Money, Central Banking, and
Inflation
Chapter 13
Money
Aspects of Money
1. Medium of Exchange – Token that can be
offered as a payment for goods.
2. Unit of Account – All goods will have a
value in money and, thus, can be used to
measure all goods
3. Store of Value – If money is to be
accepted for goods today it must have
durable value. (Money is an Asset).
Evolution of Money:
Money is a technology
• Commodity Money – Metals (ca.1400 B.C.).
• Minting coins for standardization (ca. 700 B.C.)
• Paper banknotes backed by precious metals
(600 AD in China, 1650 in Sweden)
• Fiat Money Paper declared legal tender (800
AD in China, 1700 in France/USA)
Evolution of Money
In more advanced societies with sophisticated
banking systems, broad money may be used for
transactions.
• Checks: Paper promises to pay definitive money
on demand.
• Electronic Transfers: Funds can be transferred
from account to account in banking system.
• Debit Cards and ATM Cards can be used to
transfer funds to definitive money or in direct
exchange for goods.
Money Supply The stock of the medium of
exchange.
Types of Financial Assets
M1
Currency in Hands of the Public [C] + Demand
Deposits [D]
M2
M1 + Savings Deposits + “Small” Time Deposits +
[Liquid Money Market Instruments inc/ “Small” NCD’s]
M3
M2 + LTD [“Large” Time Deposits and NCD’s]
Hong Kong Guide to Money and Banking Terms
M1 The sum of legal tender notes and coins held by
the public plus customers' demand deposits
placed with banks.
M2 M1 plus customers' savings and time deposits
with banks plus negotiable certificates of deposit
(NCDs) issued by banks held outside the
banking sector.
M3 M2 plus customers' deposits with restricted
licence banks and deposit-taking companies
plus NCDs issued by these institutions held
outside the banking sector.
Monetary Aggregates in HK
8,000,000
7,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
M1
M2
HKMA Monthly Statistical Bulletin
M3
Jan-09
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
0
Jan-85
HK$ Million
6,000,000
Real Balances
MS
P
• Real balances are the purchasing power
of monetary assets, i.e. the money supply
divided by the price level.
• Taking the price level as given, real
balances can be shifted by the central
bank through changes in money supply.
• Taking the money supply as given, real
balances can change through changes in
the price level.
Real Balances and HK Deflation
4100000
4000000
3800000
3700000
3600000
3500000
3400000
ay
-0
Au 0
g00
N
ov
-0
0
Fe
b01
M
ay
-0
Au 1
g01
N
ov
-0
1
Fe
b02
M
ay
-0
2
Au
g02
N
ov
-0
2
Fe
b03
M
ay
-0
Au 3
g03
M
-0
0
3300000
Fe
b
Million HK$
3900000
Money Supply
Real Balances
Liquidity Theory
Money is part of the liquid end of the asset
portfolio. We consider a theory of how this
liquidity is divided up.
1. Liquid Assets (Currency, Checking Accounts,
Savings Accounts) that are useful for
transactions which pay zero or below market
interest rates.
2. Money market assets (Government bills,
commercial paper, jumbo CD’s) that pay a
market rate, i, but which cannot be used for
transactions.
Determinants of Holding Money
• Trade-off: The benefit of holding real
balances is that doing so will make
transactions more convenient. The cost is
that you will earn interest income.
• The greater is the quantity of real
transactions, Y, the more attractive is real
balances.
• The greater is the real interest rate, i, the
less attractive are real balances.
Money Demand
Money Demand
The greater is the
market interest rate,
the greater is the
opportunity cost of
holding money.
i
i*
MD
MS
P
M
P
P
What shifts the money demand curve?
1. An increase in real spending (GDP) will
increase the need for money for
transactions shifting the demand curve
out. A reduction in GDP will shift the
demand curve in.
2. There are also large shifts in money
demand due to liquidity preference
(possibly related to risk level of financial
assets).
Central Banks
What is a central bank?
• Central banks have two main roles:
– Banker to the government
• Manage many financial assets of the government.
• Monopoly on the issue of banknotes/currency (true
almost everywhere, but not HK)
• Arm of government policymaking
– Banker to commercial banks.
• Operate the Payment System
• Regulate Banking System
• Lender of Last Resort during a crisis
• Central Bank:
A special
governmental
organization or
quasigovernmental
institution within
the financial
system that
controls the
medium of
exchange.
Economy
Central Bank
HK
?
USA
?
Eurozone
?
PRC
?
UK,
Canada,
Japan,
Korea
?
The Monetary Base
• The monetary base, also called “high powered
money” consists of:
C Currency in the Hands of the Public
+ R + Reserves of the Banking System
=MB
= Monetary Base
• Monetary base is typically the monetary
liabilities of the central bank.
