Lecture 7 and 8 Money, Prices and the Central Bank PDF

Lecture 7 and 8 Money, Prices and the Central Bank and the Economy Pentecost University College, Principles of 1 Macroeconomics by Prof. P. Onyina  Outline of Presentation After the lecture, students...

Lecture 7 and 8 Money, Prices and the Central Bank and the Economy Pentecost University College, Principles of 1 Macroeconomics by Prof. P. Onyina  Outline of Presentation After the lecture, students will understand: Definition and functions of money Relationship between money and inflation Functions of a central bank The Exchange Settlement Account Monetary tools in controlling money supply Pentecost University College, Principles of 2 Macroeconomics by Prof. P. Onyina  Introduction Barter is a trade system where commodities were exchanged for one another. It was a system which was highly complicated. It was termed “double coincidence of wants”. Problems with barter system Durability Portability Divisibility/Measurability Acceptability Pentecost University College, Principles of 3 Macroeconomics by Prof. P. Onyina  Definition of Money Money is anything generally accepted and recognize as a means of payment of goods and services, thus, it must solve the problems associated with the barter system. Money has three main uses: 1. Medium of exchange: avoids barter and promotes specialization 2. Unit of account: the basic yardstick for measuring economic value 3. Store of value: a way of holding wealth Pentecost University College, Principles of 4 Macroeconomics by Prof. P. Onyina  Functions of Money Money must be used as a. Medium of exchange b. Unit of account c. Store of value/wealth d. Standard of deferred payment Money should have the following characteristics Scarce, durable, divisible, recognize, acceptable, portable, and its liquidity should be quick. Pentecost University College, Principles of 5 Macroeconomics by Prof. P. Onyina  Measuring Money: Definitions Economists use several alternative definitions of money which vary in how broadly money is defined: – Currency = notes and coins on issue, less holdings of notes and coins by banks. – M1 = currency + current deposits held by banks – M2= M1 +Time deposit, savings account – M3 = M2 + all bank deposits of the private non-bank sector. – Broad money (L) = M3 + borrowings from the private sector by non-bank depository corporations, less holdings of currency and deposits of non-bank depository corporations. Pentecost University College, Principles of 6 Macroeconomics by Prof. P. Onyina  Money Supply (M1) Money Supply (M1) = Currency + Bank Deposits. What determines the amount of money (credit) in the economy? The credit creation process is very similar to the multiplier in the Keynesian short-run model Therefore, the amount of money (credit) partly depends on the behaviour of commercial banks and Depositors (Public’s desire to hold currency). – These are leakages from the system (as was savings, marginal taxes etc) Pentecost University College, Principles of 7 Macroeconomics by Prof. P. Onyina  Money and Prices (Inflation) The money supply is important because in the long run, there is a close link between the amount of money circulating in the economy and the general level of prices. A rapidly growing supply of money leads to quickly rising prices, i.e. inflation. This in most cases is not good for the economy Why? Pentecost University College, Principles of 8 Macroeconomics by Prof. P. Onyina  Money and Inflation: Velocity Velocity is defined as the value of transactions completed in a period of time divided by the stock of money required to make those transactions. Velocity is an important determinant of the price level in the economy. – The higher this ratio, the higher the speed at which money circulates. value of transaction nominal GDP Velocity = = money stock money stock It is given by: p y V= M Pentecost University College, Principles of 9 Macroeconomics by Prof. P. Onyina  Velocity (cont.) Let V stand for velocity and M stand for the particular money stock being considered (e.g. M1 or broad money). Nominal GDP (a measure of the total value of transactions) equals the price level, P, times real GDP, y. Using this notation, we can write the definition of velocity as: V= Pxy M Pentecost University College, Principles of 10 Macroeconomics by Prof. P. Onyina Money and inflation in the long run The quantity equation describes the relationship between money and prices: MxV=pxy Assumptions: – If V depends on payment technologies and is approximately constant over the period of interest; and – Real output, y, is approximately constant during the period of interest, then: MxV=pxy Example: If M was to increase by 10%, there would be a corresponding increase in p of 10%. This is because V and y are assumed to be constant Pentecost University College, Principles of 11 Macroeconomics by Prof. P. Onyina Example of Inflation rates 1996 – 2016 in Three Countries Pentecost University College, Principles of 12 Macroeconomics by Prof. P. Onyina  The Central Bank (CB) [Bank of Ghana] The Bank of Ghana is the central bank, and has two main responsibilities: 1. Maintaining stability of the currency, which is regarded as maintaining low inflation via monetary policy. 