Principles of Macroeconomics
Lecture 7
MONEY AND COMMERCIAL BANKS
CENTRAL BANKING AND MONETARY POLICY
Money

Money is anything that is generally accepted as a
medium of payment.

Money is not income, and money is not wealth.

Money has the following functions:
 Medium
of payment
 Store of value
 Unit of account
Money: Medium of Payment


Barter system: direct exchange of goods and
services for other goods and service
Barter system requires a double coincidence of
needs for trade to take place.

Money eliminates the barter problem.

Money facilitates market transactions.
Money: Store of Value


Money is as an asset that can be used to transport
purchasing power from one time period to another.
Money is easily portable across time and space.
Liquidity


The liquidity property of money makes money the
best medium of exchange as well as a good store
of value.
Money is the most “liquid” asset.
• Currency Debasement: The decrease in
the value of money that occurs when its
supply is increased rapidly.
Money: Unit of Account

Money serves as a unit of account for
 quoting
prices
 keeping books
 calculating debts
Types of Money



Commodity Money: an item used as money that also
has intrinsic value in some other use (e.g., gold &
silver).
Fiat or Token Money: money that is basically
worthless (e.g., coins & bills).
Legal Tender: money that a government requires to
be accepted in settlement of debts (e.g., bills).
Supply of Money


M1 or Transactions Money is money that can be
directly used in transactions.
M1 = currency held outside banks + demand
deposits + plus traveler’s checks + other checkable
deposits
Supply of Money


M2 or Broad Money includes near monies that are
close substitutes for transactions money.
M2 = M1 + savings accounts + money market
accounts + other near monies
Central Banking System


The Central Bank regulates the private banking
system
the Central Bank requires a fraction of any deposit
at a bank to be held at the bank’s account at the
Central Bank; this fraction is called the Required
Reserve Ratio
Functions of the Central Bank

Clearing interbank payments

Regulating the banking system

Assisting banks in difficult financial times

Managing the nation’s foreign exchange rates
and foreign exchange reserves
Functions of the Central Bank


Control of mergers between banks
Examination of banks to ensure that they are
financially sound

Setting the short-term interest rate

Lender of last resort
Commercial Banking: Bank Reserves



Total Reserves = Total deposits at a bank
Required Reserves: A fraction of Total Reserves a
bank must hold at the Central Bank by law
Excess Reserves: The rest of Total Reserves that a
bank can use for loans
Commercial Banking: Money Creation

Banks usually use up their Excess Reserves to
make loans.
Excess Reserves  Total Reserves  Required Reserves
Commercial Banking: Money Creation

Assume Jim deposits €100 of newly printed
money in his checking account in Bank 1. Also
assume the Central Bank requires 20% in
Required Reserves. Bank 1 can increase its loans
by €80.
 Total
Reserves = 100
 Required Reserves = 20
 Excess Reserves = 80
The Creation of Money
Bank 1 makes an €80 loan and deposits it in the
checking account of a borrower, Andrew, who
uses the loan to buy a good and pays by a check.
The seller, John, deposits the check in his account
in Bank 2:
 Total
Reserves = 80
 Required Reserves = 16
 Excess Reserves = 64
The Creation of Money
Now, Bank 2 makes a €64 loan and deposits it
in the checking account of a borrower, Peter,
who uses the loan to buy a good and pays by a
check. The seller, Steven, deposits the check in
his account in Bank 3:
Total Reserves = 64
 Required Reserves = 12.80
 Excess Reserves = 51.20

The Creation of Money

Now, Bank 3 makes a €51.20 loan and deposits
it in the checking account of a borrower,
Neithan, who uses the loan to buy a good and
pays by a check. The seller, Jennifer, deposits
the check in her account in Bank 4:
Total Reserves = 51.20
 Required Reserves = 10.24
 Excess Reserves = 40.96

The Creation of Money
Summary:
Bank 1
Bank 2
Bank 3
Bank 4
.
.
.
Deposits
100
80
64
51.20
.
.
.
Total
500.00
The Money Multiplier

The multiple by which deposits can increase
for every monetary unit increase in excess
reserves:
1
Money Multiplier =
Required Reserve Ratio
• In this example where the required reserve
ratio is 20%, the money multiplier is 1/0.20 = 5.
It means a €1 increase in excess reserves
could cause an increase in deposits of €5 if
there were no leakage out of the system.
Monetary Policy
the Central Bank uses three instruments to
manage the money supply and interest rates:
The Required Reserve Ratio
 The Discount Rate
 Open Market Operations

