Money and banking -

Money and banking -

Money and Banking Part II. The Demand for Money The Role of the Central Bank Micro- and macroeconomic Measures of money Cash, by definition, is completely liquid. Sight deposits (chequing accounts) are almost as liquid. Time deposits (savings accounts) used to be less liquid, but now many banks offer automatic transfer between savings and chequing accounts when the

latter run low. Savings deposits are almost as liquid as chequing accounts. Interest / rate of return Liquidity Money is the medium of exchange available to make transactions. Hence, the money supply is cash in circulation outside banks, plus bank deposits. We can think of a spectrum of liquidity: 2 UK monetary aggregates (part 1) Wide monetary base M0

banks cash and their balances with Bank of England = cash in circulation outside banks + retail sight deposits at banks + wholesale sight deposits = money supply M1 (narrow money) + retail deposits and shares in building societies

= money supply M2 3 UK monetary aggregates (part 2) Liquidity + UK private sector time deposits and certificates of deposit = money supply M3 + UK private sector deposits and

shares in building societies Building society holdings of cash, bank deposits and bank CDs = money supply M4 (wide[st]/broad[est] money) Interest / rate of return money supply M1 4 The wide monetary base and narrow money

The figure on the previous slide shows different monetary aggregates and their relation to one another. M0 is the wide monetary base: cash in circulation outside the banks, cash inside banks, and the banks own accounts at the Bank of England (central bank). M0 is the narrowest measure of money. Wider measures begin from cash in circulation. Adding all sight deposits, we get M1, which used to be considered a good measure of narrow money. 5 M2, M3, and M4 (near money and wide money) Augmenting M1 by (UK) private-sector time deposits and CDs gives M3. That used to be considered the

best definition of broad money. M2 is cash in circulation plus retail sight deposits at banks and retail deposits and shares in building societies. M4 is the old M3 plus (UK) private sector deposits and shares in building societies, minus building society holdings of cash bank deposits and bank CDs. 6 Competition between banks Financial deregulation, allowing the entry of more and more banks, has made modern banking very competitive. Banks compete with one another both in the interest rates they offer to attract depositors and in the interest rates they charge

borrowers for loans. WHICH IS THE MOST ATTRACTIVE PROPOSITION? 7 Competition and profits The interest rate spread between the lending rate and the rate paid on deposits is what covers the cost of providing banking services. When spreads exceed this amount, banks make profits. Profits are a signal for new banks to enter, which competes away spreads. With more competition, interest rates on loans fall and rates paid on deposits rise. Rate paid on deposits

Interest rate spread Lending rates 8 The demand for money Money is the medium of exchange, for which it must also be a store of value. These two functions of money provide the reasons why people wish to hold it. People can hold their wealth in various forms money, bills, bonds, equities, and property. For simplicity, assume that there are only two assets: money, the medium of exchange that pays no interest, and bonds, which we use to stand for all

other interest-bearing assets that are not directly a means of payment. HOW MUCH MONEY SHOULD I HOLD? 9 Motives for holding money The cost of money is the interest given up by holding money rather than bonds. People hold money only if there is a benefit to offset the cost. What is that benefit? The transactions motive The precautionary motive The asset motive 10

The transactions motive for holding money reflects the fact that payments and receipts are not synchronized. Must we hold money between being paid and making subsequent purchases? We could put our income into interest-earning assets, to be resold later when we need money for purchases. However, every time we buy and sell assets there are brokerage and bank charges. It is easier to hold some money. How much money we need to hold depends on the value of transactions we later wish to make and the degree of synchronization of our payments and receipts. 11

