Money and Monetary Policy

A major way the economy and it’s workings are kept in check is by having some control over what we call money, and what we want to do with it. This is monetary policy. What would you do with you’re money if interest rates were higher, if you could get credit when you wanted, what would you buy??

The Monetary Policy Committee knows that they can manipulate what people and businesses do to some extent by changing what we do with money we have. Their tools are interest rates, the money supply and controlling credit conditions. Also changing exchange rates….

What is Money…Sounds a bit stupid, but in an economic sense money is a major part of the economy for the functions it performs:

  1. A Medium of Exchange. Without money, trading would be more difficult, money is an acceptable and liquid trade for any good. Instead of buyer and seller having to want each others offerings, money is a medium between selling what we want and buying what we want. Makes trading easy……..
  2. A Store of Value. If you have money, it is worth something. You can simply hold it and wait for what you want to use it for, storing it’s value before a trade.
  3. A Unit of Account. If everyone was offered wages in wood and houses, if businesses had balance sheets in amethysts, how could you have any knowledge of what was worth investing into or whether the employer if making a good deal. With things measured in money units, people know what they are getting, and can make rational comparisons.

Interest Rates, Old and New Theory…..

The classical economists view of how the interest rate is defined is by the Loanable Funds Theory. This theory dominated thought throughout the 19th and early 20th century….It is a basic supply and demand theory, which looks into the minds of lenders and borrowers.

Supply The old theory said the supply of loanable funds shows how much is saved at different rates of interest. Understandably, at higher rates more is saved, and more ‘loanable funds’ are supplied to the banks.

Demand: The main way money is demanded is to invest out of borrowing(the theory assumes). With higher rates, less risks are seen as worth taking with borrowed money, so less demand.

Equilibrium: It was assured that if the interest rate was too high(for instance), there would be too much saving for banks to take, so by cutting the rate, savers would be deterred and borrowers encouraged. We are at rest where the money saved out of a given income equals the money borrowed, working, with free market forces. Levels of income are assumed constant…

The Birth of Liquidity Preference Theory….

The loanable funds theory is certainly valid for a single market, such as that faced by a bank, but for the money supply and demand for the whole economy it was found flawed by Keynes(again).

The Flaws of Loanable Funds when applying to a WHOLE Economy………

He stated in his General Theory that the amount of investment borrowings and savings for different rates of interest cannot define the economy’s interest rate, but rather the level of income. His argument was that if investment increases by, say, a shift in the demand curve in the Loanable Funds Theory than the assumption that incomes stay constant go out of the window, and that, surely, if this happens there will be more to save and supply shifts ‘pari passu'(with equal step, as Keynes uses). Interest rates on the aggregate are unlikely to move….Using borrowing for investment as the demand curve poses problems….

So…..Whats the New Theory…

Supply: Something has happened, it’s vertical! Well think, how many £ are there right….now? It will be fixed when we look at the economy as a whole. And so, whatever the rate of interest, there will be a certain amount of £ circulating, which can be changed by the MPC, shifting the curve.

Demand for money as a whole. Keynes thought, why do we hold money? Then came up with these 3 which define the demand curve…….

  1. ‘Transactions Motive’. People want money to buy goods(medium of exchange), so the demand for money is influenced heavily by the demand for goods.
  2. ‘Precautionary Motive’ Is where individuals demand idle cash if they have fears for the future, mainly fearing redundancy or bank insecurity. Safe haven(if low inflation, of course).
  3. ‘Speculation Motive’. As money is a store of value, people may demand money holdings if there is fears in the animal spirits as to the economy. Better than a crashing asset market…

And so, for the economy as a whole equilibrium is where people demand as much money as there is present, and there is no demand for money which isnt there(take a loan, which does rise the loanable funds like market rate for the bank, but not the economy) etc….The interest rate can be seen as an average of all the rates and bonds maturities available, for an economy where all those lenders and borrowers are there.

Also note the Forex Market…Something which is very neglected in the course which I question, but demand in the Forex market(which gives the exchange rate) is surely a part of the demand for money as a whole! Factored into the demand curve.

The Fisher Equation of Exchange..

An identity…

MV=PY

Symbols: M is the money supply, V is the velocity of circulation(how many times money is spent), P is the average price level and Y is the number of exchanges.

This is time dependant as we need a time measurement for the number of exchanges and velocity to be put into numbers. Usually per year.

The equation is reliable and simple, the historic debate is rather how each part changes in response to a change in M. Do people buy more, or less? Or do prices increase, or fall? Both? To what extent??

The Fisher Effect

Inflation and Rates: The theory says the rate of inflation changes at roughly the same rate as the rate of interest, with nominal rates staying a contant above inflation. Real interest rates over time have shown to be stable.

RI Nominal=Inflation+k

Where k is the real interest rate.

Why is This: The liquidity preference theory coupled with the demand for money will rise when prices are rising, increasing money demand, interest rates can rise. Also a control of inflation, if high, the central bank will target this with high rates and vice versa.