The Required Reserve Ratio


If the Central Bank wants to increase the money
supply, it lowers the Required Reserve Ratio.
As a result, banks will have to hold less money
in RR and keep more money in ER. To lend the
additional ER, banks will lower the rate of
interest on business loans.
The Discount Rate


Banks can borrow from the Central Bank. The
interest rate they pay to the Central Bank is the
Discount Rate.
If the Central Bank wants to increase the money
supply, it would lower the discount rate, which
encourages banks to borrow from the Central Bank.
To lend these additional reserves, banks will lower
the interest rate on business loans.
Open Market Operations
These are defined as the Central Bank’s
purchases and sales of government bonds to
member banks.

If the Central Bank wants to increase the money
supply, it would buy government bonds from private
banks. Banks receiving additional reserves from the
Central Bank will lower the interest rate on business
loans.
Open Market Operations
These are the Central Bank’s preferred
means of controlling the money supply
because:


They can be used with some precision.
They are extremely flexible and fairly
predictable.
Easy Monetary Policy

To increase the money supply and reduce the
interest rate, the Central Bank could
 Lower
the required reserve ratio
 Lower the discount rate
 Buy government securities from member banks
The Supply of Money

Md
A vertical money
supply curve says the
Central Bank sets the
money supply
independent of the
interest rate.
Increase in Money Supply
Ms
Md
• An increase in money supply causes
interest rate to fall and investment to rise.
Tight Monetary Policy

To decrease the money supply and reduce
the interest rate, the Central Bank could
 Increase
the required reserve ratio
 Raise the discount rate
 Sell government securities from member banks
Any or a combination of these actions will reduce
the money supply and increased the rate of
interest.
Tight Monetary Policy

To decrease the money supply and reduce
the interest rate, the Central Bank could
 Increase
the required reserve ratio
 Raise the discount rate
 Sell government securities from member banks
Any or a combination of these actions will reduce
the money supply and increase the rate of
interest.
Note: To understand how these tools can affect macro economic
activities, we first view the impact of changes in money
supply.
Factors affecting demand for money:
Factors affecting investment and consumption expenditure
such as: income, interest rate, expectation ..etc.
Factors affecting supply of money:
Factors affecting saving decisions and central bank policy
such as: income, interest rate, macroeconomic conditions
Now assuming all factors are constant except interest
rate, then money demand is inversely related to
interest rate, while money supply is positively related
to interest rate
i
Ms
i
Md
q
Qm
i
Ms
Ms2
i
i2
Md
q
q2
Qm
If the central bank increases the money supply
lower
interest rate
stimulate consumption and investment
expenditure , i.e increases output (other things equal)
Note: This is an expansionary monetary policy that can
be applied to increase output (e.g in case of a
deflationary gap)
Ms2
Ms
i
i2
i
Md
q2 q
Qm
If the central bank reduces the money supply
raise
interest rate
reduced consumption and
investment expenditure , i.e reduce output (other things equal)
Note: This is a contractionary monetary policy that can be
applied to reduce output (e.g in case of an inflationary gap)
If an economy is facing a deflationary gap, the central
bank can increase money supply, i.e applying an
expansionary monetary policy
An expansionary monetary policy tools:
1- Reducing discount rate :
reduce
interest rate
stimulate consumption &
investment expenditure
increase
output
An expansionary monetary policy tools:
2- Reducing RRR :
increase money
supply
lower interest rate
stimulate consumption & investment
expenditure
increase output
3- Buying government bonds :
increase
money supply
lower interest rate
stimulate consumption & investment
expenditure
increase output
If an economy is facing an inflationary gap, the central
bank can reduce money supply, i.e applying a
contractionary monetary policy
a contractionary monetary policy tools:
1- increasing the discount rate :
increase interest rate
lower
consumption & investment expenditure
lower output
A contractionary monetary policy tools:
2- Raising RRR :
reduce money supply
raise interest rate
reduce consumption
& investment expenditure
reduce
output
3- Selling government securities :
lower
money supply
raise interest rate
reduce consumption & investment
expenditure
reduce output
Effect of Money Demand on Output
Effect of Money Demand on Output
Helpful Reading
Economics. Samuelson, & Nordhaus (2005) Ch. 25-26