Money and monetary policy SBC Economics Money and monetary policy Learning outcome AB Describe the functions and forms of money Describe the main measures of the money supply Define monetary policy Explain the difference between nominal and real interest rates Describe the structure of interest rates in the UK Explain the process of credit creation Describe the functions of the Bank of England Evaluate the arguments for and against an independent central bank Reading: Units 37, 82 & 85

Money When most people think of money they think of notes and coins however the concept of money is much wider than that To be considered money something must be: A medium of exchange A unit of account A store of value A standard for deferred payment

Functions of money Medium of exchange Money is used to buy and sell goods and services Money must be an acceptable form of payment to both parties in a transaction Before money was used as a medium of exchange people were forced to barter but this was inefficient

Functions of money Unit of account Money acts as a measure of value Money provides consumers with clear signals as to the value of goods and services In a barter system or at times of very high inflation money is not a useful unit of account

Functions of money Store of value Money must retain its’ value as people do not spend their money as soon as they receive it People prefer to keep their money and spend it when it is convenient; however people will only do this when the value what they can buy in the future is roughly equal to what they can buy today In times of high inflation money fails to store its’ value

Functions of money Standard for deferred payment A person will only lend money if they think the value of the money they receive back will be roughly equal Example: a firm will only accept delayed payment if they believe the value of the money they receive in the future will be roughly equal to the current value In times of high inflation money fails to act as a standard for deferred payment

Forms of money In a modern economy there are a number of things that can be classified as money: Cash Money in current accounts (money saved in the bank that can be immediately withdrawn as cash) Near Monies i.e. money in deposit accounts (money saved in the bank that requires notice to be withdrawn) Non-money financial assets (all assets that can be converted into money i.e. houses, cars, shares)

Measures of money supply There are a number of measures of money supply, however the two most common are: NARROW MONEY- money which can be used as a medium of exchange BROAD MONEY- narrow money plus near monies

Interest rates When talking about interest rates it is important to distinguish between nominal and real rates The nominal interest rate is the rate offered by the bank The real interest rate is the rate adjusted for inflation Example: the bank offers an interest rate of 8%, inflation is 3%; the nominal rate is 8% and the real rate is 5%

Interest rates When saving or borrowing money there is no set interest rate, instead the rate of interest will depend on a number of factors including: Risk Duration (length) of the loan Notice (current accounts vs. deposit accounts) Competition between financial institutions Minimum deposits (set amount that must be saved)

Interest rates Banks will offer a lower interest rate to customers who deposit money in their bank Backs will charge a higher interest rate when lending money to individuals or firms Banks use the deposits to lend money and the difference between the rates of interest is how they earn profit

Credit creation Banks can create credit through their holdings of deposits Banks must keep a certain % of their assets as cash, this is known as the cash ratio The rest of the assets are free to be loaned to customers Example: the cash ratio is 10% and the bank holds $5million in cash, they can therefore lend out $45million The amount of credit a bank therefore depends on the cash ratio; this is known as the credit multiplier

Control of the interest rate, money supply and volume of credit Monetary policy Control of the interest rate, money supply and volume of credit

Monetary policy Since 1997 monetary policy in the UK has been controlled by the Bank of England The Bank of England is a Central Bank

Central banks (Bank of England) Central backs (such as the Bank of England) have a number of functions including: Issuing notes and coins Supervising the financial system Managing the country’s gold and currency reserves Acting as bankers to the government i.e. managing the national debt Act as bankers for the banking system (lender of last resort)

Central banks (Bank of England) Another very important role that is carried out by the bank of England is the control of interest rates (bank base rate) The decisions regarding interest rates are made by a group known as the Monetary Policy Committee (MPC) The MPC make monthly decisions as whether or not to change the bank base rate

Central banks In many countries the central bank will act independently of the government This means that decisions regarding monetary policy are made by the central bank rather than the government There are arguments for and against the independence of central backs

Central bank independence Main arguments supporting independence Less vulnerable to political pressure to create booms before elections Have greater credibility with the market Main argument against independence The decision makers of the Central Bank are not selected by the people and are not accountable to the public