Lecture 6_ Money Supply PDF

***MONEY, PRICES AND INFLATION:*** **Nominal values in the long run:** ***SCENE SETTING:*** We have spent the last few lectures discussing the REAL economy, identifying models to explain variables such as: - Output - Real wages - Real interest rate - Real exchange rate We now turn to...

***MONEY, PRICES AND INFLATION:*** **Nominal values in the long run:** ***SCENE SETTING:*** We have spent the last few lectures discussing the REAL economy, identifying models to explain variables such as: - Output - Real wages - Real interest rate - Real exchange rate We now turn to consider the NOMINAL side of the economy. We need models to explain variables such as: - Nominal interest rates - Nominal price of output - Inflation In order to do this, we need a model that explains the role of money in the economy. **[What is Money?:]** Money is what money does: - Medium of exchange - Unit of account - Store of value These functions of money determine what assets are money. A narrow definition of money (M1), based on money being a medium of exchange, is: - **Currency -** this is referred to as *Monetary Base*. - **Bank deposits** which can be used to make transactions (e.g. by using debit cards). Financial instruments like credit cards are NOT money but they do increase the ability of money to make transactions and hence influence the demand for (narrow) money (velocity of money). - Not using money directly, but indirectly. - **Narrow money:** often denoted as **M1**, refers to the most liquid forms of money in an economy---those that are readily available for transactions. **[History of Money:]** Initially, money developed as commodity money i.e. made of precious metals. The development and acceptance of *fiat* money (currency issued by governments and not backed by a physical commodity like gold or silver) enhanced the capability of the monetary economy since it didn't constrain monetary creation to precious metal supply and removed the large cost involved with producing commodity money. - Little intrinsic value. - Means we wouldn't see large increases in the money supply when there is an increase in physical commodities. Commodity money has evolved in particular situations (see case study in Mankiw p.77 on cigarettes as money in a POW Camp). Money can also be created from social conventions such as the use of claims on stone wheels on the Island of Yap (see case study in Mankiw p.78). How about Digital Money? It has been adopted in a very limited way as a means of payment, but, at this point in its development, it is essentially a speculative asset. **[Operational definitions of money:]** +-----------------------------------------------------------------------+ | Money is relatively easy to define in a narrow sense where the medium | | of exchange function is crucial. | | | | To get a broader view of the monetary situation, not just for today, | | but in the future, many central banks monitor multiple money | | definitions, such as | | | | - **M0** - monetary base (most basic level of money in an economy) | | | | - **M1** - money as a means of payment | | | | - **M2** - M1 plus non-transactions deposits which can be rapidly | | converted into money | | | | - **M3** - including highly liquid stores of value such as Money | | Market funds. | +-----------------------------------------------------------------------+ ***BANKS AND THE MONEY SUPPLY:*** Banks are very important institutions in determining how much money exists Start with the (narrow) definition of money supply (M) as the sum of household demand for currency (CH) and demand deposits (D). - M = CH + D To understand how D is determined, we need to introduce the concept of *fractional reserve banking*. Suppose that banks operate under 100% reserve banking. - This means that when a bank receives deposits, it will hold all of these deposits as reserves. We now turn to the development of *fractional reserve banking*. In this situation, banks hold only a fraction of their deposits as reserves and then lend out the rest. - Suppose the only bank (for multiple bank set-up see Mankiw pp. 82-84) starts with an inflow of deposits of Φ. - The bank retains a fraction K of its deposits as a cash reserve to be able to meet sudden liquidity needs in case deposits are withdrawn unexpectedly. - This implies that, for an initial inflow of deposits Φ, the bank can make loans by creating deposits equal to (1-k)Φ. - This lending comes into the bank as further deposits. The second round of lending generates (1-k)\^2Φ of lending for the third round. - Lenders buy things, this cash goes to the producer/seller, which deposits the money in the bank. - The process continues for n lending rounds with a total increase in deposits of: - Banks have equity capital of owners (shareholders) as liabilities and will hold other sorts of assets such as government securities to protect against loan default and other risks that they face. (See more discussion of this in Mankiw