Monetary Economics

ECON-4803

Topic: Introduction about Monetary Economics

Dilara Jahan
Lecturer
Department of Economics
Faculty of Arts and Social Science

Bangladesh University of Professionals

Cell: 01769021915
Email: [email protected]
 Overview of Macroeconomics

 Macro vs micro
 National Income, GDP, GNP, Differences between GDP &
GNP
 Unemployment, Types of Unemployment, Full employment
concept.
 Inflation, Types of Inflation, Causes of Inflation, Impact of
Inflation on Social life.
 Growth, Transition from economic growth to Human Capital
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 The Heritage of Monetary Economics
• The heritage of current monetary theory lies in two different sets
of ideas: the classical and the Keynesian. This heritage
includes both the microeconomic and macroeconomic aspects
of monetary economics.
• The monetary aspects of the traditional classical approach were
encapsulated in the quantity theory for the determination of the
price level and the loanable funds theory for the determination
of the interest rate. The statement of the quantity theory was an
evolutionary one, with several – at least three – quite distinct
approaches to the role of money in the economy.
 Definition of Monetary Economics
• The Keynesian approach discarded the quantity theory and
integrated the analysis of the monetary sector and the price level
into the complete macroeconomic model for the economy. For the
monetary sector, it elaborated on the motives for holding money,
leading to the modern approach to the analysis of the demand for
money.
• Monetary economics is about the relationship between real and nominal
variables. Its aim is to develop and test models that can help in evaluating
the effects of policy on inflation, employment, nominal and real interest
rates and production. We start with some evidence on the relationship
between nominal and real variables and then describe some of the
questions that occupy monetary economics.
Why does study Monetary Economics as a separate subject?

