Money and Monetary Policy
The Money Market
“Behind everything is money”.
(Milton Friedman)
Money: What it does?
Three main functions of money.
1. Unit of account. Everything in
economic life can be measured by
money.
2. Store of value. You can hold your
wealth as money.
3. Medium of exchange. Money
allows us to carry on purchasing
transactions.
Money: What it Is?
Money = everything used as a tool for
exchange
Historical development:
 Natural exchange.
 Commodity money: Many things have been money
over the centuries: cattle, stones, beads, iron, copper,
zinc, cigarettes, silver and gold, ...
Gold and silver hold a place of special importance.
Why? Because they have qualities which are important for
any useful commodity money:





are relatively scarce,
have a high value for unit of mass,
are easily divisible,
are durable and easily worked,
are considered rather valuable themselves.
Gold standard
 Up until quite recently, gold was money.
 1933 - the United States went off the
domestic gold standard. Gold was stored in
government vaults, and in it's place people
were issued paper money which was
"backed" by gold or silver on a one for one
basis.
 1973 - the U.S. left off the international
gold standard.
 This meant that gold and silver no longer had any
monetary role whatever. They became (and remain)
„normal” industrial commodities.
If money is no longer gold or silver--or even
"backed" by gold or silver, what is it?
The main feature of money is that money have
a certain level of liquidity.
 Liquidity is a measure of how quickly an
assets can turn into cash.
 Liquid asset - asset which can be turned
into cash quickly and without capital loss or
interest loss.
Money groups according to liquidity
High
Liquidity
Money aggregates
 Transaction money M1:
 Currency (paper bills and coins) is obviously
the most liquid of all assets.
 Checking accounts (current accounts) are
nearly as liquid as currency. With the advent of
debit (or check) cards, it is simple to spend
from the balances in you checking account.
 Broad money M2:
 M1 (currency and checking accounts)
 + deposits in saving accounts (short time)
 Aggregate M3:
 M2 + shares of money market, deposits in
saving accounts (long time) …, etc.
Low
Monetary Policy
Monetary policy is the process of
managing a nation's money supply to
achieve specific goals.
Main participant: Central Bank (Czech
National Bank, Federal Reserve Bank, the
Bank of Canada, State Bank of
Namibia….)
 Who controls central banks and determines
their actions?
 What motivates their behavior?
Central Bank – “Bank of banks”
Functions:
 Fights against inflation.
 Promotes the efficiency of finance system.
 Ensures financial system stability.
Main Central Bank’s clients:
 Commercial banks:
 Transaction execution between banks.
 Control of their assets and their performance.

The government:
 Keeps it’s accounts.
 Accumulates tax-income.

Other central banks.
Monetary Policy Goals

Steady economic growth: Goal of steady economic
growth closely related to high employment goal, as firms
will invest more when unemployment is low.

High employment: If unemployment is high, economy
has unused workers and unused resources which results in
loss of output and lower GDP levels.

Price stability: Price stability increasingly viewed as the
most important goal of monetary policy. Inflation
(increasing price level) creates uncertainty in an economy
and leads to slowdowns in economic growth.

Interest rate stability: Fluctuations in interest rates can
create uncertainty in the economy, making it harder to plan
for future (for households or firms).
Monetary Policy Goals
5. Stability of financial markets: financial crisis causes
recessions.
 Financial crises decreasing investment opportunities, therefore
decreasing real GDP,
 Stability of financial markets also support by interest rate
stability… as interest rate uncertainty is a main concern for
financial institutions.
6. Stability of foreign exchange: value of CZK (Euro, US
dollar) affects competitiveness of Czech (European, US)
goods and services in the international economy.
 Value of the CZK relative to other currencies is also a major
consideration for the Czech National Bank.
 Rise in value of CZK makes Czech firms less competitive.
 Decline in value of CZK stimulates inflation in the CR.
Demand for money
 The demand for money is related with peoples intensions
to hold (save) or spend the money.
 There are three reasons why people wish to save/spend:
 Transactions demand: demand for day-to-day money by
firms and households for buying goods and services.
 Precautionary demand: demand for money by firms and
households caused by the wish to save money in case of
unexpected.
 Speculative demand: this is demand for money as financial
asset for investment opportunities.
Demand for money



