary base.

16
 The Role of Central bank Reserve
in the Money Creation Process
 Other tools central bank has available to
change the money supply, although less
important and not used as often as Open
Market Operations are:
 Changes in the reserve requirement: banks are
asked to hold a smaller or larger fraction of their
deposits as reserves.
 Changes in the discount rate, or the rate at which
banks can borrow from central bank in short-term.

17
 Central Bank Independence

 The matter of central bank independence

from political authorities is a lively debate
among economists.
 Monetary discipline is important for the
performance of the economy.
 In Saudi Arabia, SAMA is owned by the
government and it is not independent unlike
UK and USA.
18
 Monetary Policy

 Monetary policy is basically a type of

stabilization policy adopted by countries to deal
with different economic imbalances.
 The effectiveness of monetary policy as a tool of
economic stabilization various from one economy to
an-other, due to:
1. Differences among economic structures.
2. Divergence in degrees of development in money
and capital markets.
19
 Monetary Policy goals

The ultimate goals of monetary policy in both the

developed and developing countries are:
1. price stability
2. high employment rates
3. enhancing economic growth rates
4. controlling imbalances in external payments
5. protection of the external purchasing power of the
currency.

20
 Expansionary Monetary Policy

 Expansionary monetary policy is an

increase in the money supply aimed at
increasing aggregate output (income) .
 An increase in the money supply
decreases the interest rate and
increases investment and income.

21
 Expansionary Monetary Policy

 However, the higher level of output

increases the demand for money, and this
keeps the interest rate from falling as far
as it otherwise would.
 The effectiveness of monetary policy
depends on the shape (or responsiveness)
of the investment function.
22
Saudi Arabian Monetary Agency SAMA
 It is the Central Bank of Saudi and it was
established by Royal Decree in 1952.
 SAMA is supervised by a Board of Directors:
 Headed by Governor and Vice Governor, both
whom are appointed by Royal Decree by the King
for terms of four years. These terms can be
extended by Royal Decree for similar periods.
 Three other members nominated from the private
sector who also appointed by Royal Decree to
serve for five years.
23
 Saudi Arabian Monetary Agency SAMA
 SAMA follow Western Central Bank and
International Monetary Fund philosophies.
 That does not mean that SAMA does not have
different policies from Western Banks
 but such a differences can be explained by
environmental influences based on the natural
of Saudi economy and of public perceptions and
acceptance of this sector such as the regulations
of the Islamic banks.
24
 SAMA Main Roles = 8
1. Issuing the national currency, the Saudi Riyal
(SR). 500 - 100 - 50 - 20 - 10 - 5 – 1 – 1/2
2. Acting as banker to the government.
3. Supervising commercial banks operating in
Saudi Arabia.
4. Advising the government on the public debt.
5. Managing the kingdom’s foreign exchange
reserves.
25
 SAMA Main Roles
6. Conducting monetary policy for promoting
price and exchange rate stability.
7. Promoting economic growth and ensuring
the soundness of the Saudi financial system.
8. SAMA had also over time acquired for itself
several other function such as primarily a
direct management role of the conduct of
the Saudi Stock Market.

26
 The Key Objects of SAMA
1. Stabilize inflation and the general level
of prices.
2. Maintain a fixed exchange rate of Saudi
Riyal against the U.S. dollar.
3. Allow free movement of currency and
capital.
4. Develop and stabilize the Financial
Market.
27
 The History of SAMA Roles
i. When SAMA was established, Saudi Arabia did
not have a monetary system and : foreign
currencies circulated in the kingdom as a
medium of exchange along with silver riyal
coins.
ii. Saudi bank note had not yet been issued and
banking was conducted through foreign bank
branches for example Netherland Trading
Company “which later became the Saudi Dutch
Bank”.
28
 The History of SAMA Roles
III. In 1953 SAMA issued Saudi Arabia’s gold coins
and eliminate the circulation of foreign
currencies.
IV. In 1954 SAMA issued the “pilgrim receipts” in
order to relieve pilgrims of the burden of carrying
heavy metallic currency and they were
acceptable.
V. In 1961 SAMA issued the Saudi riyal notes,
besides, all gold and sliver coins, and all pilgrim
receipts were demonetized.
29
 The History of SAMA Roles
VI. 1960-1972: SAMA focused on establishing the
basis for commercial banks regulations.
VII. 1973-1982: SAMA was preoccupied with
containing the inflation pressures of a booming
Saudi economy fuelled by the massive oil price
rises and managing the expansion of the
banking system to cover most of the country.

30
 The History of SAMA Roles
 1983-2004: SAMA’s priorities were to introduce
financial market reforms and advise the
government in managing there public debt.
Furthermore, both SAMA and commercial banks
have completion the Saudization during this period.
 2004-2012: SAMA used expansion monetary policy
during this period and it advises helped the
government paying back the most of the public
debt. Moreover, SAMA allows international banks
to open branches in Saudi.
31
 SAMA relies on four policy instruments
Policy
Instrument Rationale and Operational Usage Effectiveness
Tool
• Used for implementing structural
• To ensure banks have adequate to cover changes in bank liquidity.
Cash Reserve customer deposits. • Produces strong signal effects but
Ratio CRR • 7% on current accounts and 2% on infrequently used .
saving/time deposits since 1980. • Not imposed on inter-banks
transactions.
Statutory • Banks required to maintain minimum • “free liquidity” at disposal of banks
Liquidity amount specified liquid assets equal to is reduced and can influence overall
Ratio SLR 20% of demand and time deposits. bank lending structure.

• SAMA alters liquidity position of banks • Allows for all short tem injection of
by dealing directly in the market to reserves and automatic withdrawal
upon repo maturity.
Repos make temporary additions to banks
short-dated •
Efficiency depends on SAMA’s
reserves through holding of securities and size and
repurchase agreements.
depth of market.

32
 SAMA relies on four policy instruments
Policy
Instrument Rationale and Operational Usage Effectiveness
Tool

• SAMA can absorb rather than provide

Reverse • Need for banks to place excess liquidity
with SAMA throughout overnight matched •
Repos sale-purchased operations.
bank reserves.
A definitive purchase of financial
assets reversible at short notice not
affecting prices in bond market; serves
to regulate the money market.

Intention to influence capital outflow, •

More flexible than repo/ reverse repos
• in terms of their maturity and volume
Foreign avoiding disruptions to monetary policy
per deal.
Exchange from foreign exchange markets.
Swap • Used for liquidity management and • Affect liquidity but do not generally
exercise influence on foreign exchange
currency speculation. rate.

• A “rough tuning” instrument providing

Placement of • At SAMA’s discretion to place government banks with long term liquidity support.
Public Funds institutions' funds with selected banks. • Can signal crises management and
problems in banks.

33
 References
• Ramady M. (2005). “The Saudi Arabian
Economy”.Springer. Chapter 4
• Parkin M. (2012). “Macroeconomics”. Prentice.
Chapter Money and Banking
• SAMA (Annual Report, Financial Report).