Money and Banking

The quantity theory of money

Examines the relationship between price changes and the supply of money within an economy

What’s the Fisher equation

MV=PY

What does M represent in the Fisher equation?

The amount of money in circulation/the money supply

What does V represent in the Fisher equation?

The frequency by which a unit of money is used across transactions in a given year/velocity of circulation

What does P represent in the Fisher equation?

The economy's price level for a given period of time

What does Y represent in the Fishers equation?

The real value of finished goods and services sold in a year/real GDP

Monetarist perspective on the quantity theory of money

• Inflation is tied directly to the supply of money

• They hold both V and Y constant

• Therefore, an increase in M will result in an increase in P as P = MV/Y

Keynesian perspective on the quantity theory of money

They don't hold V and Y constant

What is the money supply?

The total amount of money in circulation in an economy at a given point in time

What’s Narrow money?

Money that can be spent directly

What is Broad money?

Money used for spending AND saving

Give Examples of narrow money

• Notes and coins in circulation

• Current account deposits

• Commercial bank's liquid assets at the central bank

Examples of broad money

• Narrow money

• Savings accounts

• Government bonds

State the credit creation process

1. A deposit is made at the bank
2. The bank keeps a percentage as reserves and loans out the rest
3. Loans are made to customers
4. Customers use these loans to pay for goods and services
5. Firms earn profit from this expenditure
6. Process repeats itself

How do banks earn a profit?

They receive deposits, pay interest to depositors and use a percentage of these deposits to make loans at a higher interest rate that is paid to depositors

What’s a Liquidity ratio?

The percentage of deposits that a commercial bank holds as cash or assets

Give the The credit multiplier formula

100/liquidity ratio

What does the credit multiplier measure?

How much an initial deposit will ultimately increase the money supply

2nd credit multiplier formula

Δ Money supply/Δ Deposits

What happens when the government borrows from the central bank?

• It creates a debt to the central bank

• The government introduces the money into circulation

• Once the government spends the money, it will eventually end up as deposits for commercial banks

• The credit creation process takes effect-

What happens when the government borrows from commercial banks?

• Government borrows and issues a short term security e.g. bonds

• The bonds can serve as a cash asset against which the commercial bank can make more loans

What is Quantitative easing (QE)?

When the central bank purchases financial assets such as government bonds and corporate bonds from the private sector in an attempt to increase the money supply and lower the interest rate

When are QE measures used?

When traditional monetary policy has failed

What is the Liquidity trap?

In a low interest rate environment, it's difficult to lower interest rates any further. Individuals are likely to prefer holding cash rather than putting their money in low return financial assets

Examples of times where QE could be used

• Low interest rate environment (liquidity trap)

• Banks reluctant to lend

• Emergency response

How does QE work?

• The government purchases bonds and other financial assets from commercial banks and other financial institutions

• This provides liquidity for the financial institutions and increases the demand for bonds

• Increasing the demand for bonds, increases their price and thus reduces their yield

• The reduced yield reduces the attractiveness of bonds to investors, so they will invest their money elsewhere

What happens to the money supply as a result of effective QE?

It increases because:

• Commercial banks have more reserves to lend out

• Investors move funds out of bonds into assets that can provide better returns e.g. stocks

• Investment into stocks can increase their prices, creating a wealth effect

• The market can view the action by the central bank as a sign that the government is taking action which boosts confidence

What is total currency flow?

The net flow of money based on international transactions in goods, services and assets

What happens if there is a net inflow of money?

The money supply will increase

What happens if there is a net outflow of money?

The money supply will decrease

How does a net inflow of money result in an increase in the money supply?

• To purchase goods from another country, foreign buyers must exchange their local currency for the other country's

• If the value of a country's exports exceeds the value of imports then there will be an increase in the amount of that country's currency circulating and hence an increase in their money supply

How does a net outflow of money result in a decrease in the money supply?

If the value of a country's imports exceeds the value of exports then there will be a decrease in the amount of that country's current circulating and hence a decrease in their money supply

What is the The monetary transmisson mechanism?

A process by which a change in the official rate ultimately leads to changes in AD, real GDP and the price level

What is the official rate?

The rate at which commercial banks can borrow from the central bank

Which channels does the official rate work through to influence the price level and real GDP?

• Market rates

• Wealth

• Expectations

• The exchange rate

What are Market rates?

The rates charged by commercial banks to borrowers for a variety of loans

Official rate and the market rate

• If the official rate rises/falls, it's likely that market rates will also increase/decrease

• This will reduce/increase borrowing

• This will reduce/increase consumption, which will effect AD, employment, real GDP and the price level

What is wealth?

All of ones assets and liabilities

Official rate and wealth (real estate)

• An increase/decrease in market rates will reduce/increase real estate and stock prices

• As the value of their assets fall/rise, individuals are less likely/more likely to spend

• This will reduce/increase consumption which will effect AD, employment, real GDP and the price level

Official rate and wealth (stock prices)

• Lower market rates cause investors to seek better returns from other financial assets e.g. stocks

• As demand for stocks increases, so does their price

• Higher/lower stock prices leave investors feeling wealthier which is likely to increase consumption which will have an effect on AD, employment, real GDP and the price level

Official rate and expectations

• If interest rates reduce/increase, the central bank is pushing for economic growth/perceiving inflation as a threat

• This will shape the behaviour of firms and individuals

Official rate and the exchange rate (AD)

• A change in the interest rate paid on deposits will wither result in capital inflows or outflows

• Higher/lower interests will increase/decrease demand for the currency which will appreciate/depreciate its value

• The change in the value of the currency will impact the net export component of AD

• This will have an effect on employment, real GDP and the price level

Official rate and the exchange rate (AS)

• If the currency appreciates/depreciates, imported resource costs will decrease/increase

• The impact of this change will affect AS as the cost of production for firms will change

What does the ultimate effect on AD, employment, real GDP and the price level depend on?

The amount of spare capacity in the economy

Time lag of monetary policy

12 - 24 months as it takes time for the policy changes to impact the various channels and thus the economy

Liquidity preference

The preference for cash over less liquid assets such as government bonds

Individuals will choose to hold cash over other financial assets for three key reasons:

• Transaction motive

• Precautionary motive

• Speculative motive

Transactions motive

The desire to hold money for the day-to-day buying of goods and services

Precautionary motive

A reason for holding money for unexpected or unforeseen events

Speculative motive

A reason for holding money with a view to make future gains from buying financial assets

What are the transaction and precautionary motives variable to?

Income

What is the speculative motive sensitive to?

Changes in the interest rate

Active balances

All money held for the transactive and precautionary motives

Idle balances

All money held for the speculative motive