Money, Central Banking, and Inflation Chapter 25, 31

Money

Aspects of Money Medium of Exchange – Token that can be offered as a payment for goods. Unit of Account – All goods will have a value in money and, thus, can be used to measure all goods Store of Value – If money is to be accepted for goods today it must have durable value. (Money is an Asset).

Evolution of Money In more advanced societies with sophisticated banking systems, broad money may be used for transactions. Currency: Paper assets issued by central bank Checking Accounts: Paper promises to pay definitive money on demand. Savings Accounts: Electronic Transfers, Credit Cards, Debit Cards and ATM Cards can be used to transfer funds to.

Money Supply The stock of the medium of exchange. Types of Financial Assets M1 Currency in Hands of the Public [C] + Demand Deposits [D] M2 M1 + Savings Deposits + “Small” Time Deposits + [Liquid Money Market Instruments inc/ “Small” NCD’s] M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Japan’s Money Supply

Monetary Aggregates in HK HKMA Monthly Statistical Bulletin

Real Balances Real balances are the purchasing power of monetary assets, i.e. the money supply divided by the price level. Taking the price level as given, real balances can be shifted by the central bank through changes in money supply. Taking the money supply as given, real balances can change through changes in the price level.

Real Balances and HK Deflation

Liquidity Theory Money is part of the liquid end of the asset portfolio. We consider a theory of how this liquidity is divided up. Liquid Assets (Currency, Checking Accounts, Savings Accounts) that are useful for transactions which pay zero or below market interest rates. Money market assets (Government bills, commercial paper, jumbo CD’s) that pay a market rate, i, but which cannot be used for transactions.

Determinants of Holding Money Trade-off: The benefit of holding real balances is that doing so will make transactions more convenient. The cost is that you will earn interest income. The greater is the quantity of real transactions, Y, the more attractive is real balances. The greater is the real interest rate, i, the less attractive are real balances.

Money Demand Money Demand The greater is the market interest rate, the greater is the opportunity cost of holding money. i i*

What shifts the money demand curve? An increase in real spending (GDP) will increase the need for money for transactions shifting the demand curve out. A reduction in GDP will shift the demand curve in. There are also large shifts in money demand due to liquidity preference (possibly related to risk level of financial assets).

Central Banks

Economy Central Bank HK ? USA Eurozone PRC UK, Canada, Japan, Korea Central Bank: A special governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

The Monetary Base The monetary base, also called “high powered money” consists of: C Currency in the Hands of the Public + R + Reserves of the Banking System =MB = Monetary Base Monetary base is typically the monetary liabilities of the central bank.

Interbank Payment Systems Commercial banks keep accounts at the central bank for interbank payments. referred to generally as reserves, specifically as clearing balances in Hong Kong. These accounts, along with cash, constitute the monetary base. Hong Kong Interbank Clearing Limited

Interbank Market Individual banks will face a short-fall in reserves if they have too many outflows and borrow funds from other banks facing a surplus. Banks will keep an inventory of reserves to meet their own liquidity needs but the interest rate is the opportunity cost of holding reserves. Desire to hold reserves is a declining function of the interest rate. Central bank controls the total supply of reserves available to banks.

Interbank Market Ch. 31, 759-768 Supply iIBR i* Demand Reserves

Equilibrium in the Interbank Market If interest rates are too low, banks will want to hold more reserves than available. Banks facing a shortfall of reserves will be willing to bid up interest rates until all banks are content with reserves available. If interest rates are too high, banks will want to lend out their excess reserves. To do so in a liquid market, they must lower interest rates.

Equilibrium S iIBR i* i D Reserves

Monetary Base and Money Supply

Fractional Reserve Banking & the Banks keep only a fraction of deposits on reserve. → each reserve dollar of base money backs up multiple levels of broad money.

Money Supply vs. Monetary Base Multiplier = *

Money Supply Multiplier The money multiplier can be derived by the ratio of aggregate money to the monetary base. As long as the reserve ratio is less than 1, the money multiplier is greater than 1. Multiplier is decreasing in reserve-deposit ratio.

Central Bank and Money Supply The central bank can adjust the stock of reserves through transactions with commercial banks. An increase in reserves will increase the deposits that banks can accept and will have a multiple impact on overall money supply.

Money Market EQUILIBRIUM Money Demand i i*

Equilibrium in the Money Market If interest rates are too high, excess supply of money: people will want to buy interest paying assets like bank accounts or treasury bills. Banks can reduce the interest rates they are willing to offer If interest rates are too low, excess demand for money: people will want to sell interest paying assets like bank accounts or treasury bills to get more liquidity. Bond dealers and banks must raise interest rates.

Money Market: GDP Rises 2 i** i* 1 M

Interbank Market Supply iIBR Y↑ i** i* Demand' Demand Reserves

Money Demand and Reserve Markets If demand for money rises, households will want to hold more money. They will pull funds from non-liquid instruments (like jumbo CD’s) and convert them into cash or liquid deposits. Banks will need to hold more reserves to backup the liquid deposits. This will increase the demand for reserves.

Open Market Operations In an Open Market PURCHASE, the central bank purchases government securities from banks and credits their reserve accounts. This increases the aggregate supply of reserves. In an Open Market SALE, the central bank sells government securities from banks and debits their reserve accounts. This reduces the aggregate supply of reserves.

Money Supply and Interest Rates If the central bank engages in an open market PURCHASE, they will increase the reserve holdings of counter-party commercial banks. This will increase liquidity in the reserve funds market. Banks with excess reserves can lend them out creating more liquid bank deposits. Increase in liquid bank deposits will increase money supply. More liquid money market reduces interest rates.

Reserve Market/Money Market iIBR i* i** Money Market D i Reserves i* i**

Fed Funds & Money Market Rates

Money Market at ZIRP i When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

Liquidity Trap i i* i** When nominal interest rate reaches zero, increases in the money supply will not reduce the level of the interest rate.

Inflation

Moneyt * Velocity = Pt * Yt Quantity Theory Simplest monetary theory is the Quantity Theory of Money. Purchasing power of money is equal to the quantity of money (Mt) times the speed of circulation (V, # of transactions) Purchasing power means # of goods (Yt) multiplied by price per good (Pt) Moneyt * Velocity = Pt * Yt

Rule of Thumb Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

Money and Inflation Assuming stable velocity Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

Dynamic AS-AD Model: Trend Path YtP YPt+1 ASt ASt+1 P Demand expansion matches supply expansion P*t+1 Average Inflation Pt* ADt+1 ADt Y Yt* Y*t+1

Money & Inflation: 1975-1994

Costs of steady Inflation Shoe Leather Costs – Money is a technology for engaging in transactions. The greater is inflation, the greater the cost for individuals of holding money. Individuals must make efforts as a substitute for the convenience of holding money. Menu Costs – Firms must engage in costs of changing posted prices. More generally, when prices change rapidly over time, more time and effort must be put into calculating relative prices.

Learning Outcomes Students should be able Calculate the relationship between the money supply, multiplier and base. Use the model of money market to describe the impact of events on equilibrium outcomes.