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Money, Financial System and Monetary Policy
• Money
• Fractional Reserve Banking
– Financial System – Deposit Creation
• Central Banking and Monetary Policy – Monetary Policy
– Equilibrium in the Money Market • Money
• Fractional Reserve Banking
– Financial System – Deposit Creation
• Central Banking and Monetary Policy – Monetary Policy
Barter system and evolution of money
• Before the discovery of money (and the alternative to money system) economies rely on a barter system
• A barter system is characterized by direct exchange of one good for another
What is Money?
•Definition: “Money is anything that serves as a commonly accepted medium of Exchange”
•Throughout history, a number of different commodities have been used as money
•These include
Paper versus Commodity Money
•The main disadvantage of commodity money is that they the items used as money had intrinsic value
– they could be in high demand for reasons other than their money functions they were limited in supply
– These limitations led to the use of paper money, which is not wanted for its own sake
Functions of Money
• Money performs three main functions:
• As a medium of exchange
• As a unit of account
–Money allows us to value all things and compare how valuable things are
• As a store of value
Monetary Aggregates (Components of
Money Supply)
• Monetary aggregates can be classified into two main groups:
• Narrow money or M1 which consists of
– Paper currency and coins with the public – Demand deposits (checking) accounts
• Broad money or M2 – M1
Demand for Money
• The demand for money is the demand for real money balances
– this is the demand for the most liquid form of money rather than other interest-bearing assets
• The demand for money refers the quantity of money
– individuals want to hold for transactions and other purposes
• There are two sources of demand for money: – transactions demand for money
Transactions Demand for Money
• This derives for the need to have money to make purchases of good and services
• The transactions demand for money is the amount of money held for the purchases of making transactions of goods and services
• Example: Suppose you earn GHC 100 per month an use all this amount for purchases of goods and services
Transactions Demand for Money
• The transactions demand for money is affected by a number of factors such as interest rate
– The interest rate is the opportunity cost of holding
– This the what you forgo by holding assets in money rather than interest-bearing assets
• Other determinants of the transactions demand for money are the level of prices and incomes
Asset Demand for Money
• The asset demand for money arises out of money's function as a store of value
• When households allocate their wealth/income among various financial assets, their portfolio typically includes less liquid high-interest bearing assets and some very safe and very liquid assets
– money is the safest and most liquid asset
The Financial System
• The financial system captures on activities involving finance in an economy – it is responsible for linking the other markets within the economy (goods
market and factor markets)
• Financial markets link the economic agents within an economy: households, firms and governments carrying our their financial decisions
What are Financial Markets
• Financial markets are markets that trade financial instruments – these instruments include stocks, bonds, currencies
What are Financial Intermediaries
• Financial intermediaries are institutions that provide financial services and products
• The most important financials institutions are banks (commercial, investment, central)
Role of financial systems
• Mobilizing and allocating resources
• Managing risks within an economy
• Acting as clearing houses
Deposit Creation
• Central Banks determine the level of money supply in almost all economies – They print money, both literary and figuratively
• Commercials banks do not print money and they contribute to money supply through deposit creation
Commercial Banks Balance Sheet
• There are two sides to the balance sheets of commercial banks: assets and liabilities
• The asset side include cash in their vaults, loans, securities and reserves with central banks, investments
Commercial Banks Balance Sheet
Assets Liabilities
Reserves: GHC 200 Deposits: GHC 1000
Deposit Creation Process (1)
• Consider the case of a new bank whose rst client makes a GHC 100 deposit
• We assume that the required reserve ratio is 10%
Deposit Creation Process (2)
• With the 10% reserve requirement, this bank is required to hold only GHC 10 as reserves
• Since reserves traditionally pay no interest, the bank has an incentive to make loans out of the 90 excess reserves
• We assume that it makes a loan of GHC 90 to another client in by issuing a cheque of GHC 90
Balance sheet: Bank 1
Assets Liabilities
Reserves: GHC 10 Deposits: GHC 100
Deposit Creation Process (3)
• When bank 2 receives this GHC 90 deposit, it is required by law to keep GHC 9 as reserves can make loans out of or invest the remaining GHC 81
• We will assume that this bank to will make loans worth GHC 81 of the deposits it receives
Balance sheet: Bank 2
Assets Liabilities
Reserves: GHC 9 Deposits: GHC 90
Deposit Creation Process (4)
•When bank 3 receives this GHC 81 deposit, it is required to keep GHC 8.1 as reserves can make loans out of or invest the remaining GHC GHC 72.9
•At this point, the total amount of additional demand deposits created out of the initial GHC 100 deposit is GHC 243.9 (90+81+72.9)
•We can allow this process to continue and we can show that total additional amount of demand deposits that can be created out of this initial deposit is GHC 900
Deposit Creation Process (5)
•Our example make many simplifying assumptions
•It is assumed that all money is kept within the banking system
– in practice, the public keep some money as cash out of the banking system – banks cannot make loans out of such money
•It is not always the case that banks only keep the required reserve, in practice some banks keep excess reserves
What is Monetary Policy?