Empricism: A stable real rate of interest has held true, especially in stable periods.

Following on, high interest rates are both a cause of high inflation, and an effect. The IS-LM relationship is useful when looking at this.

Monetary Policy in The UK

Changing what we do with money to change the economy is managed by the Monetary Policy Committee. What it tries to achieve by doing this is a stable rate of inflation, which it picks a % rate and allows a + or – percentage margin around the target. This is known as symmetric inflation targets, and it uses the Consumer Price Index as it’s measurements. 2010 target is 2%

Why Inflation, instead of growth??

When we look back at the functions of money, we just need to think that we need money stability for each of those functions(esp a store of value/unit of account) to hold out. With stable inflation, money is stable as to what it can buy, and it remains a trustworthy and useful tool in the economy, which is vital in an economy which relies so much upon it’s functions. Also, inflation stability means we are on course for stable growth/employment, just think of the animal spirit money illusion, and the irrational effects this can have on markets(which does affect employment/growth). With stable inflation, money illusion is small growth/employment is stable, a desired result.

We just need to look aswell at the costs of inflation in a monetary economy, especially wealth erosion which would severely hurt the UK given it’s financial sector. I mean, who would lend to a bank if it was a russian roulette, if you’re £10000 could only buy a kettle in a year. Would banks lend to anyone if their £50000 loan would turn to dust?? The centrepoint of money access, banks, just would not work….No credit, no safehaven, but we need to think, little investment.

To Know More Visit Bank of England’s Website..http://www.bankofengland.co.uk/index.htm

Ways Money Supply is Controlled

Regulation of the Banking System:Required Reserve Ratios

The central bank can control the maximum amount of credit issued by banks, thus limiting the size of their balance sheet, by setting a rule that they must have a certain amount of liquid capital in relation to the money they have supplied as credit or deposit, their assets and liabilties.

This can be divided into subsectors:

Tier 1 Capital Ratio is Basel 2 and 3, the banking regulations. From the passing of Basel 3, banks must have at least 8% of their balance sheet in ‘Tier 1’ capital. This is shareholders equity+retained profit. See: http://www.bloomberg.com/news/2010-09-12/basel-boosts-bank-capital-ratios-firms-get-till-2018-to-comply.html

Cash Ratios: The bank has to hold a proportion of its balance sheet in cash to meet the demands of its depositors (as its usually around only 10% banks can suffer during ‘bank runs’ which have been calmed down in recent years).

Capital Adequacy Requirements: The bank must have a limited ‘risk weighted asset’ score in relation to its tier 1 and tier 2 capital.

Stress Tests are conducted frequently and are an aspect of European Union membership upon the strength of a bank. In order to pass a stress test, its balance sheet must enable it to remain afloat in a series of worst case scenarios. See more here: http://www.eba.europa.eu/News–Communications/Year/2011/The-EBA-announces-the-benchmark-to-be-used-in-the-.aspx

The Money Multiplier and other ways to control it:

The Money Multiplier is simply the factor by which the money supply changes with respect t0 the change in cash in the system. It is

Money Multiplier=1/Cash Ratio 

Assumptions:

  1. That no cash is sitting idly
  2. Banks are maximising their balance sheet whilst following regulation
  3. Cash in the system eventually becomes credit
How it Works
The money multiplier by the strict definition follows the above assumptions. You may wonder how we actually reach the equation in practice…
Well say a bank is given £1mn in extra cash and we have a cash ratio of 10%. £900k will be lent in credit which will eventually find its way back into the banking system which will take another 10% leaving 810k to add to the system, then 729k, 656k etc, etc……This continues leaving a geometric series and is derived through the sum to infinity of the series equation.
Cash Stashed  under the Bed!
The money multiplier assumes people don’t do this….
The money finds its way back into the system after it is lent out. A typical example is a building company taking a loan to pay in cash an instalment for materials, which will then be deposited by the supplier.
The process can be lengthy though, the supplier may buy something for its office, which then may pay its workforce which may buy domestic appliances etc.

Other determinants

Other than the variety of required reserve ratios (most relevant here the cash ratio), we can see via the above assumptions that, if they are strayed from, the money multiplier will also stray from its strict definition and rise or fall.

  • The incentive to hold cash: The money multiplier will be smaller the higher the precautionary and speculative motive to hold cash rather than spend or bank it (which tends to occur in recessions).
  • The demand for credit: Assuming money filters through the system from saver to borrower and iterates to a limit requires a high level of consumer and business confidence to keep credit demand.
  • The prudence of banks: Banks will not hold, at all times, the exact cash ratio. If the system is more conservative, banks will hold considerably more cash then they need to, and vice versa if they are not being regulated correctly or are able to disguise their holdings through shady accounting. A changing cash ratio means a changing multiplier.

Quantitative Easing

Controlling the money supply to change interest rates and demand was given some popularity again with the adventurous monetary policy needed to get the US and the UK out of recession.