• ‘Money buys goods and goods buy money but in a monetary economy
goods do not buy goods. Really, without money the world would not go
around.’ -Professor Bob Clower.
• Monetary economics is concerned with the effects of monetary
institutions and policy on economic variables including commodity
prices, wages, interest rates, quantities of employment, consumption, and
production.
• So, the study of monetary economics enables us to understand not just
how an economy functions efficiently but also how monetary policy can
help the economy adjust from one state to another and how it can find
balance and grow.
 What is money and what does it do?
• Money is not itself the name of a particular asset. Since the assets which function
as money tend to change over time in any given country and among countries, it
is best defined independently of the particular assets that may exist in the
economy at any one time.
• At a theoretical level, money is defined in terms of the functions that it performs.
The traditional specification of these functions is:
1. In a modern context, in which transactions can be conducted with credit cards, it
is better to refer to it as the medium of (final) payments.
2. Store of Medium of exchange/payments. This function was traditionally called
the medium of exchange value, sometimes specified as a temporary store of
value or temporary abode of purchasing power.
3. Standard of deferred payments.
4. Unit of account.
 What is money and what does it do?
• Of these functions, the medium of payments is the absolutely essential
function of money. Any asset that does not directly perform this function –
or cannot indirectly perform it through a quick and costless transfer into a
medium of payments – cannot be designated as money. A developed
economy usually has many assets which can perform such a role, though
some do so better than others.
• The particular assets that perform this role vary over time, with currency
being the only or main medium of payments early in the evolution of
monetary economies.
• It is complemented by demand deposits with the arrival of the banking
system and then by an increasing array of financial assets as other
financial intermediaries become established.
 Definition of money
• Money is that good which serves directly as a medium of payments.
• In financially developed economies, this role is performed by currency
held by the public and the public’s checkable deposits in financial
institutions, mainly commercial banks, with their sum being assigned the
symbol M1 and called the narrow definition of money. The checkable or
demand deposits in question are ones against which withdrawals can be
made by check or debit cards. Close substitutes to money thus defined as
the medium of payments are referred to as near-monies.
 Definition of money
• An empirical answer to the definition of the money stock is much more
eclectic than its theoretical counterpart. It could define money narrowly or
broadly, depending upon what substitutes to the medium of payments are
included or excluded.
• The broad definition that has won the widest acceptance among economists is
known as (Milton) Friedman’s definition of money or as the broad definition
of money. It defines money as the sum of currency in the hands of the public
plus all of the public’s deposits in commercial banks. The latter include
demand deposits as well as savings deposits in commercial banks.
• Friedman’s definition of money is often symbolized as M2, with variants of
M2 designated as M2+, M2++, or as M2A, M2B, etc. However, there are now
in usage many still broader definitions, usually designated as M3, M4, etc.
 Money supply and money stock
• Money is a good, which, just like other goods, is demanded and supplied by
economic agents in the economy. There are a number of determinants of the demand
and supply of money.
• The most important of the determinants of money demand are national income,
the price level and interest rates, while that of money supply is the behavior of
the central bank of the country which is given the power to control the money
supply and bring about changes in it.
• The equilibrium amount in the market for money specifies the money stock, as
opposed to the money supply, which is a behavioral function specifying the amount
that would be supplied at various interest rates and income levels. The equilibrium
amount of money is the amount for which money demand and money supply are
equal.
 Money supply and money stock
• The money supply and the money stock are identical in the case where the money
supply is exogenously determined, usually by the policies of the central bank.
• In such a case, it is independent of the interest rate and other economic variables,
though it may influence them.
• Much of the monetary and macroeconomic reasoning of a theoretical nature assumes
this case, so that the terms “money stock” and “money supply” are used
synonymously. One has to judge from the context whether the two concepts are
being used as distinct or as identical ones.
• The control of the money supply rests with the monetary authorities. Their policy
with respect to changes in the money supply is known as monetary policy.
 Nominal versus the real value of money
• The nominal value of money is in terms of money itself as the measuring
unit. The real value of money is in terms of its purchasing power over
commodities. Thus, the nominal value of a $1 note is 1 – and that of a
$20 note is 20.
• The real value of money is the amount of goods and services one unit of
money can buy and is the reciprocal of the price level of commodities
traded in the economy. It equals 1/P where P is the average price level in
the economy.
• The real value of money is what we usually mean when we use the term
“the value of money.”
Money and bond markets in monetary macroeconomics
• The “money market” in monetary and macroeconomics is defined as the market
in which the demand and supply of money interact, with equilibrium representing
its clearance. However, the common English-language usage of this term refers to
the market for short-term bonds, especially that of Treasury bills. To illustrate this
common usage, this definition is embodied in the term “money market mutual
funds,” which are mutual funds with holdings of short term bonds. It is important
to note that our usage of the term “the money market” will follow that of
macroeconomics. To reiterate, we will mean by it the market for money, not the
market for short-term bonds.
• The usual custom in monetary and macroeconomics is to define “bonds” to cover
all nonmonetary financial assets, including loans and shares, so that the words
“bonds,” “credit” and “loans” are treated as synonymous. Given this usage, the
“bond/credit/loan market” is defined as the market for all non-monetary financial
assets.
 Financial Innovation
• Financial innovation has been extremely rapid since the 1960s. It has included
technical changes in the servicing of various kinds of deposits, such as the