The demand for money The demand for money is a demand for real money balances. We need a given amount of real money, nominal money deflated by the price level, to make a given quantity of transactions. When the price level doubles, other things equal the demand for nominal money balance doubles, leaving the demand for real money balances unaltered. 12 The transactions motive (2) We assume that the transactions motive for holding real money balances rises with real income. The transactions motive for holding money also

depends on the synchronization of payments and receipts. A nations habits for making payments change only slowly. In our simplified model we assume that the degree of synchronization is constant over time. Thus we focus on real income as the measure of the transactions motive for holding real money balances. 13 The precautionary motive In an uncertain world, there is a precautionary motive to hold money. In advance, we decide to hold money to meet contingencies that we cannot yet foresee. The benefits grow with the volume of transactions we undertake and with the degree

of uncertainty. If uncertainty is assumed to be roughly constant over time, the level of transactions determines the benefit from real money held for precautionary reasons. 14 The demand for money: prices, real income and interest rates The transactions and the precautionary motives suggest that there are benefits to holding money. But there is also a cost, the interest foregone by not holding higher interest-earning assets instead. People hold money up to the point at which

the marginal benefit of holding another pound (euro, dollar, etc.) just equals its marginal cost. 15 M a r g in a l c o s t , M a r g in a l b e n e fi t Desired money holdings 116 96 MC E 80

L L MC 60 60 40 40 L

24 20 4 Real money holdings The horizontal axis shows the purchasing power of money in terms of goods. The MC schedule shows the interest sacrificed by putting the last pound into money rather than bonds. The MB schedule is drawn for a given real income and shows the marginal benefits of the last pound of money. The marginal benefit falls as money holdings increase. The desired point is E, at which

marginal cost and marginal benefit are equal. An increase in interest rates, a rise in the opportunity cost schedule from MC to MC, reduces desired money holdings from L to L. An increase in real income increases the marginal benefit of adding to real balances. The MB schedule shifts up to MB. Facing the schedule MC, a shift from MB to MB increases real money holdings to L. 16 The demand for money: prices, real income and interest rates Quantity demanded

Effect of rise in Price level Real income Interest rate Nominal Rises in money proportion Real money Unaffected Rises Falls Rises

Falls If all prices of goods and services double but interest rates and real income are unaltered, neither MC nor MB shift. The desired point remains E and the desired level of real money remains L. Since prices have doubled, people hold twice as much nominal money to preserve their real money balances at L. 17 The asset motive Think of someone deciding in which assets to hold wealth. Since people dislike risk, they will not put all their eggs in one basket. As well as holding some risky assets, they will keep some of their wealth in safer assets. The asset motive for holding money reflects peoples

dislike for risk. People sacrifice a higher average rate of return to obtain a portfolio with a lower but safer rate of return. This demand is larger the larger the total wealth to be invested and the lower the interest differential between deposits and risky assets. 18 Portfolio theories Theories of money demand that emphasize the role of money as a store of value (the asset motive) are called portfolio theories. According to these theories, people hold money as part of their portfolio of assets. The key insight is that money offers a different combination of risk and return than other assets.

In particular, money offers a safe (nominal) return, whereas the prices of stocks and bonds may rise or fall. Thus, some economists have suggested that households choose to hold money as part of their optimal portfolio. 19 Portfolio theories (2) Portfolio theories predict that the demand for money should depend on the risk and return offered by money and by the various assets households can hold instead of money. In addition, money demand should depend on total wealth, because wealth measures the size of the portfolio to be allocated among money and the alternative assets.

20 The money demand function For example, we might write the money demand function as: (M/P)D = L(rs,rb,e,W), where rs is the expected real return on stock ( shares), rb is the expected real return on bonds, e is the expected inflation rate, and W is real wealth. 21 Determinants of money demand An increase in rs or rb reduces money demand, because other assets become more attractive. An increase in e also reduces money demand,

because money becomes less attractive. (e is the expected real return to holding money.) An increase in W raises money demand, because higher wealth means a larger portfolio. HOW MUCH MONEY SHOULD I HOLD? 22 Portfolio theories and money demand Are portfolio theories useful for studying money demand? The answer depends on which measure of money we are considering. Narrow measures of money, such as M1, include only currency and deposits in chequing accounts. These forms of money earn zero or very low rates of interest.

