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MONEY AND THE ECONOMY

What is money?

What does money do?

How does money affect the economy?

What determines the money supply?

What determines the demand for money?

What determines interest rates?

What is monetary policy?

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MONEY AND THE MACRO-ECONOMY

1. Definition and functions of money

2. The effect of money on the macro-economy

3. The money market

4. The role of central banks

5. Determination of interest rates: some theory

6. Monetary policy

7. Reasons for the goal of price stability

8. Independence of central banks

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WHAT IS MONEY?

What counts as money?• depends on its accessibility (degree of liquidity) - cash - bank deposits - interest-bearing deposits - time-deposits (savings) - short-term Treasury bills (near money)

What does money do? - medium of exchange - store of wealth - unit of account (measure of relative value) - relates the future to the present (wage contracts, repayment of debt)

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HOW DOES MONEY AFFECT THE MACRO-ECONOMY?

Direct effect

Monetarist view:• increase in money balances affects consumption directly

Indirect effect

Money affects the economy via interest rates:• r affects expenditure (C and I)• exchange rates (and therefore X and M)• property prices• bonds and shares

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The financial sector

Private sector organisations

- commercial banks

- large firms

- pension funds

- building societies

- foreign exchange market

Financial instruments

- govt bonds / gilts

- certificates of deposit

- loans to households

- overdrafts

- mortgages

THE MONEY MARKET

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The central bank: what does it do?

• issues cash

• banker to commercial banks

• banker to govt (manages govt borrowing)

• regulates commercial banks

• controls liquidity position of commercial banks

• operates monetary policy

• operates exchange rate policy

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How does the central bank control monetaryconditions?

• controls liquidity through lending rate (‘repo’)

- commercial banks can borrow at the repo rate

- repo rate is a ‘signal’ (determines all other interest rates)

- low repo encourages banks to borrow and lend

- high repo discourages banks from borrowing

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DETERMINATION OF INTEREST RATES

1. Demand for money

• transactions purposes - price level - income - interest rate (opportunity cost)

• precautionary purposes

• speculative purposes - expected change in price of bonds - bond price inversely related to r - hold money if bond prices are expected to fall - hence: demand for money high when r is low

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2. Supply of money

Causes of changes in money supply:

• banks can reduce their liquidity ratios - switch / direct debit has reduced demand for cash - banks borrow from each other (overnight) to achieve a satisfactory liquidity position

• surplus in balance of payments (e.g. exports > imports) - inflow of foreign exchange

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• govt creates high-powered money to finance a budget deficit - multiplier effects on ‘broad’ money (M)

M = k (H)

M = broad moneyH = high-powered money (cash + reserves of

commercial banks)k = money multiplier (k > 1)

• govt sells short-term Treasury bills (‘near money’) - commercial banks expand loans to customers • govt buys long-term bonds and sells short-term Treasury bills to increase liquidity (‘funding’)

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Determination of interest rates

Money supply: set by central bankDemand for money: determined by private sector

r

Demand / supply for money

r1

M1

Md = f(P, r, y)

Ms = M1What happens if:- money supply increases?- income increases?- prices increase?

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MONETARY POLICY IN PRACTICE

Central bank• can control either interest rates or money supply

How does the CB control interest rates?

• announces an interest rate - base rate/repo rate/ fed funds rate - all market rates respond to the announcement

• CB backs this up with open market operations (OMO) - CB buys gilts from banks to increase liquidity (results in lower r) - sells gilts to banks to decrease liquidity (banks earn an income from gilts)

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THE FEDERAL RESERVE BOARD

Aims: “..to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Policy instruments:1. Reserve requirements (R/D ratio of commercial banks) - not used in practice2. Lending to banks at the ‘discount window’ (lender of last resort)3. Open market operations Federal Open Market Committee (FOMC) sells / buys government bonds to control the federal funds rate (same as inter-bank lending rate in UK)

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What does the central bank take into account in setting interest rates?

• forecasts of inflation• spare productive capacity• growth of retail sales• trends in output growth relative to growth of productive capacity• growth of money supply• house price changes• interest rate trends in USA, EU and Japan• exchange rate trends

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REASONS FOR POLICY OF PRICE STABILITY

Adverse effects of inflation

• ‘menu’ costs (constantly changing price lists)

• shoe-leather costs: searching for best buy

• adverse effect on fixed income groups

• adverse effect on savings

• consumers get confused signals about prices (essential information for optimal resource allocation)

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• adverse effect on investment due to uncertainty - lower investment leads to slower economic growth - shortens investors time horizon (quick returns)

• costly to reduce inflation: dis-inflation => unemployment

• hyper-inflation is economically and politically disastrous - complete collapse of market economy - political instability

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An example of hyper-inflation: Germany 1923

Price index1921 July 1

1922 July 7

1923 Jan 195

July 5,230August 66,017Sept 1,674,755Oct 496,209,790Nov 15 54,448,000,000

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Adverse effects of deflation

• borrowers find their real debts increasing - discourages borrowing - fall in asset prices reduces consumption

• lenders lose if debtors go bankrupt

• prices decline but wages are sticky - decline in demand for labour - fall in profits and investment

• real interest rates increase - discourages investment

• leads to persistent recession: consumers delay spending

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INDEPENDENCE OF CENTRAL BANKS

• USA and Germany: long history of CB independence

• other countries followed in 1990s (e.g. UK in 1997)

• ECB most independent of all central banks

Advantages of independence:

• monetary policy free from manipulation

• strengthens credibility (inflation targets more ‘believable’)

• CB free to achieve its primary objective

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Disadvantages of independence:

• low inflation is not the only policy goal

• govt deflects blame for failure of economic policies

Performance of central banks:

• lower inflation achieved

• tight monetary policy has led to higher unemployment in EU

• Greenspan (and others) have been ‘lucky’

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The European Central Bank

• sets interest rate for all member states

• most independent CB in world; not accountable to any single country

• sets target inflation rate for whole of Eurozone

• sets 3 interest rates- lender of last resort (e.g. 5%)- loans to banks (e.g. 4%)- borrowing from banks (e.g. 3%) to mop up surplus liquidity

• sets minimum reserve ratio (to keep banks under control)

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CONCLUSIONS

1. Monetary authorities have become increasingly dominant in macro-economic management

2. Monetary conditions are controlled through central bank’s control over interest rates (not the money supply) 3. Active fiscal policy replaced by very active monetary policy

4. Monetary policy successful in controlling demand in the 1990s. Will this continue?