introduction of automatic teller machines, telephone banking, on-line banking
through the use of computers, etc. It has also included the creation of new assets such
as Money Market Mutual Funds, etc., which are often sold by banks and can be
easily converted into cash.
• There has also been the spread first of credit cards, then of debit or bank cards,
followed still more recently by the attempts to create and market “electronic money”
cards – sometimes also known as electronic purses or smart cards.
 Financial Innovation
• Further, competition among the different types of financial intermediaries in
the provision of liabilities that are close to demand deposits or are readily
convertible into the latter, increasingly by telephone and online banking, has
increased considerably in recent decades. Many of these innovations have
further blurred the distinction between demand and savings deposits to the
point of its being only in name rather than in effect, and also blurred the
distinction between banks and some of the other types of financial
intermediaries as providers of liquid liabilities.
• This process of innovation, and the evolution of financial institutions into
an overlapping pattern in the provision of financial services, are still
continuing.
 Financial Innovation
• Credit cards allow a payer to pay for a purchase while simultaneously acquiring a
debt owed to the credit card company. However, their usage reduces the need for the
purchaser to hold money and reduces the demand for money.
• Debit cards are used to pay for purchases by an electronic transfer from the buyer’s
bank account, often a demand deposit account with a bank. They replace the need to
make payments in currency or by issuing a check. Therefore, they reduce currency
holdings. They also reduce payments by checks. However, they do not obviate the
need to hold sufficient balances in the bank account on which the debit is made.
They are expected to have a very limited impact on the holding of deposits, which
could increase or decrease.
 Financial Innovation
• Electronic transfers are online transfers made over the Internet. They reduce the need
to use checks for making payments. However, electronic transfers may not affect
deposits in banks, or do so marginally due to better money-management practices
afforded by on-line banking.
• Smart cards embody a certain cash value and can be used to make payments at the
point of purchase. Given the increasing prevalence of online banking and debit cards,
smart cards are likely to be mainly used for small payments, as in the case of
telephone cards, library photo-copying cards, etc. Smart cards reduce the need to
hold currency and reduce its demand.
 Financial Innovation
• Therefore, financial innovations in the form of debit and smart cards reduce currency
holdings rather than demand deposits. Financial innovations in the form of online
transfers facilitate the investment of spare balances, which at one time may have
been held in savings deposits, in higher-interest money market funds, etc., thereby
reducing the demand for savings deposits.
• In recent decades, the reduction in brokerage fees for transfers between money and
nonmonetary financial assets (bonds and stocks) and the Internet revolution in
electronic banking have meant a reduction in the demand for money. Part of this is
due to a reduction in the demand for precautionary balances held against unexpected
consumption expenditures. This reduction has taken place because individuals can
more easily and at lower cost accommodate unexpected expenditure needs by
switching out of other assets into money.
 Monetary base and the monetary base multiplier
• The money supply is related to the monetary base – sometimes called the reserve
base –by the monetary base multiplier. Since this multiplier is greater than one, the
monetary base is also known as high-powered money. We will use the symbol M0
for it. Its generic definition is:
 M0=Currency in the hands of the non-bank public + currency held by the commercial banks +
reserves held by the commercial banks with the central bank.
 M1= M0+ demand deposits + traveler’s checks + (checking) assets widely used for transactions +
other checkable deposits
 M2 = M1 + savings accounts + money market accounts + other near monies
• M1(transactions money ) is a stock measure—it is measured at a point in time—on a specific
day. The main advantage of looking at M2(Broad money) instead of M1 is that M2 is
sometimes more stable.
• For any given definition of money, the “monetary base multiplier” is defined as ∂M/∂M0. If
the value of this multiplier is constant or a function of a small set of variables, the central
bank may be able to control the money supply by changing the monetary base.
Monetary base and the monetary base multiplier
• However, our remarks on the instability of the money demand function in recent
decades imply that this multiplier is definitely not a constant or even a stable
function of a small set of variables because of extensive financial innovation, so that
the central bank’s control over the monetary base has not ensured a similar degree of
control over the money supply.
• The monetary base (to money) multiplier needs to be distinguished from the “money
(to nominal income) multiplier,” which is defined as ∂Y /∂M, where Y is nominal
national income. Since Y ≡ MV, where V is the velocity of money, the money
multiplier equals V. This multiplier is normally not a constant but, at the minimum, is
a function of several variables, including the interest rate. This function may, or may
not be, also unstable.
• Therefore, the central bank’s control over the monetary base need not ensure a high
degree of control over nominal income because of the instability of the monetary
base multiplier or the instability of the velocity of circulation of money, or both.
Interest rates versus money supply as the operating target of
monetary policy
• Central banks may exercise control over the economy’s interest rates, in addition to
the money supply or, in its place, as their monetary policy instrument. If the money
supply is used as the primary instrument, the economy’s interest rates will change in
response to the central bank’s changes in the money supply and will be endogenous.
• If the interest rates are used as the primary monetary policy instrument, the economy’s
money demand will change in response to the changes in interest rates. In this case, if
the money market is to maintain equilibrium, the central bank has to accommodate the
change in money demand by appropriate changes in the money supply, so that the
money supply will become endogenous.
• While the choice between the money supply and the interest rates can be trivial under
certainty and a stable money-demand function, it is not likely to be trivial under
uncertainty and an unstable money-demand function, so that central banks are forced
to make choices between the two alternatives.
Financial intermediaries and the creation of financial assets