• A part of the monetary liabilities of a central bank. The
Monetary Base is defined, at the minimum, as the sum of
the currency in circulation (banknotes and coins) and
the balance of the banking system held with the central
bank (the reserve balance or the clearing balance). In
Hong Kong, the Monetary Base comprises Certificates
of Indebtedness (for backing the banknotes issued by
the note-issuing banks), government-issued
currency in circulation, the balance of the clearing
accounts of banks kept with the HKMA (the Aggregate
Balance), and Exchange Fund Bills and Notes.
Hong Kong Guide to Money and Banking Terms
Interbank Payment Systems
• Commercial banks keep accounts at the
central bank for interbank payments.
referred to generally as reserves,
specifically as clearing balances in Hong
Kong.
• These accounts, along with cash,
constitute the monetary base.
Hong Kong Interbank Clearing Limited
Interbank Market
• Individual banks will face a short-fall in reserves if
they have too many outflows and borrow funds
from other banks facing a surplus.
• Banks will keep an inventory of reserves to meet
their own liquidity needs but the interest rate is the
opportunity cost of holding reserves.
• Desire to hold reserves is a declining function of
the interest rate.
• Central bank controls the total supply of reserves
available to banks.
Interbank Market
iIBR
S
i*
D
Reserves
Equilibrium in the Interbank Market
• If interest rates are too low, banks will
want to hold more reserves than available.
Banks facing a shortfall of reserves will be
willing to bid up interest rates until all
banks are content with reserves available.
• If interest rates are too high, banks will
want to lend out their excess reserves. To
do so in a liquid market, they must lower
interest rates.
Equilibrium
iIBR
S
i
i
D
Reserves
Monetary Base and Money Supply
Money Supply vs. Monetary Base
Monetary
Base
*
Money
Multiplier
=
Money
Supply
Fractional Reserve Banking
• Banks keep only a fraction of any deposits
they receive on hand in the form of vault.
The rest is used to acquire other assets,
especially loans.
R
• Reserves- Deposit Ratio: D
The fraction of deposits kept as reserves is
the Reserves-Deposit Ratio.
– D = Deposits (for M1 this is Demand Deposits;
for M2 this is a broader category of deposits).
Liquidity Portfolio
• Savers keep some of their asset portfolio in
liquid assets.
• We can divide up liquid assets into currency and
deposits
C
• Currency-Deposit Ratio: D
– Bank deposits and currency are both assets which
will be part of the portfolios of savers.
Money Supply Multiplier
• The money multiplier can be derived by the ratio
of aggregate money to the monetary base.
C 1
MS C  D
D
mm 


MB C  R C  R
D
D
• As long as the reserve ratio is less than 1, the
money multiplier is greater than 1.
• Multiplier is decreasing in reserve-deposit ratio
and decreasing in cash-deposit ratio.
Determinants of Reserve Ratio
1. Regulatory Requirements – Some regulatory
regimes have minimum reserve levels.
Reserve Ratio =
Required Reserves Ratio + Excess Reserves Ratio
(R/D) = rr + ER/D
2. Volatility of Deposit Outflows – If deposit outflows are
likely to be large, banks hold more reserves.
Monetary Feedback
Reserves
Central Bank
rd
Banks
Cash
Borrower
Depositor
Monetary Feedback
Central Bank
Reserves
rd
Banks
Cash
Borrower
Depositor
Monetary Feedback
Central Bank
Reserves
rd
Banks
Cash
Borrower
Depositor
Central Bank and Money Supply
• The central bank can adjust the stock of
reserves through transactions with
commercial banks.
• An increase in reserves will increase the
deposits that banks can accept and will
have a multiple impact on overall money
supply.
Money Demand
Money Demand
i
i*
MD
MS
P
M
P
P
Equilibrium in the Money Market
• If interest rates are too high, excess supply of
money:
– people will want to buy interest paying assets like
bank accounts or treasury bills.
– Bond dealers and banks can reduce the interest
rates they are willing to offer
• If interest rates are too low, excess demand for
money:
– people will want to sell interest paying assets like
bank accounts or treasury bills to get more liquidity.
– Bond dealers and banks must raise interest rates.
Open Market Operations
• In an Open Market PURCHASE, the central
bank purchases government securities from
banks and credits their reserve accounts. This
increases the aggregate supply of reserves.
• In an Open Market SALE, the central bank sells
government securities from banks and debits
their reserve accounts. This increases the
aggregate supply of reserves.
Money Supply and Interest Rates
• If the central bank engages in an open market
PURCHASE, they will increase the reserve
holdings of counter-party commercial banks.
• This will increase liquidity in the reserve funds
market.
• Banks with excess reserves can lend them out
creating more liquid bank deposits.
• Increase in liquid bank deposits will increase
money supply. More liquid money market
reduces interest rates.
