Money and Interest Rates

Money and Interest Rates The Meaning and Functions of Money

THE MEANING AND FUNCTIONS OF MONEY n Money supply and aggregate demand n The functions of money < medium of exchange < means of storing wealth < means of establishing value of future claims and payments n Money supply and aggregate demand n The functions of money < medium of exchange < means of storing wealth < means of establishing value of future claims and payments

THE FINANCIAL SYSTEM n Liquidity and profitability < profitability < liquidity < the balance between liquidity and profitability < liquidity ratio n The central bank < note issue < banking functions < management of government’s borrowing programme n Liquidity and profitability < profitability < liquidity < the balance between liquidity and profitability < liquidity ratio n The central bank < note issue < banking functions < management of government’s borrowing programme

THE FINANCIAL SYSTEM n The central bank (cont.) < provider of liquidity to banks < operates monetary policy < manages reserves n The central bank (cont.) < provider of liquidity to banks < operates monetary policy < manages reserves

Balance sheet of the Bank of England: (30/1/02) 1 2 1: Issue Department

Balance sheet of the Bank of England: (30/1/02) 1 2 1: Issue Department

Balance sheet of the Bank of England: (30/1/02) 1 2 1: Issue Department 2: Banking Department

Balance sheet of the Bank of England: (30/1/02) 1 2 1: Issue Department 2: Banking Department

UK monetary supply using ECB measures: (end March 2002) UK monetary supply using ECB measures: (end March 2002) Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M £ million

UK monetary supply using ECB measures: (end March 2002) UK monetary supply using ECB measures: (end March 2002) Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M £ million

UK monetary supply using ECB measures: (end March 2002) UK monetary supply using ECB measures: (end March 2002) Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M £ million

The creation of credit n Banks can create money by giving credit < Assume that banks have just one type of liability – deposits – and two types of asset – cash (to achieve liquidity) and advances (loans) to customers (to earn profit). < Banks want to achieve profitability while maintaining sufficient liquidity. Assume that they believe that sufficient liquidity will be achieved if 10% of their assets are held as cash. The remaining 90% will then be in loans to customers. The banks operate 10% cash ratio. n Banks can create money by giving credit < Assume that banks have just one type of liability – deposits – and two types of asset – cash (to achieve liquidity) and advances (loans) to customers (to earn profit). < Banks want to achieve profitability while maintaining sufficient liquidity. Assume that they believe that sufficient liquidity will be achieved if 10% of their assets are held as cash. The remaining 90% will then be in loans to customers. The banks operate 10% cash ratio.

The creation of credit This cannot possibly be an equilibrium – all assets are held as cash!

The Money Multiplier n The money multiplier is equal to 1/r = 1/0.10 = 10 < An initial deposit of 100 will lead to an increase in the money supply of 1000 < In real life, the multiplier will be lower. Not all funds will find the way to the banking system – people may hold part of the assets in cash and not just deposits < Assume q is the publics desired cash ratio. Money multiplier is then (1 + q)/(q + r) If q is 10%, the multiplier is 1.1/0.2 = 5.5 n The money multiplier is equal to 1/r = 1/0.10 = 10 < An initial deposit of 100 will lead to an increase in the money supply of 1000 < In real life, the multiplier will be lower. Not all funds will find the way to the banking system – people may hold part of the assets in cash and not just deposits < Assume q is the publics desired cash ratio. Money multiplier is then (1 + q)/(q + r) If q is 10%, the multiplier is 1.1/0.2 = 5.5

Political independense n Should the central banks be under political control? < Today, most central banks in advanced economies are independent < Independent central banks have generally had more success in controlling inflation < Question - what should the goal of monetary policy be? n Should the central banks be under political control? < Today, most central banks in advanced economies are independent < Independent central banks have generally had more success in controlling inflation < Question - what should the goal of monetary policy be?

New Zealand n The Reserve Bank of New Zealand Act 1989 requires the Reserve Bank to independently manage monetary policy - the supply of money and credit - to maintain overall price stability. Price stability is defined in a separate agreement with the Government, the Policy Targets Agreement, as inflation of between 0 and 3 per cent annually, as measured by the Consumers Price Index (CPI). The CPI is calculated by Statistics New Zealand.Statistics New Zealand n Price stability is achieved through influencing short- term interest rates with the announcement of an Official Cash Rate, which in turn influences saving and borrowing by the public and businesses. Decisions on short-term interest rates influence the exchange rate as well, and therefore the prices of imports and exports. n The Reserve Bank of New Zealand Act 1989 requires the Reserve Bank to independently manage monetary policy - the supply of money and credit - to maintain overall price stability. Price stability is defined in a separate agreement with the Government, the Policy Targets Agreement, as inflation of between 0 and 3 per cent annually, as measured by the Consumers Price Index (CPI). The CPI is calculated by Statistics New Zealand.Statistics New Zealand n Price stability is achieved through influencing short- term interest rates with the announcement of an Official Cash Rate, which in turn influences saving and borrowing by the public and businesses. Decisions on short-term interest rates influence the exchange rate as well, and therefore the prices of imports and exports.

Does it matter at all? n It's important that the Reserve Bank does not claim that it can deliver miracles when it cannot. Many factors go into making an economy successful, and monetary policy has no influence on most of them. Raising or lowering interest rates won't make the soil more fertile, the weather better, our workforce better educated or motivated, our transport system more efficient, our commercial law easier to understand, our tax system easier to comply with, and so on. The weather cannot be controlled, and the rest are influenced by decisions made by governments or individuals, and not central banks.

What is monetary policy? n Monetary policy is conducted by the central bank n Lumsden (p. 17/9)..The most important instrument of control is open market operations, which involve the buying or selling government bonds in the open market” n I disagree. In most economies, there is a more direct policy through setting key interest rates n Monetary policy is conducted by the central bank n Lumsden (p. 17/9)..The most important instrument of control is open market operations, which involve the buying or selling government bonds in the open market” n I disagree. In most economies, there is a more direct policy through setting key interest rates

Open market operations Open market operations: buy bonds (increases money supply) sell bond (reduces money supply)