eco 101 ch.12 interest rates, money and inflation(1)

8/13/2019 ECO 101 Ch.12 Interest Rates, Money and Inflation(1)

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The McGraw-Hill Companies, 2009

Ch12. Interest rates, money and inflation

Dr.Agim Mamuti


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Money

Money Any generally accepted means of payment for delivery of goods or

settlement of debt. It is the medium of exchange.

Barter economy has no medium of exchange - goods are simply swapped for other

goods

Unit of account is the unit in which prices are quoted and accounts are kept

Store of value Money is available for future purchases.

Token money

has a value as money that greatly exceeds its cost of production orvalue in consumption.

IOU ("I owe you)money is a medium of exchange based on the debt of a private bank.


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Modern bankingBank reserves

cash in the bank to meet possible withdrawals by depositorsReserve ratio

ratio of reserves to deposits.

Banks assets mainly loans to firms and households, but also financial securities

such as bills and bonds, issued by governments and firms

Banks liabilities mainly sight and time deposits

Sight deposits

Where a depositor can withdraw money on sight with no notice (suchas cheque accounts)

Time deposits pay higher interest rates and need a period of notice before

withdrawing money

Banks make profits through the interest rate spreadthe amount by

which interest rates on loans exceed interest rates on deposits


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Measures of money

Liquidity is the ease with which an asset canbe turned into money

The money supply consists of a spectrum ofliquidity: M0 (wide monetary base)= all cash + banks deposits

with the Bank of England

M1 = M0 + sight deposits of banks

M3 = M1 + other bank deposits

M4 (broad money) = M3 + building society deposits


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Interest rates and monetary policy

Central bank

responsible for:

printing money

setting interest rates

acting as banker to commercial banks and the

government

In the UK, the Bank of England fulfils these

roles


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Three ways in which the central bank MAYinfluence money supply:

Reserve requirements

central bank sets a minimum ratio of cash reserves todeposits that commercial banks must meet

Discount rate

the interest rate that the central bank charges when thecommercial banks want to borrow

setting this at a penalty rate may encourage commercialbanks to hold more excess reserves

Open market operations

actions to alter the monetary base by buying or sellingfinancial securities in the open market

The bank and the money supply


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Lender of last resort

The lender of last resort lends to bankswhen financial panic threatens the financialsystem.

The Bank will therefore always lend to thebanking system if the financial system is underthreat

this function can be used by the Bank when

the financial system is not under threat toaffect the money supply



The demand for money

Focus on three determinants of desired money holdings

interest rates price level

real income

Assume that money pays no interest and bonds are all

the other assets that pay interest How do people split their assets between money and bonds?

Holding money means not earning interest from holding bondsinstead

The cost of holding money is the interest given up by holding

money rather than bonds.

People hold money only if there is a benefit to offset thiscost

So what is the benefit?




The demand for money is a demand for real money

balances M/P.

Transactions motive

payments and receipts are not perfectly synchronized:

so money is held to finance known transactions

depends upon income and payment arrangements

Precautionary motive

because of uncertainty:

people hold money to meet unforeseen contingencies

depends upon the (nominal) interest rate




Asset motive

In deciding in which assets to hold wealth to bespent at some distant date, a wise portfolio ofassets will include

some high-earning assets such as company shares

but are potentially risky

Plus some safer assets with a return that is lower

on average but less volatile

Holding some wealth in interest-bearing bankaccounts is part of a well-diversified portfolio



In summary, the demand for money

depends upon the motive for holding money

people want money for purchases - transactions

demand

people want money as a precaution -

precautionary demand

people want money to buy assets - asset demand




How much money will

people hold?

People will equate the MC and MBof holding moneyE

Higher prices

If all prices and wages doublewith interest rates unaltered - MCstays the same

Real income unaltered so MBschedule is unaffected

Desired holding of real moneyremains L

People hold twice as muchnominal money M when prices Pdouble.

Real income and real money M/Pare unaffected.



Money market equilibrium

Real money holdings

MD

Other things being equal,the demand for real moneybalances will be lower when

the opportunity cost (the rateof interest) is relatively high.

The position of thisschedule depends uponreal income and the pricelevel.

When money supply is L0, money market equilibriumoccurs when the rate of interest is at r0.

L0

r0



Monetary policy

Interest rates are the instrument of monetarypolicy

The monetary instrument is the variable over

which a central bank exercises day-to-day control

The Bank of England has operationalindependence from government to set interest

rates But the Chancellor has decided the Banks ultimate

objective is to set interest rates to try to keep inflationclose to 2 per cent a year



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InflationThe rate at which the generallevel of prices for goods andservices is rising, and,subsequently, purchasing poweris falling.

As inflation rises, every dollar will

buy a smaller percentage of agood. For example, if the inflationrate is 2%, then a $1 pack of gumwill cost $1.02 in a year.

Most countries' central banks willtry to sustain an inflation rate of2-3%.


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Committing to low inflation

Central Bank independence is a usefulcommitment to tight monetary policy and

low inflation

Institutional commitment has succeeded in

keeping inflation in many countries in

recent years.

eco 101 ch.12 interest rates, money and inflation(1)

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