Reserve Market/Money Market
Reserve Market
S S'
iIBR
i*
Money Market
i**
D
i
Reserves
MS
MS
P

P
i*
i**
MD
M
P
P
Ju
l-0
No 1
v0
M 1
ar
-0
2
Ju
l-0
No 2
v0
M 2
ar
-0
3
Ju
l-0
No 3
v0
M 3
ar
-0
4
Ju
l-0
No 4
v0
M 4
ar
-0
5
Ju
l-0
No 5
v0
M 5
ar
-0
6
Ju
l-0
No 6
v0
M 6
ar
-0
7
Fed Funds & Money Market Rates
6.000
5.000
4.000
3.000
2.000
1.000
0.000
Fed Funds
NCD
CP-Fincl
CP-NonFincl
Tbill
Money Markets and Interest Rate
Policy
Money Market: GDP Rises
i
MD
MS
P
P
i**
2
i*
1
Y↑
M D/
M
P
Money Demand and Reserve Markets
• If demand for money rises, households will
want to hold more money. They will pull
funds from non-liquid instruments (like
jumbo CD’s) and convert them into cash or
liquid deposits.
• Banks will need to hold more reserves to
backup the liquid deposits. This will
increase the demand for reserves.
Inflation
Quantity Theory
• Simplest monetary theory is the Quantity
Theory of Money.
– Purchasing power of money is equal to the
quantity of money (Mt) times the speed of
circulation (V, # of transactions)
– Purchasing power means # of goods (Yt)
multiplied by price per good (Pt)
Moneyt * Velocity = Pt * Yt
Rule of Thumb
• Rule of Thumb The growth rate of product
is approximately equal to the sum of the
growth rates of the elements of a product.
Zt  X t  Yt  g  g  g
Z
t
X
t
Y
t
Z t  Z t 1
g 
Z t 1
Z
t
Money and Inflation
• Assuming stable velocity
g  g  t
M
t
Y
t
t  g
P
t
• Inflation occurs when money growth
speeds ahead of output growth. The
unbounded creation of fiat money leads to
inflation which ultimately will make the
money worthless.
Money & Inflation: 1975-1994
Inflation & Money OECD Countries
0.2
0.18
Average Inflation Rate
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.02
0.04
0.06
0.08
0.1
0.12
Average Money Growth
0.14
0.16
0.18
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be
made before future inflation is known so
they must be made on the basis of an ex
ante (predicted) real interest rate.
• Fisher Hypothesis: Ex ante real interest
rate is determined by forces in the
financial market. Money interest rate is just
the real ex ante rate plus the market’s
consensus forecast of inflation.
it  rt  
EA
FORECAST
t 1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Great Inflation Download
Fisher Effect: OECD Economies
Great Inflation of 1970’s
20
18
Interest Rates-1984
16
14
12
10
8
6
4
2
0
0
2
4
6
8
10
12
Average Inflation 1970-1984
14
16
18
Loanable Funds Market
Fisher Effect
S
i*
r*

 tE1
E
t 1
LF*
D
LF
Ex Ante vs. Ex post
• We can also examine the ex post real
return on a loan as the money interest rate
less the actual outcome for inflation.
rt
ExP
 it  
ACTUAL
t 1
• The gap between actual and forecast
inflation determines the gap between the
ex post (actual) and ex ante (forecast)
return.
ExP
ExA
FORECAST
ACTUAL
rt
 rt
  t 1
  t 1
Unexpected Inflation
Winners and Losers
– Higher than expected inflation means ex
post real rates are lower than ex ante.
Borrowers are winners/lenders are
losers.
– Lower than expected inflation means ex
post real rates are higher than ex ante.
Lenders are winners/borrowers are
losers.
Inflation Risk
• When inflation is variable, lenders will
demand some premium for inflation risk.
This will put cost on borrowers.
• High inflation rates tend to be associated
with unpredictable inflation.
Costs of Anticipated Inflation
• Shoe Leather Costs – Money is a technology for
engaging in transactions. The greater is inflation,
the greater the cost for individuals of holding
money. Individuals must make efforts as a
substitute for the convenience of holding money.
• Menu Costs – Firms must engage in costs of
changing posted prices. More generally, when
prices change rapidly over time, more time and
effort must be put into calculating relative prices.
The Inflation Tax
• Banknotes do not pay interest.
• The real interest rate on banknotes is
rt
CASH
  t 1
• If inflation is high, currency has sharply
negative returns. People will avoid holding
money leading to society losing the
convenience of money transactions.
•Zimbabwe Inflation Download
Causes of Extremely Rapid Inflation
• Government generates revenues by printing
new money (referred to as seignorage).
• Government facing borrowing constraints
may be forced to rely on inflation tax for
deficit financing and real returns to owning
money.
• Explain the link between deficits and inflation.
19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
Israel 1970-1990
Inflation
400
350
300
250
200
150
100
50
0
Israel 1970-1990
Surplus (% of GDP)
5.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
0.00%
Money Market at ZIRP
MD
r
0
-πt+1
P
When nominal interest rate
reaches zero, demand for
money turns infinite since
money pays just as good
an interest rate as bonds.
M
P
Learning Outcomes
Students should be able
• Calculate the relationship between
expected inflation, real and nominal
interest rate.
• Calculate the relationship between the
money supply, multiplier and base.
• Use the model of money market to
describe the impact of events on
equilibrium outcomes.