2. Oversight and regulation of financial markets. Monetary policy is now conducted by directly targeting interest rates. Pentecost University College, Principles of 13 Macroeconomics by Prof. P. Onyina  Functions of the Central Bank Some functions of the bank include: Issue and redeem currency Promote, regulate and supervise payment and settlement systems License, regulate, promote and supervise non- banking financial institutions Regulate, supervise and direct the banking and credit systems of the financial sector Promote the stabilization of the currency Act as banker and financial advisor to the government Promote and maintain relations Pentecost University with College, Principles of international 14 Macroeconomics by Prof. P. Onyina  Exchange Settlement Accounts Exchange Settlement Accounts (at the Clearing House) – Accounts kept by commercial banks with the CB – These accounts allow the banks to settle transactions between them e.g. a customer at Ecobank receives a cheque from the Standchart. Ecobank credits the account of their customer & then the Standchart credits the account of Ecobank via the exchange settlement accounts – The interest rate (r) on these accounts is kept low by the CB to discourage banks parking funds in the account – However, the banks have to keep enough cash in these accounts to meet their obligations Pentecost University College, Principles of 15 Macroeconomics by Prof. P. Onyina  Controlling Money in Circulation The Central Bank’s three tools to change (increase /reduce) the money supply are to conduct an: 1.Open-market Operation (OMO) 2. Change legal reserve requirements 3. Reduce/Increase lending to banks. Pentecost University College, Principles of 16 Macroeconomics by Prof. P. Onyina 1. Open market operations (OMO) Open market operations are the buying and selling of financial assets such as short-term government bonds in order to affect the level of reserves in the commercial banks’ exchange settlement accounts. OMO helps to change the amount of money in circulation. Pentecost University College, Principles of 17 Macroeconomics by Prof. P. Onyina  Open Market Purchases (CB buys bonds) If r > target r then the CB buys bonds from the banks The CB then credits the exchange settlement accounts. Exchange settlement accounts pay only low interest rates The banks then loan their excess funds in the overnight cash market (higher interest rate) This acts to decrease the cash rate (r) Pentecost University College, Principles of 18 Macroeconomics by Prof. P. Onyina Open market sales (CB sells bonds) If r < target r then the CB sells bonds from the banks The CB then debits the exchange settlement accounts. Exchange settlement accounts pay only low interest rates The banks then borrows funds in the overnight cash market (higher interest rate) to meet obligations in exchange settlement accounts This acts to increase the cash rate (r) Pentecost University College, Principles of 19 Macroeconomics by Prof. P. Onyina  Maintaining the Cash Rate The CB not only intervenes daily to keep the interest rate at the target level but it also intervenes to either increase or decrease the target cash rate – - The mechanisms used to change the cash rate are slightly different than those used to maintain the cash rate – We do the changing of the cash rate in Lecture 8 Monetary policy seeks to affect all interest rates in the economy, not just the overnight cash rate. Longer term interest rates do tend to track the cash rate quite closely. Pentecost University College, Principles of 20 Macroeconomics by Prof. P. Onyina  CB targets the cash rate At its bi-monthly meeting the CB board of governors decides what changes, if any, shall be made to the cash rate. Financial markets follow these meetings with intense interest because the outcome immediately influences most interest rates and the bond, share and housing markets. Having set the cash rate, the CB conducts open market operations to achieve it. Pentecost University College, Principles of 21 Macroeconomics by Prof. P. Onyina 2 Change legal reserve requirements A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement. This is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out, and limits bank’s credit creation. Pentecost University College, Principles of 22 Macroeconomics by Prof. P. Onyina  Increase legal reserve requirements [cont] If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out. In practice, the CB rarely uses large changes in reserve requirements to execute monetary policy. Increasing or reducing the reserve requirement can reduce or increase money in circulation. Pentecost University College, Principles of 23 Macroeconomics by Prof. P. Onyina  3 Reduce/Increase lending to banks (Discount rate) We call the interest rate banks pay for such loans the discount rate. The third traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the CB. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse. Pentecost University College, Principles of Macroeconomics by Prof. P. Onyina 24  Summary Money is used as a medium of exchange, unit of account and store of value. The reserve–deposit ratio is the key to money creation in a fractional banking system. In the long run, the quantity equation shows money supply is closely related to inflation. Open market operations are used to achieve the target cash rate in the overnight money market. Reserve requirement and discount rate are other tools of monetary control the CB pursues. Pentecost University College, Principles of 25 Macroeconomics by Prof. P. Onyina  Questions 1. Discuss how the increase in money supply can bring an increase in inflation. 2. How can the central bank control the commercial banks operations? 3. i) What is a policy reaction function curve? ii) Show a diagram of policy reaction function curve and explain it. 4. How effective is a monetary policy? 5. Discuss how the exchange settlement account works. Pentecost University College, Principles of 26 Macroeconomics by Prof. P. Onyina