it deals with interest rate in the financial system

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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 monetary
conditions?
• 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 money
H = 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 bank
Demand for money: determined by private sector
r
Demand / supply for money
r1
M1
Md
= f(P, r, y)
M
s
= M1
What 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 practice
2. 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 index
1921 July 1
1922 July 7
1923 Jan 195
July 5,230
August 66,017
Sept 1,674,755
Oct 496,209,790
Nov 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?