There are other assets such as savings accounts, Treasury bills, certificates of deposit, and money market mutual funds that earn higher rates of interest and have the same risk characteristics as currency and chequing accounts. 23 Narrow money as a store of value Economists say that narrow money (M1) is a dominated asset: as a store of value, it exists alongside other assets that are always better. Thus, it is not optimal for people to hold narrow money as part of their portfolio, and portfolio theories (or the asset motive) cannot explain the demand for these dominated forms of money.

24 Broad measures of money Portfolio theories are more plausible as theories of money demand if we adopt a broad measure of money. The broad measures include many of those assets that dominate currency and chequing accounts. When we examine why people hold assets in the form of M2, M3, or M4, rather than bonds or stock, the portfolio considerations of risk and return may be paramount. Hence, although the portfolio approach to money demand may not be plausible when applied to M1, it may be a good theory to explain the demand for M2, M3, or M4. 25

Simplified money demand function For the rest of this course, we will use a simplified money function: (M/P)D = L(i, Y) This version uses real income Y, as a proxy for real wealth W (or value of transactions T). The only return variable it includes is the nominal interest rate i, which is the sum of the real return on bonds and expected inflation: i = r + e HOW MUCH MONEY SHOULD I HOLD? Less if the interest rate rises and more if income increases! 26

Currency and the underground economy How much currency are you holding right now in your wallet? How many 20000 forint (or 100) notes? In the United States, the amount of currency per person is about $2000. About half of that is in $100 bills. Most people find this fact surprising, because they hold much smaller amounts and in smaller denominations. 27 Underground economy Some of this currency is used by people in the

underground economy that is, by those engaged in illegal activity such as the drug trade and by those trying to hide income to evade taxes. People whose wealth was earned illegally may have fewer options for investing their portfolio, because by holding wealth in banks, bonds, or stock, they assume a greater risk of detection. For criminals, currency may not be a dominated asset: it may be the best store of value available. 28 Inflation as a tax Some economists point to the large amount of currency in the underground economy as one reason that some inflation may be desirable. Inflation is a tax on the holders of money,

because it erodes the real value of money. A drug dealer holding 20,000 in cash pays an inflation tax of 2000 per year when the inflation rate is 10%. The inflation tax is one of the few taxes those in the underground economy cannot evade. 29 Central banks and the instruments of monetary policy In most modern economies, the central banks (FED, ECB, Bank of England etc.) control the money supply indirectly by altering either the monetary base or the reserve-deposit ratio. The main instruments of monetary policy are: Open-market operations (most frequently used)

The discount rate Reserve requirements (least frequently used) 30 Open-market operations Open-market operations are the purchases and sales of government bonds by the central bank. When the central bank buys bonds from the public, the pounds (or euros, dollars etc.) it pays for the bonds increase the monetary base and thereby increase the money supply. When the central bank sells bonds to the public, the pounds it receives reduce the monetary base and thus decrease the money supply. 31

Reserve requirements Reserve requirements are government regulations that impose on banks a minimum reserve-deposit ratio (cb). An increase in reserve requirements raises the reserve-deposit ratio and thus lowers the money multiplier and the money supply. Changes in reserve requirements are usually the least frequently used of the central banks main policy instruments. 32 The discount rate The discount rate is the interest rate that the central bank charges when it makes loans to

banks. Banks borrow from the central bank when they find themselves with too few reserves to meet reserve requirements. The lower the discount rate, the cheaper the borrowed reserves, and the more banks borrow at the central banks discount window. Hence, a reduction in the discount rate raises the monetary base and the money supply. 33 Central banks and the money supply Although these three instruments openmarket operations, reserve requirements and the discount rate give the central banks substantial power to influence money supply, they cannot control the money supply

perfectly. Bank discretion in conducting business can cause the money supply to change in ways the central bank did not anticipate. 34 Unexpected changes (money supply) Banks may choose to hold excess reserves that is, reserves above the reserve requirement. The higher the amount of excess reserves, the higher the reserve-deposit ratio, and the lower the money supply. As another example, the central banks cannot precisely control the amount banks borrow from the discount window. The less banks borrow, the smaller the monetary base, and the smaller the money

supply. Hence, the money supply sometimes moves in ways the central bank does not intend. 35

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