016_The Monetory System

Government, Business and Society

The Monetary System

The Monetary System

• Medium of exchange • Barter System: double coincidence of wants—

the unlikely occurrence that two people each have a good or service that the other wants.

• As money flows from person to person in the economy, it facilitates production and trade, thereby allowing each person to specialize in what he or she does best and raising everyone’s standard of living.

The Meaning of Money • Money

– Set of assets in an economy that people regularly use to buy goods and services from other people

– Those few types of wealth that are regularly accepted by sellers in exchange of goods and services

• The functions of money – Medium of exchange

• Item that buyers give to sellers when they want to purchase goods and services – Unit of account

• Yardstick people use to post prices and record debts – Store of value

• Item that people can use to transfer purchasing power from the present to the future

• Wealth: total of all stores of value, including money and nonmonetary assets (Time Value of Money)

• Liquidity: Ease with which an asset can be converted into the economy’s medium of exchange

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The Kinds of Money

• Commodity money – Money that takes the form of a commodity with

intrinsic value . • Intrinsic value

– Item would have value even if it were not used as money

• Gold standard - Gold as money – Or paper money that is convertible into gold on

demand

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The Kinds of Money

• Fiat money – Money without intrinsic value – Used as money because of government decree

– To a large extent, the acceptance of fiat money

depends as much on expectations and social convention as on government decree.

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Money in the Economy (Money Stock)

• Money stock – Quantity of money circulating in the economy has a powerful influence on many

economic variables.

• At the core of monetary policy is regulation of the supply of money. - to keep the value of money as stable as possible. This value is guaranteed by stabilizing the money supply, which is measured by the central bank as M1, M2 and M3, each of which is more broadly defined and less liquid than the previous one.

• M1 = cash + coins + checking deposits + traveler's checks. • M2 =M1 +savings deposits+ small (i.e., under $100,000 certificates of deposit)

time deposits + money market deposits + money market mutual funds. • M3 = M2 +large (over $100,000) time deposits. • At any given point in time, the supply of money is a constant. This implies that the

current money supply curve is vertical. Because other measures of money supply are based upon the most liquid M1, when we discuss the money supply, we focus on M1. Insight gained from studying the expansion and contraction of M1 can be applied to M2 and M3.

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Money Stock in India • The Reserve Bank of India defines the monetary aggregates as: • M0 (Reserve Money) : Currency in circulation + Bankers’ deposits with the

RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities.

• M1 : Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI).

• M2 : M1 + Savings deposits with Post office savings banks. • M3 : M1+ Time deposits with the banking system = Net bank credit

to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net nonmonetary liabilities o f the banking sector (Other than Time Deposits).

• M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

• Reserve Bank of India controls monetary policy tools like repo, reverse repo, CRR, SLR to manage money supply in the economy.

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Two Measures of the Money Stock for the U.S. Economy

The two most widely followed measures of the money stock are M1 and M2. This figure shows the size of each measure in 2009.

Where is all the currency? • 2009: $862 billion currency outstanding

– Average adult: holds about $3,653 of currency – Much of the currency is held abroad – Much of the currency is held by drug dealers, tax

evaders, and other criminals

• Currency – not a particularly good way to hold wealth – Can be lost or stolen – Doesn’t earn interest

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India

• Population= 1.22 Billion • M1 24237.40 80.15 INR Billion • M2 24701.67 1127.49 INR Billion • M3 112200.55 123.52 INR Billion

The Central Banking System

• Central bank - Institution designed to – Issue of currency – Banker to Government – Bankers Bank and Supervisor – Controller of Credit and Money Supply- Monetary Policy – Exchange Control – Lander of Last Resort – Custodian of Foreign Exchange – Clearing House Function: facilitates banks transactions. – Collection and Publication of Data

• Federal Reserve (Fed)- The central bank of the United States • Reserve Bank of India – The Central bank of India

