Money, Proces and the Role of Central Banks

Money in Economics

• The term "money" in economics has a specific meaning different from every day use

• To an economist:

  • Your pay check is income

  • The income you don't spend is saving

  • The increase in the value of your stock is a capital gain

  • When your house appreciates, your wealth increases

• Money is any asset that can be used in making purchases

  • Examples include coins and currency, checking account balances, and traveller's checks

• Money makes barter unnecessary

  • Barter is trading goods directly

  • Barter is difficult to implement, as it requires each party to want exactly what the other person has to offer

  • In a society with money, there is no need for the double coincidence of wants for trades of goods and services to take place

  • Money permits individuals to specialize in producing different goods and services, as opposed to producing only what one needs

  • Increased economic efficiency

3 Principle uses of Money

• Medium of exchange

  • an asset used in purchasing goods and services

• Unit of account

  • a basic measure of economic value (stocks, wages, current accounts, financial assets, goods, services)

  • Example: are 1,000 litres of milk economically more valuable than a tonne of coal?

  • Allows to make easy comparisons

• Store of value

  • an asset that serves as a means of holding wealth, and retain purchasing power into the future

  • Money as a store of value saves purchasing power from the time we receive income until the time we spend it

  • Example: keeping money in your chequing account, you are holding part of your wealth in the form of money

  • Cash has the advantage of being anonymous and difficult to trace

Wealth

• “Maria is rich—she has so much money”

  • The term money is often used as a synonym of wealth

  • But that is too broad: wealth is all property including not only money but also other assets such as bonds, stocks, land, houses, furniture, cars, art

Income

• "Victor has a good job and earns a lot of money”

  • People use the word money to describe what economists call income

  • Income is a flow of earnings per unit of time, whereas money is a stock

Why are people willing to exchange physical goods and services for a piece of paper whose intrinsic value is essentially zero?

• The answer is confidence: intrinsically worthless money has value because people expect that they will be able to exchange it in the future for goods

• Today, virtually all currency is issued by governments and is not backed by any commodity like gold

• People accept to hold and use money because they trust their government and its ability to maintain the value of money

Liquidity

• The relative ease and speed with which an asset can be converted into a medium of exchange; liquidity is highly desirable

• Money is the most liquid asset of all because it is the medium of exchange; it does not have to be converted into anything else to make purchases

• Other assets involve transaction costs when they are converted into money

Other Reasons for Holding Money

• Illegal activities, including drug and arms trafficking and tax evasion

• Corruption

• Fear of political and economic instability, banking crises

• Fear of deflation and negative interest rates

  

Measuring Money

• Firstly, economists have to decide what is and isn’t ‘money’

• In the U.S. the Fed uses two definitions:

• M1

  • a relatively ‘narrow’ definition of the amount of money in the economy

  • the sum of currency outstanding and balances held in chequing accounts

• M2

  • includes all the assets in M1 plus some additional assets that are usable in making payments, but at greater cost or inconvenience than the use of currency or cheques

• Definitions of money range from narrow to broad

Demand for Money

• The amount of wealth an individual chooses to hold in the form of money

• The nominal interest rate ‘i’:

  • The opportunity cost of holding wealth in the form of money is the real return to monetary assets relative to real return on alternative assets, such as government bonds

• The real return to any asset is the nominal rate of interest on that asset minus the rate of (expected) inflation: r  = i - π

• As we are assuming that monetary assets pay zero nominal interest, the real return to money is just: (0 - π)

• Hence, the opportunity cost of holding money is the real return on alternative assets minus the real return to money: (i - π) - (0 - π) = i

Money Demand Curve

• Shows the relationship between the aggregate quantity of money demanded (M) and the nominal interest rate (i)

• Because an increase in the nominal interest rate increases the opportunity cost of holding money, which reduces the quantity of money demanded, the money demand curve slopes down

Bank Reserves

Cash or similar assets held by commercial banks used for the purpose of meeting depositor withdrawals and payments

Money Supply and Banks

cash in a banks vault isn’t part of the money supply

• unavailable for payments

• bank deposits available for use in transactions are part of the money supply

100% Reserve Banking

a situation where banks reserves equal 100% of their deposits

Fractional-Reserve Banking System

a banking system in which banks hold fewer reserves than deposits so the reserve-deposit ratio is less than 100%

Desired Reserve-Deposit Ratio

bank reserves/bank deposits

Money Supply

currency held by public + bank reserves/(desired reserve-deposit ratio)

Securitisation

A practice by which banks can pool existing loans and sell them to another financial institution

• Advantage: securitization increases the supply of credit

• Drawback: securitization depends on the creditworthiness of the mortgagees and of the willingness of capital markets to hold securitized debts

The Federal Reserve

central bank of the US

• Does not attempt to maximize profit

• Promotes public goals such as economic growth, low inflation, and smoothly functioning financial markets

