MONEY AND THE ECONOMY

1
MONEY AND THE ECONOMY What is money? What does
money do? How does money affect the
economy? What determines the money supply? What
determines the demand for money? What determines
interest rates? What is monetary policy?
2
MONEY AND THE MACRO-ECONOMY 1. Definition and
functions of money 2. The effect of money on the
macro-economy 3. The money market 4. The role
of central banks 5. Determination of interest
rates some theory 6. Monetary policy 7.
Reasons for the goal of price stability 8.
Independence of central banks
3

• WHAT IS MONEY?
• What counts as money?
• depends on its accessibility (degree of
  liquidity)
• - cash
• - bank deposits
• - interest-bearing deposits
• - time-deposits (savings)
• - short-term Treasury bills (near money)
• What does money do?
• - medium of exchange
• - store of wealth
• - unit of account (measure of relative value)
• - relates the future to the present
• (wage contracts, repayment of debt)

4

• HOW DOES MONEY AFFECT THE MACRO-ECONOMY?
• Direct effect
• Monetarist view
• increase in money balances affects consumption
  directly
• Indirect effect
• Money affects the economy via interest rates
• r affects expenditure (C and I)
• exchange rates (and therefore X and M)
• property prices
• bonds and shares

5
THE MONEY MARKET
The financial sector


Private sector organisations - commercial
banks - large firms - pension funds - building
societies - foreign exchange market
Financial instruments - govt bonds / gilts -
certificates of deposit - loans to households -
overdrafts - mortgages
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• The central bank what does it do?
• issues cash
• banker to commercial banks
• banker to govt (manages govt borrowing)
• regulates commercial banks
• controls liquidity position of commercial banks
• operates monetary policy
• operates exchange rate policy

7

• How does the central bank control monetary
• conditions?
• controls liquidity through lending rate (repo)
• - commercial banks can borrow at the repo rate
• - repo rate is a signal
• (determines all other interest rates)
• - low repo encourages banks to borrow and lend
• - high repo discourages banks from borrowing

8

• DETERMINATION OF INTEREST RATES
• 1. Demand for money
• transactions purposes
• - price level
• - income
• - interest rate (opportunity cost)
• precautionary purposes
• speculative purposes
• - expected change in price of bonds
• - bond price inversely related to r
• - hold money if bond prices are expected to
  fall
• - hence demand for money high when r is low

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• 2. Supply of money
• Causes of changes in money supply
• banks can reduce their liquidity ratios
• - switch / direct debit has reduced demand for
  cash
• - banks borrow from each other (overnight) to
• achieve a satisfactory liquidity position
• surplus in balance of payments (e.g. exports gt
  imports)
• - inflow of foreign exchange

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• govt creates high-powered money to finance a
• budget deficit
• - multiplier effects on broad money (M)
• M k (H)
• M broad money
• H high-powered money (cash reserves of
• commercial banks)
• k money multiplier (k gt 1)
• govt sells short-term Treasury bills (near
  money)
• - commercial banks expand loans to customers
• govt buys long-term bonds and sells short-term
• Treasury bills to increase liquidity
  (funding)

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Determination of interest rates Money supply
set by central bank Demand for money determined
by private sector
What happens if - money supply increases? -
income increases? - prices increase?
Ms M1
r
r1
Md f(P, r, y)
Demand / supply for money
M1
12

• MONETARY POLICY IN PRACTICE
• Central bank
• can control either interest rates or money
  supply
• How does the CB control interest rates?
• announces an interest rate
• - base rate/repo rate/ fed funds rate
• - all market rates respond to the announcement
• CB backs this up with open market operations
  (OMO)
• - CB buys gilts from banks to increase
  liquidity
• (results in lower r)
• - sells gilts to banks to decrease liquidity
• (banks earn an income from gilts)

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THE FEDERAL RESERVE BOARD Aims ..to promote
effectively the goals of maximum employment,
stable prices and moderate long-term interest
rates. Policy instruments 1. Reserve
requirements (R/D ratio of commercial banks)
- not used in practice 2. Lending to banks at the
discount window (lender of last resort) 3.
Open market operations Federal Open Market
Committee (FOMC) sells / buys government
bonds to control the federal funds rate (same
as inter-bank lending rate in UK)
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• What does the central bank take into account in
• setting interest rates?
• forecasts of inflation
• spare productive capacity
• growth of retail sales
• trends in output growth relative to growth of
• productive capacity
• growth of money supply
• house price changes
• interest rate trends in USA, EU and Japan
• exchange rate trends

15

• REASONS FOR POLICY OF PRICE STABILITY
• Adverse effects of inflation
• menu costs (constantly changing price lists)
• shoe-leather costs searching for best buy
• adverse effect on fixed income groups
• adverse effect on savings
• consumers get confused signals about prices
• (essential information for optimal resource
  allocation)

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• adverse effect on investment due to uncertainty
• - lower investment leads to slower economic
  growth
• - shortens investors time horizon (quick
  returns)
• costly to reduce inflation dis-inflation gt
  unemployment
• hyper-inflation is economically and politically
  disastrous
• - complete collapse of market economy
• - political instability

17
An example of hyper-inflation Germany
1923 Price index 1921 July 1 1922 July
7 1923 Jan 195 July
5,230 August 66,017 Sept
1,674,755 Oct 496,209,790 Nov 15
54,448,000,000
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• Adverse effects of deflation
• borrowers find their real debts increasing
• - discourages borrowing
• - fall in asset prices reduces consumption
• lenders lose if debtors go bankrupt
• prices decline but wages are sticky
• - decline in demand for labour
• - fall in profits and investment
• real interest rates increase
• - discourages investment
• leads to persistent recession consumers delay
  spending

19

• INDEPENDENCE OF CENTRAL BANKS
• USA and Germany long history of CB independence
• other countries followed in 1990s (e.g. UK in
  1997)
• ECB most independent of all central banks
• Advantages of independence
• monetary policy free from manipulation
• strengthens credibility (inflation targets more
  believable)
• CB free to achieve its primary objective

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• Disadvantages of independence
• low inflation is not the only policy goal
• govt deflects blame for failure of economic
  policies
• Performance of central banks
• lower inflation achieved
• tight monetary policy has led to higher
  unemployment
• in EU
• Greenspan (and others) have been lucky

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• The European Central Bank
• sets interest rate for all member states
• most independent CB in world not accountable to
  any
• single country
• sets target inflation rate for whole of Eurozone
• sets 3 interest rates
• - lender of last resort (e.g. 5)
• - loans to banks (e.g. 4)
• - borrowing from banks (e.g. 3) to mop up
• surplus liquidity
• sets minimum reserve ratio (to keep banks under
  control)

22
CONCLUSIONS 1. Monetary authorities have become
increasingly dominant in macro-economic
management 2. Monetary conditions are controlled
through central banks control over interest
rates (not the money supply) 3. Active fiscal
policy replaced by very active monetary
policy 4. Monetary policy successful in
controlling demand in the 1990s. Will this
continue?