• Financial intermediaries are institutions that intermediate in the financial process

between ultimate borrowers and ultimate lenders in the economy.
• The ultimate borrowers include
(a) Consumers who need to borrow to finance part or all of their consumption,
(b) Firms that borrow to invest in physical capital, and
(c) The government when it borrows to finance its deficits.
• The ultimate lenders are the economic units that save part of their current income
by spending less than their current income on their purchases of commodities and
want to lend some or all of these savings to others for some duration. Householders
form the major bulk of the ultimate lenders, saving part of their current income.
Financial intermediaries and the creation of financial assets

• Financial intermediaries borrow from the ultimate lenders or from other

intermediaries by issuing their own liabilities in exchange and re-lend to others by
accepting the latter’s liabilities. In the modern economy, only a small proportion of
the savings is directly transferred from the savers to the ultimate borrowers.
• Most of the savings are directed by the savers to financial intermediaries such as
banks, mutual funds, pension funds, insurance companies, etc., which re-channel the
funds thus obtained to firms and the government, either directly by buying their
shares and bonds or indirectly through other financial intermediaries such as
investment banks.
Financial intermediaries and the creation of financial assets

• Banks are financial intermediaries that borrow from the public by inviting demand
and time deposits or issuing their own securities and hold the liabilities issued by
others. Their existence is a superb example of asset transmutation through financial
intermediation. The main liabilities of banks are deposits which are virtually riskless
to the depositors since they are payable on demand or after a short specified notice.
In short, they are highly liquid.
• By contrast, the assets held by the banks are government securities, loans to the
public, etc., possessing some risk of loss and, as with loans, a limited degree of
marketability or encashment at short notice. Therefore, the assets issued by the banks
are much more liquid than the assets held by them. Conversely, the return paid by the
banks on the former is less than the return that the banks earn on the latter.
 Multiple creation of financial assets
• All financial assets are “created” and have no intrinsic physical existence but are the
liabilities of some economic unit or other. They may be examined in terms of their
characteristics, especially in terms of their yield or expected yield, risk of loss,
marketability, maturity and so on.
• Anyone purchasing a financial asset may be thought of as purchasing a particular set
of characteristics, such as risk and marketability etc., in exchange for a specified
expected yield on the asset.
• Financial intermediaries cater to this demand through the creation of assets with
differing combinations of characteristics. For many pairs of assets, it is feasible for
some intermediary to create a third asset that offers a mix of the characteristics of the
original two assets, so that the multiplicity of differentiated assets is a common
outcome of unregulated financial intermediation.
 Multiple creation of financial assets
• Financial intermediaries typically issue assets with more desirable characteristics for
lenders than do the ultimate borrowers, persuading the latter to hold the liabilities of
the intermediaries. In turn, the intermediaries use the funds obtained from the sale of
their liabilities to purchase the liabilities of other borrowers which pay a higher
expected net yield, thus covering the expenses of intermediation and making a profit
in the process.
• Financial intermediaries permeating an unregulated economy lead to a multiplicative
creation of their liabilities. To illustrate, consider an economy in which everyone is
willing to hold the asset A issued by a given intermediary. Now assume that an
ultimate lender saves $100 and exchanges it for the asset A. The intermediary
transfers (lends) the $100 to another individual B, who transfers them in some way,
such as through consumption or investment expenditures, to a third individual C.
 Multiple creation of financial assets
• The last individual again exchanges the $100 of funds for the assets issued by the
intermediary. Suppose these are the only transactions that take place in a given
period and there are no leakages at any point. Then, the intermediary, for an initial
$100 lent to it, has created $100 of its liabilities. The amount created over n periods
will be $100n and will approach infinity over time.
• The implication of this example is clear: the multiplicative creation of the liabilities
of financial intermediaries is inherent in an economy in which these liabilities are
widely held. The extent of this creation is limited by the leakages out of the recycling
process. Thus, if individual C had only deposited $50 of resources with the
intermediary and retained the remainder in his storage, the recycling process would
have had a leakage of $50 (or 50 percent). The total assets created by the
intermediary in the period would be worth only $50 and only $100 over time.
 The Modern Banking System
• Assets are things a firm owns that are worth something. A bank’s assets are its loans,
cash in hand, and reserve deposits at the Federal Reserve.
• Liabilities are the firm’s debts—what it owes. A bank’s liabilities are deposits owed
to customers.
• Banks are legally required to hold a certain minimum percentage of their deposit
liabilities as reserves. The percentage is the required reserve ratio.
• A brief review of accounting: Assets – liabilities / Net Worth, or Assets / Liabilities +
Net Worth
• A bank’s most important assets are its loans. Other assets include cash on hand
and deposits with the Fed. A bank’s liabilities are its debts—what it owes.
Deposits are debts owed to the bank’s depositors.
 The Modern Banking System
• Reserves are the deposits that a
bank has at the Federal Reserve
bank plus its cash on hand. The
required reserve ratio is the
percentage of its total deposits that
a bank must keep as reserves at
the Federal Reserve.
• T-Account for a Typical Bank:
The balance sheet of a bank must
always balance, so that the sum of
assets (reserves and loans) equals
the sum of liabilities (deposits and
net worth).
 Commercial Banks
Functions of Commercial Banks
• Accepting deposits
• Lending money
• Other banking services
• Money creation
Money creation
• Required reserve ratio (RRR): percentage of deposits that is required by
the central bank to keep as reserves.

