Money, Central Banking, and Inflation
Chapter 25, 31
Money
Aspects of Money
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).
1.
Evolution of Money
In more advanced societies with sophisticated
banking systems, broad money may be used for
transactions.
 Currency: Paper assets issued by central bank
 Checking Accounts: Paper promises to pay definitive
money on demand.
 Savings Accounts: Electronic Transfers, Credit Cards,
Debit Cards and ATM Cards can be used to transfer
funds to.
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]
M3
M2
M1
2011/04
2010/10
2010/04
2009/10
2009/04
2008/10
2008/04
2007/10
2007/04
2006/10
2006/04
2005/10
2005/04
2004/10
2004/04
2003/10
2003/04
Billion Yen
Japan’s Money Supply
12000
10000
8000
6000
4000
2000
0
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
 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.
M
P
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*
M 
 P
MS
D
M
P
P
What shifts the money demand curve?
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).
1.
Central Banks
 Central Bank:
A special
governmental
organization or
quasi-governmental
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.
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
Ch. 31, 759-768
Supply
i*
Demand
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*
i
D
Reserves
Monetary Base and Money Supply
Fractional Reserve Banking & the
 Banks keep only a fraction of deposits on reserve.
→ each reserve dollar of base money backs up
multiple levels of broad money.
Hong Kong Montary Statistics November 2011
4,500,000
4,000,000
Millions of HK$
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
Monetary Base
M3
Money Supply vs. Monetary Base
Monetary
Base
*
Money
Multiplier
=
Money
Supply
Money Supply Multiplier
 The money multiplier can be derived by the ratio of
aggregate money to the monetary base.
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.
C
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 Market EQUILIBRIUM
Money Demand
i
i*
M 
 P
MS
D
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.
 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.
Money Market: GDP Rises
i
M 
 P
D
MS
P
i**
2
i*
1
Y↑
D
M  
 P
M
Interbank Market
iIBR
i**
Supply
Y↑
i*
Demand'
Demand
Reserves
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.
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 reduces 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
M S
P
P
i*
i**
M 
 P
M
P
D
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 Market at ZIRP
i
0
M 
 P
D
M
P
When nominal interest rate reaches
zero, demand for money turns infinite
since money pays just as good an
interest rate as bonds.
Liquidity Trap
i
MD
P
MS
P
M S
P
M S 
P
i*
i**
M
P
0
When nominal interest rate reaches zero,
increases in the money supply will not
reduce the level of the interest rate.
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.
Z t  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.
Dynamic AS-AD Model: Trend Path
YtP
P
ASt
YPt+1
ASt+
1
P*t+1
Pt*
Demand
expansion
matches
supply
expansion
Average
Inflation
ADt+1
ADt
Yt*
Y*t+1
Y
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
Costs of steady 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.
Learning Outcomes
Students should be able
 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.