Money and Monetary Policy: An Overview

Money and Monetary Policy

• Course title is "Money and Monetary Policy"
• Course is for the first semester of 2025
• Professor Carlos González Rodríguez leads the course

Index

• Covered topics include: definition of money, monetary aggregates, monetary base, savings, sources and uses of resources in the economy, monetary policy, and exchange rate regime.

Monetary Policy

• Monetary policy involves actions taken by monetary authorities to achieve macroeconomic goals, using financial variables like money supply and interest rates.
• The objectives of monetary policy are:
  • Price stability
  • Economic growth
  • Exchange rate stability
  • Employment promotion
  • Balance of payments stability

Money Definition

• Money is generally accepted for buying/selling goods/services and paying debts.
• Examples include bills, coins, debit cards, and electronic transfers.
• Throughout time there have been different forms of money:
  • Commodity Money - allows exchange but requires a mutual willingness to trade specific goods. It has a disadvantage of a loss of time.
  • Metallic Money - gold, silver, or bronze retains its value and divisibility. Its storage and transportation are problematic.
  • Fiduciary Money - currency (bills and coins) is government-issued legal tender, which is durable, portable, divisible, homogenous, with controlled issue, low operating costs, and high security. Its emission must occasionally be renewed.

Functions of Money

• Medium of Exchange: Facilitates economic transactions
• Unit of Account: Measures value in the economy
• Store of Value: Acts as a deposit of purchasing power
• Standard of Deferred Payment: Allows accumulating wealth in effective form

Requirements for Money

• Must be standardized for easy valuation.
• Must be widely accepted.
• Must be divisible for facilitating exchanges.
• Must be easily portable.
• Must not deteriorate quickly.

Legal Tender and Modern Banking

• Legal tender is government-accepted paper money; bills and coins can be stolen and are expensive to transport.
• Modern banking and the invention of checks evolved the payment system, reducing transaction costs and improving economic efficiency.

Electronic Money

• Debit cards were the first form of electronic money, allowing consumers to electronically transfer funds from their bank accounts
• Other forms include stored-value cards (prepaid phone cards) and smart cards (with a computer chip to load digital cash).

Cryptocurrencies Overview

• Cryptocurrencies are virtual currencies traded on digital platforms, employing cryptography for transaction security, creation control, and asset transfer verification.
• Blockchain technology is decentralized database using blocks in a chain that enables financial transactions.
• Bitcoin emerged in 2009 (by Satoshi Nakamoto) and other cryptocurrencies have emerged since.

Cryptocurrencies Benefits and Concerns

• Cryptocurrencies are not backed by central banks so is decentralized, with no authority to oversee issuance or activity record.
• Anonymous transactions enable illicit activities.
• Cryptocurrencies not backed financially so cannot be used for monetary policy management.

Payment Systems

• Bills and coins are useful for payments but can be inconvenient and unsafe.
• Banks created payment tools like credit/debit cards and checks for easier transactions.
• Internet transfers allow payments without visiting a bank.
• Electronic payments transfer money directly (SPEI electronic interbank payment system).

Payment System Infrastructure

• Infrastructure and efficient transfer methods facilitate instruments for safe and easy payments.
• A reliable system is needed to facilitate a country's economic activity.
• Banco de México ensures proper payment systems.
• Monetary aggregates are financial assets held by the public classified by liquidity, domestic or foreign.

Monetary Aggregates Classification

• Monetary aggregates classified by assets liquidity and by who owns them
• Liquidity refers to how easily an asset can be converted into cash
• Ownership considers whether the asset is held by residents or non-residents

Monetary Base

The Monetary Base is also known as high-powered money or primary money issuance

• Monetary base is the sum of bills and coins in circulation plus the net balance of current accounts that the Central Bank has with credit institutions (from the uses side)
• Monetary base equals international reserves in national currency with credit from the interior side
• Usages of the Monetary Base:
  • Notes and coins in circulation
    • In the public
    • In bank vaults
  • Bank deposits that are current accounts at the Central Bank

Sources of the Monetary Base

• The sources of the monetary base include:
  • International Reserves
  • Net Domestic Credit, including:
    • Net holding of governmental securities
    • IPAB values (Banking Fund)
    • Federal government
    • Deposits of Enterprises and Agencies of the Public Sector
    • Net Monetary Regulation Deposits -Credit to Banks
    • Net Financing to other financial intermediaries. -IPAB Financing
    • Net of Repo Values

Currency in Circulation

• Currency in circulation is divided between that held by the public and that held in bank vaults.
• Deposits comprise of bank deposits in the central bank

Factors Influencing Monetary Base

• Banks holdings of government securities as well as banking sectors loans and finances can play a part in monetary base levels.
• International deposits and fund deposits also influence monetary base.

Key Monetary Concepts

• Currency in circulation: The sum of payment methods needed to achieve all types of economic transactions: the balance of checking accounts in national currency plus bills and coins held by the public.
• Monetary aggregates: Financial assets depend on liquidity and the asset holder.
• Payments system: the group of tools, procedures, and interbank systems ensure circulation of money.

Money Demand and Interest Rates

• Money demand is inversely proportional to interest rates

Effects of Interest Rates on Money Demand

• The higher the interest rate, the lower the demand for money because bond returns become more attractive
• The opportunity cost of holding money is the interest forgone.
• Yield to maturity is the most precise measure of interest rate.

Interest Rates and Economic Activity

• During economic expansion, the demand for money shifts to the right, increasing equilibrium interest rate,.
• When money supply increases, the supply curve shifts right, lowering equilibrium interest rate.

Impact of Money Supply on Exchange Rates

• More money supply leads to lower interest rates. The peso depreciates relative to the dollar as these two factors occur.

