Comprehensive Study Notes on Monetary Policy and Central Banking

Definition and Global Context of the Central Bank

A central bank is defined as a specialized institution that oversees the entirety of a nation's banking and financial system. It carries the primary responsibility for the formulation and execution of monetary policy. Different nations maintain their own central banking institutions to manage their respective economies. In Saudi Arabia, this institution is the Saudi Arabian Monetary Agency (SAMA). In the United Arab Emirates, it is the Central Bank of the U.A.E., while Kuwait and Egypt utilize the Central Bank of Kuwait and the Central Bank of Egypt, respectively. In the United States of America, the central bank is the Federal Reserve Bank, commonly known as the Fed. The United Kingdom is served by the Bank of England, and Canada’s monetary authority is the Bank of Canada.

The Specific Functions of the Saudi Arabian Monetary Agency (SAMA)

The Saudi Arabian Monetary Agency (SAMA) performs several critical roles within the Kingdom's economy. Its first primary function is the issuance of the national currency, the Saudi Riyal. Additionally, SAMA acts as the official banker to the government and serves as the regulator for all commercial banks operating within the country. One of its most vital responsibilities is the management of the Kingdom’s foreign exchange reserves. SAMA conducts monetary policy with the specific aim of promoting both price stability and exchange stability. Furthermore, it is tasked with promoting general economic growth and ensuring the overall soundness and health of the financial system.

Determination and Calculation of the Money Supply

The money supply, also referred to as the money stock, represents the total quantity of money available within an economy. To determine which assets are categorized as part of the money supply, economists typically look at two major candidates. The first is currency, which includes the paper bills and coins held by the non-bank public. The second consists of demand deposits, which are balances held in bank accounts that depositors can access on demand by writing a check. The interaction between these components determines the total liquidity available in the market.

Mechanisms of the Fractional Reserve Banking System

In a fractional reserve banking system, banks do not keep the entirety of their deposits on hand. Instead, they keep a fraction of deposits as reserves and utilize the remaining funds to generate profit by making loans. SAMA is responsible for establishing reserve requirements, which are regulations that dictate the minimum amount of reserves banks are legally obligated to hold against their deposits. While banks must meet this minimum, they are also permitted to hold more than this amount if they choose. Mathematically, the reserve ratio is denoted as $R$. This ratio is defined as the fraction of deposits that banks hold as reserves, calculated as total reserves as a percentage of total deposits.

Analyzing Bank Assets and Liabilities via T-Accounts

A T-account is a simplified accounting statement used to visualize a bank's financial position, specifically its assets and liabilities. In this structure, a bank’s liabilities include the deposits it holds for customers, while its assets include the loans it has issued and the reserves it maintains. For example, if Riyad Bank has reserves of $SR10$ and has issued loans of $SR90$, its total assets equal $SR100$. On the other side of the ledger, it would have deposits of $SR100$ as liabilities. In this specific scenario, the reserve ratio would be calculated as $R = SR10 / SR100 = 10\%$.

Theoretical Models of Banks and the Money Supply

To understand the impact of banks on the money supply, economists compare three distinct cases using an initial circulation of $SR100$. In Case 1, where no banking system exists, the public holds the entire $SR100$ as currency, making the total money supply exactly $SR100$. In Case 2, a $100\%$ reserve banking system is utilized. Here, the public deposits the $SR100$ into a bank like Riyad Bank. The bank holds all $SR100$ in reserves and makes no loans. In this instance, the money supply is the sum of currency ($SR0$) and deposits ($SR100$), resulting in a total of $SR100$. This demonstrates that in a $100\%$ reserve system, banks do not change the size of the money supply.

Case 3 involves a fractional reserve banking system. If the reserve ratio $R$ is set at $10\%$, Riyad Bank will keep $SR10$ and loan out $SR90$. The depositors still have $SR100$ in their accounts, but the borrower now holds $SR90$ in currency. Consequently, the money supply ($C + D$) equals $SR90 + SR100 = SR190$. The money supply grows because when banks make loans, they create money. The borrower gains an asset in the form of currency which is counted in the money supply, and a liability in the form of debt, which does not have an offsetting effect on the money supply. It is important to note that while this system creates money, it does not create actual wealth.