•Changes in money supply that influence the level of economic activity
•Monetary policy conducted by central banks
Monetary Policy
•Monetary policy may be expansionary or contractionary
•Expansionary monetary policy (loosening): increase in money supply – mostly communicated as a reduction in policy interest rate
Money Supply (1)
•The supply of money in an economy is determined by the banking system – Directly controlled by the central bank through monetary policy
– Indirectly influenced by commercial banks (and the public) through the deposit creation process
Money Supply (2)
•Central banks are responsible to conducting monetary policy
•In some countries, the central bank is independent of the central government to conduct monetary policy
•Recall that monetary policy refers to changes in a country’s stock of money supply that seeks to stabilize the level of economic activity and price level
Tools of Monetary Policy
•When bank 3 receives this GHC 81 deposit, it is required to keep GHC 8.1 as reserves can make loans out of or invest the remaining GHC GHC 72.9
•At this point, the total amount of additional demand deposits created out of the initial GHC 100 deposit is GHC 243.9 (90+81+72.9)
•We can allow this process to continue and we can show that total additional amount of demand deposits that can be created out of this initial deposit is GHC 900
Tools of Monetary Policy
•Central banks usually have an array instruments for conducting monetary policy
•The main ones are:
Open Market Operations (1)
•Open market operations (OMO) refer to the purchase or sale of government securities in the open market
– the open market here refers to dealers in government bonds and individuals
– government securities are government bonds/treasury bills
Open Market Operations (2)
•To see how OMO affects the money supply, consider open market purchase of government securities worth GHC 100m
•The central banks issues the initial a check worth GHC 100m which can be drawn as cash or deposited into an account with a commercial bank
– Note that either of these actions will increase the money supply
– If the check is deposited in an account, the commercial bank can creating additional loans out of it, increasing the money supply further
Open Market Operations (3)
•In Ghana the Bank of Ghana's Monetary Policy Committee announces the direction of monetary policy after its meeting
•In general the policy is announced as a target policy interest rate – in Ghana, the monetary policy rate
– in the US, the federal funds rate
Discount Rate
•Commercials can borrow from central banks when they are short of reserves
•The interest rate charged on commercial banks borrowing from the central bank is the discount rate
Reserve Requirements
• For the purposes of prudence commercial banks keep a small fraction of their deposits as cash or its close equivalent to pay depositors who desire to
withdraw
• Part of these reserves are required by regulators (central banks)
– The required reserve ratio is the fraction of deposits required by banks to keep as reserves
• Banks may in addition to the required reserves, keep additional excess reserves
Demand for Money
• Recall the demand for money is made of transactions demand and asset demand
• The major determinants of demand for money are real interest rate, level of income and expected inflation rate
• The quantity of money demanded falls when the interest rate rises
How does Monetary Policy Work?
• A change in money supply shifts the money supply curve in the money market
• This changes the real interest rate
• A change in the real interest rate affects consumption and investment demand
Transmission Mechanism: Monetary Tightening
• Let us look at recent monetary policy in Ghana
• Refer to the MPC Press Statement of November 2015
• In the release the Committee indicates that it was concern by inflation and inflation expectation
– see points 4 and 6 and summary (point 11)
Transmission Mechanism: Monetary
Tightening
• How does tight monetary policy help fight inflation?
• An a decrease in money supply increases the real interest rate
• Higher real interest rate reduces investment and consumption demand