p.85-5.) **[A model of the money supply:]** Using a narrow definition of money M = CH + D, where CH is the amount of money held by households, we assume households hold currency according to CH = cD. Banks hold an amount of cash CB = κD. The total amount of currency in the system, called the monetary base (B), must either be held by banks as reserves or households as currency, so B=CH + CB = cD +κD = (c+κ)D. Hence, D = B / c+κ M = cD + D = (1 + c)D = (1+c / c+k)B The money supply is a function of the monetary base B and two key behavioural parameters (c and k). For constants k and c, varying B changes M. - (1+c)/(c+k) \> 1 ***CONTROLLING THE MONEY SUPPLY:*** **Open market operations:** Monetary policy maker (Central Bank) buys / sells (typically) government bonds for monetary base. **Lender of Last Resort:** lending directly to banks (usually covered by bank assets as collateral, which will usually be more than the value of the loan), through what is called the *discount window*. - This carries an interest rate which can be changed. **Auction:** Central Banks can announce in advance the amount of funds they will lend and then banks bid for them. **Changing interest rates:** reserves may earn interest and the interest rate can be varied so influencing bank holding of monetary base. **Required reserve ratio:** this is not used extensively since usually banks are left to choose the reserves they require. **[Monetary policy in the Great Depression:]**  This table shows the impact on the money supply over the Great Depression. - Whilst the monetary base increased, the money supply fell, driven by a large fall in bank deposits. This related to bank failures and increases in the bank reserve ratio and household cash ratio. The problems of the banking sector are regarded as a key factor creating the Great Depression and provided the rationale for the direct support for the banking sector when the Global Financial Crisis happened in 2008. **[Monetary Base and the Money Supply: The Global Financial Crisis (GFC) and The Pandemic:]** +-----------------------------------------------------------------------+ | GFC had major effects on the banking system. | | | | Banks suffered loan defaults and some were insolvent. | | | | Banks couldn't raise money on the money markets e.g. the interbank | | market had become very selective in its lending. | | | | Conditions for the banks were similar to the Great Depression. | | | | In the US, the Federal Reserve provided emergency liquidity using its | | *lender of last resort* facility. | | | | Some Financial Institutions were taken over by the Government. | | | | *Quantitative Easing* (QE) continued post GFC with the Federal | | Reserve buying government bonds with Monetary Base. | +-----------------------------------------------------------------------+  +-----------------------------------------------------------------------+ | Despite the large increase in the Monetary Base from 2008, the Money | | Supply didn't increase as much since banks voluntarily held higher | | reserves (k increased) and households held more **cash** (c | | increases). | | | | Contrast this with the Pandemic period where there were very large | | growth rates in Money Supply (because households couldn't spend and | | held savings in money). | | | | These two periods illustrate that the operation of monetary policy | | needs to take into account the specifics of the crisis that is taking | | place. | +-----------------------------------------------------------------------+ **[The UK perspective:]** +-----------------------------------------------------------------------+ | We see in this chart the M2 measure of money supply from 2010 to | | 2021. | | | | Note that growth increased around 2015 and there is a significant | | rise as a result of the pandemic. | | | | The Bank of England took the view that this additional growth wasn't | | excessive and would be controlled by a slow increase in interest | | rates and a further rollback of the QE programme. | +-----------------------------------------------------------------------+ ***SUMMARY:*** - The money supply can be defined narrowly (based on money's use as a medium of exchange) or more broadly (recognising that stores of value can be converted to medium of exchange very quickly). - In explaining the amount of money in the economy, we recognised the importance of banks and the concept of fractional reserve banking. - Using a narrow definition of money, we derived a simple model of the money supply that demonstrated the money supply multiplier and how controlling the monetary base would give control over the money supply. - We examined ways in which the Monetary Policy Agency (usually the Central Bank) controls the monetary base. - We drew lessons about monetary control from looking at the behaviour of money supply during the Great Depression, in the aftermath of the global financial crisis, and also considered what has happened in the context of the pandemic.