The Cumulative Process of Money Creation and the Money Multiplier

The process of money creation continues as loans are deposited into subsequent banks. For example, if a borrower deposits the $SR90$ from Riyad Bank into Rajhi Bank, and Rajhi Bank maintains a $10\%$ reserve, it will keep $SR9$ and loan out $SR81$. If that $SR81$ is then deposited into Bank Al-Bilad, that bank will keep $SR8.10$ and loan out $SR72.90$. This cycle continues indefinitely. The total money supply can be determined by the money multiplier, which is the amount of money the banking system generates with each dollar of reserves. The formula for the money multiplier is $1/R$. In a scenario where $R = 10\%$, the multiplier is $1/0.1 = 10$. Therefore, an initial deposit of $SR100$ of reserves can generate a total of $SR1000$ in the money supply.

Mathematical Application: The Sofa Cushion Scenario

Consider a scenario where an individual finds a $50$ dollar bill and deposits it into a checking account. If SAMA’s reserve requirement is $20\%$, the maximum and minimum increases in the money supply can be calculated. For the maximum increase, assuming banks hold no excess reserves, the money multiplier is $1/0.2 = 5$. The maximum possible increase in deposits is $5 \times 50 = 250$. however, since the currency in circulation fell by $50$ when it was deposited, the net maximum increase in the money supply is $250 - 50 = 200$ dollars. Conversely, the minimum increase would be $0$ dollars. This occurs if the bank chooses to make no loans from the deposit; the decrease in currency is perfectly offset by the increase in deposits, leaving the total money supply unchanged.

SAMA's Primary Tools for Monetary Control

SAMA manages the money supply by influencing either bank reserves or the money multiplier using three main tools. The first is Open Market Operations (OMOs), which involve the purchase and sale of Saudi government bonds. When SAMA buys a bond from a bank, it increases that bank's reserves, enabling more loans and increasing the money supply. Selling bonds has the opposite effect. The second tool is the Discount Rate, which is the interest rate SAMA charges on loans it makes to banks. Reducing the discount rate makes it cheaper for banks to borrow reserves, leading to an increase in the money supply. Raising the rate decreases the supply. The third tool is changing the Reserve Ratio. By reducing reserve requirements, SAMA lowers the reserve ratio and increases the money multiplier, thereby expanding the money supply.

Obstacles to Precise Money Supply Control

There are several variables that can complicate the central bank's ability to control the money supply accurately. If households decide to hold a larger portion of their money as currency rather than depositing it, banks have fewer reserves to lend, causing the money supply to fall. Additionally, if banks decide to hold excess reserves beyond the legal requirement, they make fewer loans, which also reduces the money supply. Finally, if investors and households choose to borrow less due to a bleak economic outlook, the volume of loans decreases, leading to a contraction in the overall money supply.

The Equilibrium Interest Rate in the Money Market

The equilibrium interest rate is determined by the intersection of the Money Supply (MS) curve and the Money Demand (MD) curve. The MS curve is depicted as a vertical line because the quantity of money is fixed by the central bank (SAMA) and does not change based on the interest rate ($r$). In contrast, the MD curve is downward sloping, reflecting that a fall in the interest rate increases the quantity of money demanded. The point where these two curves meet establishes the equilibrium interest rate ($r_1$) for the fixed quantity of money.

Objectives and Strategic Types of Monetary Policy

Monetary policy is the process by which a country's monetary authority manages the supply of money and interest rates to achieve specific macroeconomic goals. According to Article 1 of the Charter of the Saudi Arabian Monetary Agency, SAMA's specific objective is to issue and strengthen the Saudi currency and stabilize its internal and external value. Generally, the goals of monetary policy are to keep prices stable, maintain low unemployment, and achieve economic growth.

There are two primary types of monetary policy. Expansionary Monetary Policy is used during recessions to combat unemployment by increasing the money supply and lowering interest rates ($r$). This encourages consumption and investment, shifting Aggregate Demand (AD) to the right and increasing GDP ($Y$). Contractionary Monetary Policy is used to slow inflation by decreasing the money supply and raising interest rates. This reduces consumption and investment, shifting Aggregate Demand to the left and reducing the price level ($P$).

Technical and Behavioral Limitations of Monetary Policy

The effectiveness of monetary policy can be limited by human and market behavior. Simply increasing the money supply may not successfully increase Aggregate Demand if the resulting lower interest rates fail to entice borrowers. If businesses and households feel pessimistic about the future state of the economy, they may refrain from borrowing or spending on goods and services regardless of how low the interest rates are. This behavioral barrier can prevent expansionary policy from achieving its desired impact on the GDP and the overall economy.