 Example: if RRR=10% , of an initial deposit = KD100

Required reserves = 100 * 10% =10
Excess reserves = 100 -10 = 90

• Total Reserve = Required reserves + Excess reserves

 Distinctive role of banks as financial intermediaries
• Banks are not the only financial intermediaries in the economy. But they are the most
widespread and their liabilities are so widely demanded that the multiple creation of
their liabilities is both the greatest and the most widely recognized. Banks, accepting
demand and time deposits, differ from other financial intermediaries in that their
liabilities are readily acceptable and are liquid since demand deposits are a medium
of payments and hence a form of money.
• Further, another of their liabilities, time deposits, is a very close substitute for
currency and demand deposits. By comparison, the liabilities of non-bank financial
intermediaries are not directly a medium of payments, nor are they perfect substitutes
for it. This special role of the liabilities of banks in the economy makes the banks a
rather distinctive type of financial intermediary and makes a study of their behavior
and reaction to monetary policy especially important.
 Fragility of the financial system
• The financial system is said to be fragile in the sense that it is prone to crisis. The
reasons for this include banks’ reliance on fractional reserves and asset transmutation.
Since they hold only a small part of their liabilities, mainly deposits, in reserves
(currency holdings and deposits with the central bank), they are not able to refund these
deposits if the depositors wish to suddenly and simultaneously try to withdraw a
considerable fraction of deposits. Such a withdrawal from a bank is known as a “run” on
the bank and its most visible manifestation is long lines of depositors waiting to enter the
bank to make their withdrawals.
• Asset transmutation means that banks’ liabilities have a much shorter maturity than their
assets. In the case of a run on the bank, if the bank tries to sell its assets at short notice it
is likely to incur a loss over the amount that it would get if it held the assets to maturity
or could sell them at a more opportune time. Also, note that a considerable part of the
assets held by banks are in the form of non-marketable loans, which are difficult to
convert into cash at short notice.
Thank you.