Monetary Policy Rules

• According to Taylor (1993), monetary policy rules describe how monetary instruments change with inflation and/or other economic activity in response to changes in variables
• The Taylor Rule by John Taylor determines the interest rate by: Inflation rate plus equilibrium real interest rate, plus a weighted average of two factors: deviation from inflation and the percentage deviation from real GDP

Taylor Rule Formula

• The Taylor Rule formula is: nominal interest rate = inflation + equilibrium interest rate + 0.5(inflation gap) + 0.5(output gap)
• it=α+ß(πτ-Π*)+ Y(yt-y*) -Where it= Interest Rate -πτ= Inflation -Π*= Inflation target
• yt= Product -Y*= product potential
• α= long-term equilibrium interest rate

Taylor Rule Considerations

• Taylor's rule views the nominal interest rate as the monetary policy instrument responding to inflation and output deviations
• The proposed Taylor rule sees nominal interest rates as the core of monetary policy, adapting to variations in inflation
• The economy's sensitivity can vary with inflation and output gaps
• A rate increase is likely when ẞ and Y are positive if rate of interest will increase when either happens

Applying the Taylor Rule

• To calculate a nominal interest rate, you need:
  • Real growth rate: 3.0%
  • Potential GDP growth rate: 5.0%
  • Inflation: 8.0%
  • Inflation target: 3.0%
  • Real interest rate: 2.5%
• Nominal interest = 8.0 + 2.5 + 0.5(8.0-3.0) + 0.5(3.0 - 5.0)
• The final rate is 12.0

Output Gap Defined

• The difference between observed and potential GDP is the output gap
• An economy that grows in activity beyond its potential, creates a positive output gap
• A positive output gap is an economy that generates above pressures of inflationary proportions.
• An economy that declines instead is below its potential with an output gap this time will be associated with spare capacity

Approaches to Estimate Potential GDP

• Estimating potential GDP utilizes methodologies such as: Hodrick-Prescott filter, production function, growth trend estimation, and average values over prolonged study period.

Okun's Law

• Okun's Law establishes an inverse relationship between the output gap and unemployment rates
• Recent estimates suggest that uping the output gap reduces un-employment
• So if unemployment is 5.2% whilst the economy has is producing near 98%, therefore a -2 gap occurs then un-employment = 5.2% - 1/2(-2) = 6.2%

Monetary Policy Strategies

• Rules-based policies analyze decisions and macroeconomic performance, and are utilized by countries with inflation-targeting.
• When analyzing a monetary response is it best to stick to a rule or be discretionary? Rules limit deviation and can cause bias in certain situations.

Economic Expectations Importance

• Expectations is key to why we should establish baselines so consumers can plan appropriately

Banco de Mexico's Role

• Article 2 of Banco de México's law sets its purpose: to provide the country's economy with a national currency; prioritizing said currency's purchasing power stability. -Additionally, the goal involves supporting financial development, providing payment systems
• It is the only institution that can issue national currency for transactions.

Mexican Currency Production

• Mexico produces its bills and coins via the Banco de México and the "Casa de Monéda de México" respectively

Savings

• Savings is the gap between income and spending or post-tax income not consumed
• Savings is Investment in a closed economy(S=I).

Types of Savings

• Internal Savings: difference between income and consumer costs
• External Savings: resources for balance-of-payment deficits (includes: foreign investment + international loans + reserve changes)
• Financial Savings: difference between monetary stock and bills/coins the public holds

Savings and Investments

• Gross Domestic Product (GDP) = C+I+X-M, where C is general consumption, I investment, X exports and M imports
• S= [C+I+X-M+Yf+TRf]-C; Where Yf = income attributable to factors, and TRf =net external transfers

Monetary Policy and Exchange Rate Regimes

• Monetary policy is guided by the exchange rate regime

Exchange Rate Impact on Internal Policy

• Monetary policy cannot be be fully independent whilst also supporting any attempt in change
• BM =CD+RI Banking money = cash deposit + restricted internal policies

Type of Exchange and Inflation Influences

• Inflation relies on internal monetary policies due to its independence
• BM=CD+RI

Fixed Exchange Rate Impact on Monetary Actions

• A fixed exchange rate is an anchor that controls inflation.
• Monetary policy has no effect on money supply.
• Excess money supply increases aggregate demand and prices.
• Increased imports and reduced exports occur due to relative price changes that impact competitiveness.
• This creates deterioration of the Balance of Payments.
• Excess money supply is reduced by losing international reserves.
• If exchange rate remains constant, then the internal credit will be controlled by the central bank

Flexible Exchange Rate Impact on Monetary Actions

• Increased Money Supply increases inflation
• There will be a decrease due to currency depreciation with goods purchased through the monetary expansion.
• Increased access to commodities decreases dependency
• Exchange rate and supply will adjust as the real market adjusts itself.

Advantages of Flexible Exchange Rates

• Flexible exchange rates reduce transmission of price impacts
• They can avoid external disturbances
• Real fluctuations shared by adjustments in the market with little cost
• Accumulation disincentivized, with free politics, interest rates and determined equilibrium prices
• Reduced volatility for the financial market with better investment opportunities

The Impossible Trinity

• It is impossible to have a fixed or managed exchange rate.
• It is impossible to have free capital movement.
• It is also impossible to use monetary policy for domestic goals.
• It is only possible to have two simultaneously.

Factors Determining Exchange Rate Variation

• Variations of what rate occurs
• Inflation
• Interest Rates differentials
• Country Productivity

Exchange Rates in Mexico

• Floating rate implemented Since 1995
• Intervention of these rates are determined via Banco with the SHCP to instill market confidence.
• These can be either via sales, or extra subastras