Responsibilities of the Federal Reserve

• Conduct monetary policy

• Oversee and regulate financial markets

  • Central to solving financial crises

Open-Market Operations

• When the Fed purchases a bond from the public

  • Fed pays bond holder with new money

    • The new money enters the economy

    • The bond, which wasn’t money, leaves the economy

    • Receipts are deposited and this leads to a multiple expansion of the money supply

• When the Fed sells a bond to the public

  • Bondholder pays with checking funds

    • The checking funds, which were money, leave the economy

    • The bond, which is not money, enters the economy

    • Bank reserves decrease and this leads to a multiple contraction of the money supply

Increasing the Money Supply

• An economy has 1,000 shekels in currency and bank reserves of 200 shekels

  • Reserve-deposit ratio = 0.2

  • Money supply = 1,000 + (200 / 0.2) = 2,000 shekels

• Central bank pays 100 shekels for a bond held by the public

  • Assume that all 100 shekels are deposited

  • Money supply = 1,000 + (300/ 0.2) = 2,500 shekels

  • 100 shekel increase in reserves leads to a 500 shekel increase in the money supply

Money Supply Curve

• Central Bank sets the money supply at MS1

• An open-market purchase increases the money supply curve to MS2

• An open-market sale reduces the money supply and shifts the money supply to MS3

Equilibrium in the Market for Money

How the Central Bank Controls Nominal Interest Rate

• Can lower the nominal interest rate by increasing the money supply

• For the given money demand curve, an increase in the money supply from MS to MS’ shifts the equilibrium point in the money market from E to F, lowering the nominal interest rate from i to i’

Stabilising Financial Markets

Fed prevents bank panics by

• Supervising and regulating banks

• Loaning banks funds if needed

Deposit Insurance

• Congress created deposit insurance in 1934

  • Deposits of less than $250,000 will be repaid even if the bank is bankrupt

    • Decreases incentive to withdraw funds on rumours

Inflation

the price level increases rapidly, money loses value rapidly, and people become more reluctant to hold their wealth in this store of money

The Quantity Theory of Money

• How the price level is determined and why it might change over time is called the quantity theory of money

  • The quantity of money available in the economy determines the value of money

  • The primary cause of inflation is the growth in the quantity of money

  • Inflation results when the money supply rises faster than the supply of goods and services

Nominal Variables

measured in monetary units

Real Variables

measured in physical units

Velocity and the Quantity Equation

• The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:

  • The price level must rise,

  • the quantity of output must rise, or

  • the velocity of money must fall

• Example for the effects of velocity:

  • If people start hoarding cash or saving more money instead of spending it, then the velocity of money will decrease. This can lead to a decrease in overall economic activity, as fewer transactions are taking place

The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money

• The velocity of money is relatively stable over time

• When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P x Y)

• Because money is neutral, money does not affect output

Monetary Neutrality

• Changes in the money supply affect nominal variables but not real variables

• The irrelevance of monetary changes for real variables is called monetary neutrality

Velocity of Money (V)

• A measure of the speed at which money changes hands in transactions for final goods and services

  • Velocity = (nominal GDP)/(money stock)

• Nominal GDP is the price level (P) times real GDP (Y)

• M is the money stock

  • V = (P x Y)/M

Velocity

• A higher velocity is a sign that the same amount of money is being used for a number of transactions. A high velocity indicates a high degree of inflation

• Velocity is determined by a number of factors including technology such as ATMs and debit cards

• These technologies allow people to conduct business while carrying less cash

• Less cash is needed + plenty of money changing hands = higher velocity

• How fast people turn over a unit of money. Money more frequently spent

• Money and velocity are inversely related because velocity measures how frequently currency changes hands, while the money supply measures the total amount of currency in circulation

The Inflation Tax

a tax on everyone who holds money caused by governments raising revenue by printing more money

the tax is in the form of a reduction in the value of money holding which erodes purchasing power

individuals and businesses need to pay more money to purchase the same amount of goods and services

Fiscal Theory of Price Level (FTPL)

• Explains the relationship between fiscal policy, government’s budget, and the price level

• Argues that the price level in an economy is ultimately determined by the government's budget decisions, rather than by the quantity of money in circulation, as in the quantity theory of money

• According to the FTPL, fiscal policy dominates monetary policy in determining the price level

• Changes in government spending and taxation have a greater impact on the price level than changes in the money supply

• Deficits may cause governments to inflate away the debt as the real amount it must pay is smaller

Commodity Money

any money made up of precious metals or another valuable commodity

inconvenient - very hard and heavy to transport from one place to another

Fiat Money

paper currency that isn’t convertible into or tied to any commodity but that the government still declares as legal tender

can be printed and changed at will and its value becomes determined by market forces

Cryptocurrencies

a digital asset designed to be a medium of exchange

Central Bank Digital Currencies (CBDC)

inspired by Bitcoin

potential advantages - fast, secure, reduce transaction costs, reduce rents, provide information (tax collection), enable negative nominal interest rates

drawbacks - untested in periods of crisis, might affect monetary policy transmission, lots of power concentrated in the central bank