What is it? A deliberate rise in the money supply, mainly given to banks for credit markets. The central bank makes money out of nothing and adds it to the ailing economy.

Fed chairman Ben Bernanke, when he’s out of the office……..

How its done… The extra money the central bank has is then used for ‘open market operations’. The money isn’t thrown off of a roof, but rather used to buy assets, bonds etc off major banks to increase their liquid assets so that they can match the array of capital requirements whilst expanding its balance sheet and hence narrow and broad money.

Other Market Interventions by the Central Bank 

As well as open market operations, a central bank can perform other tricks:

Sale and Repurchase Agreements: The CB can create a temporary contraction in the money supply by selling off fixed income assets and making an agreement to buy them back for a certain price in the future. Expansion is by buying and selling in the future, a ‘reverse repo’.

The Base Rate: In the US, open market operations are performed so that the Fed Funds Target Rate is met. In the UK, however, our base rate is a merely signal to central banks of LIBOR without trading securities, of what rate banks can get on borrowed funds. We expect them to converge though otherwise borrowing off the BoE will prove more attractive.

Narrow and Broad Money

What Goodhart’s Law depends upon, controlling ‘narrow money’ would lead people into using ‘broad money’ if there is a lack….But what good is it without knowing what it means.

Narrow Money is you’re notes and coins, but also bank current accounts which can be credited and debited. Very liquid.

Broad Money is narrow money plus what our examiners call ‘time deposits’, like savings accounts and bonds which are fixed in for some time. If cash is restricted, people may offer bonds in exchange which are in money units(has all functions other than medium of exchange, which it can become).

European Cenral Bank Definition

Strictly in practice the money supply is put into 3 categories:

  • M1-Cash, coins and debit bank accounts
  • M2-M1 plus ‘time deposits’ (Certificates of deposit, savings accounts which are not freely drawable)
  • M3-M2 plus treasury bills and long term bonds people hold in banks such as a 5 year fixed ISA.

The Monetary Transmission Mechanism

‘How policy feeds through the economy to change inflation’

As the central goal of Monetary Policy is to achieve inflation targets(CPI in UK), it is worth seeing how a change in the most commonly used variable, the interest rate feeds through the economy to actually alter inflation.

The picture explains a lot of it, on how an interest rate fall, for instance, can lead to a cost push(rising import prices) and demand pull(domestic and overseas demand) inflationary pressure.

  1. Changes in market rates mean changing disposable income for people with a loan and changing the propensity to save. Encourages credit markets.
  2. Changing asset prices effect the economy, mainly via consumption and investment, see ‘The Wealth Effect'(Consumption page)
  3. Changes in Confidence are largely the affects listed above in market rates.
  4. Changes in Exchange Rates due to international portfolios on the capital account, change import prices and demand for exports.

It takes on average about 2 Years for an interest rate change to fully feed through, so Monetary Policy has to be planned in advance(pre-emptive because of time lags). Doing this in the exam will be great for level 5!!

Limits of Monetary Policy: The Liquidity Trap.

If the economy is in a recession, monetary policy has the power to control the money supply and alter the base rate to lower the market rate of interest. But this can only get you so far, what if the rate is already near zero?

This is a liquidity trap, and is where, no matter how common you make the money supply, there will always be a minimum opportunity cost of holding money, hence the minimum rate of interest. A negative nominal rate of interest is possible, it has been done artificially in Japan I think to stem it’s deflation. A nominal negative rate cannot be achieved however, by money supply and demand.

Attributes various forms of money must have:

After reading the Wealth of Nations, The Ascent of Money and studied the curriculum I have learned that money must, in order to serve it’s purpose in an economic system possess certain characteristics. Remember..

Money does not have to be, and hasn’t always been cash and deposits


In early society, a variety of commodities served the purpose of money to ease exchange and have varied from salt to shells to tin.

Divisible: Livestock lost it’s appeal early on as it is unlikely the seller would value what he is buying as exactly one or two cows or sheep. Money needs be divided into exact quantities

Portable: When going to an early market, or to the shops today, you don’t want to be carry something really heavy or awkward and nor does the shop want to store such a thing. Consumers become mobile and business easier.

Hard to Forge: As money, due to the reason above has to be of high value for it’s size there is a willingness for it to be forged. If it can be, trust and confidence in the system will break down.

Durable: Money will change hands often and trade must not be a game of ‘pass the bomb’ where you hope you’re not the unlucky one and have a £50 note disintegrate in your hands. The central bank will not know how much money to print per year if how many notes and coins usable is wildly unpredictable.

Commonly Accepted: Before a system of money is established, exchange requires a ‘double coincidence of wants’ i.e the person you want something from must also want what you are offering. Money must be something which is valued by all participants, so the lawyer can trade with the wine merchant who can trade with the hairdresser.

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One Response to Money and Monetary Policy

  1. Pingback: Thinktank « Zahablog's Economic Page

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