Changes in the money
supply will result is shifts
in the supply of money in
the money market,
changing the interest
rate.
An increase in the money
supply will cause the
interest rate to go down.
A decrease in the money
supply will result in an
increase in the interest
rate.
i
0
M
How much money should be in the
economy?
 The theory by Irving Fischer:
MV  PT


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M-money in circulation,
V-velocity of circulation,
P-average price level in transactions made,
T-number of transactions.
Two types of Monetary Policy
 Expansive
 Restrictive
Sm1
Sm
Sm2
i
E1
E
E2
Dm
0
Q1
Q
Q2
M
Monetary Policy and Real GDP
 A change in the interest rate would
affect both investment and
consumption expenditures.
 The higher interest rate is, the more
economical agents tend to save money,
either to spend them.
Recall that:
Agg. Exp. =C+Ig+G+Xn
Tools of the monetary policy




Direct and Indirect tools
Long-term and Short-term tools
Current and Exceptional tools
etc.
A. Direct (administrative) tools
= tools limiting and influencing market banking sector
market.
These tools are used as exceptional and short term:
 Mandatory structure of assets and liability for
commercial banks.
 Credits, loans limits. One of the most tough direct
tool.
 Obligatory deposits – obligation for state
institutions to have account at the central bank (for
example revenues authorities, ministries, etc.).
 Gentleman's agreements between central bank
commercial banks
B. Indirect tools of the Central Bank
Tools are influencing all participants of
financial market; they could be used
without time limitation.
Basic tools:
 Setting the Discount Rate
 Reserve Requirements
 Open Market Operations
 Foreign exchange market operations
Discount Rate
 This is the interest rate the CB charges to banks that
borrow funds from the CB (bank rate). Serves as a signal
to the public about its intentions over monetary policy.
 ↑ discount rate > raise price of money > commercial
banks are lending lower amount of money > money are
„suck out“ from economy > money circulation slow down
– (anti-inflation) restrictive monetary policy;
 ↓ discount rate > reduce price of money > commercial
banks are lending higher amount of money > money are
„suck in“ economy > money circulation speed up –
expansive monetary policy
Required Reserves (RR)
 This is the ratio of reserves to deposits required by law.
RR is very powerful and affects all banks equally (as
small change results in a large change in money supply).
So, cannot be used for fine tuning (small changes in MS
– money supply).
 ↑ RR raise price of money > money are „suck out“ from
economy > money circulation slow down – (antiinflation) restrictive monetary policy;
 ↓ RR > reduce price of money > money are „suck in“
economy > money circulation speed up – expansive
monetary policy
Open Market Operations
Central national bank buying and selling of bonds (e.g.
government securities) in the open market.
 NB sells bonds, commercial banks pay money to the NB,
decreasing the bank’s reserves. This is called an open
market sale.
 CB´s buy bonds > raise price of money > money are „suck
out“ from economy > money circulation slow down –
(anti-inflation) restrictive monetary policy;
 NB buys bonds, the NB pays money to the commercial
banks, increasing the bank’s reserves. This is called an
open market purchase (OMP).
 CB´s sells bonds > reduce price of money > money are
„suck in“ economy > money circulation speed up –
expansive monetary policy
Foreign exchange market operations
 National Bank influences the national currency exchange
rate by using the direct market interventions.
 When the market experiences the lack of foreign
currency > the exchange rate tend to rise > the national
currency becomes cheaper > the CB enters the market
and sells it’s foreign currency reserves therefore
supporting the exchange rate.
 When the exchange rate of national currency tend to
become very high due to the excess of foreign currency
or due to market agent’s expectations > the CB enters
the market and buys the foreign currency, increasing the
demand and therefore the price for foreign currency.
Questions
What would be the effect on the
demand for money M1 of each of
the following:
 An increase in real GDP
 An increase in the price level
 A rise in the interest rate on savings
accounts
 Allowing banks to pay interest on
checking deposits