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Banks and the Money Supply

• Reserves – Deposits that banks have received but have not

loaned out

• The simple case of 100% reserve banking – All deposits are held as reserves

• Banks do not influence the supply of money

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Fractional-Reserve Banking

• Fractional-reserve banking – Banks hold only a fraction of deposits as reserves

• Reserve ratio – Fraction of deposits that banks hold as reserves

• Reserve requirement – Minimum amount of reserves that banks must

hold; set by the Central Bank

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• Excess reserve – Banks may hold reserves above the legal minimum

• Example: First National Bank – Reserve ratio 10%

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• Banks hold only a fraction of deposits in reserve – Banks create money

• Assets • Liabilities

– Increase in money supply – Does not create wealth

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The Money Multiplier

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• The money multiplier – Original deposit = $100.00 – First National lending = $ 90.00 [= .9 ×

$100.00] – Second National lending = $ 81.00 [= .9 ×

$90.00] – Third National lending = $ 72.90 [= .9 × $81.00] – … – Total money supply = $1,000.00

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• The money multiplier – Amount of money the banking system generates

with each uni of reserves – Reciprocal of the reserve ratio = 1/R

• The higher the reserve ratio – The smaller the money multiplier

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Financial Crisis of 2008–2009

• Bank capital – Resources a bank’s owners have put into the

institution – Used to generate profit

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• Leverage – Use of borrowed money to supplement existing

funds for purposes of investment

• Leverage ratio – Ratio of assets to bank capital

• Capital requirement – Government regulation specifying a minimum

amount of bank capital

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• If bank’s assets – rise in value by 5% – Because some of the securities the bank was holding rose in price – $1,000 of assets would now be worth $1,050 – Bank capital rises from $50 to $100 – So, for a leverage rate of 20

• A 5% increase in the value of assets • Increases the owners’ equity by 100%

• If bank’s assets – reduced in value by 5% – Because some people who borrowed from the bank default on their

loans – $1,000 of assets would be worth $950 – Value of the owners’ equity falls to zero – So, for a leverage ratio of 20

• A 5% fall in the value of the bank assets • Leads to a 100% fall in bank capital

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• Banks in 2008 and 2009 – Shortage of capital

• After they had incurred losses on some of their assets – Mortgage loans – Securities backed by mortgage loans

– Reduce lending (credit crunch) • Contributed to a severe downturn in economic activity

• U.S. Treasury and the Fed – Put many billions of dollars of public funds into the banking system

• To increase the amount of bank capital – It temporarily made the U.S. taxpayer a part owner of many banks – Goal: to recapitalize the banking system

• Bank lending could return to a more normal level – Occurred by late 2009

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Central Bank’s Tools of Monetary Control

• Influences the quantity of reserves – Open-market operations – Central Bank lending to banks

• Influences the reserve ratio – Reserve requirements – Paying interest on reserves

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Tools of Monetary Control

• Open-market operations – Purchase and sale of government bonds – To increase the money supply

• buys government bonds

– To reduce the money supply • sells government bonds

– Used more often

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• Central Bank lending to banks • To increase the money supply • Borrow from discount window and pay an interest rate called the

discount rate – Higher discount rate

• Reduce the money supply – Smaller discount rate

• Increase the money supply – Term Auction Facility

• Sets a quantity of funds it wants to lend; eligible banks bid; loan go to the highest bidder

– Acceptable collateral – Pay the highest interest rate

– Uses such lending not only to control the money supply but also help financial institutions when they are in trouble.

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• Reserve requirements – Regulations on minimum amount of reserves that

banks must hold against deposits – An increase in reserve requirement

• Decrease the money supply

– A decrease in reserve requirement • Increase the money supply

– Used rarely – disrupt business of banking

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• Paying interest on reserves – The higher the interest rate on reserves

• The more reserves banks will choose to hold

– An increase in the interest rate on reserves • Increase the reserve ratio • Lower the money multiplier • Lower the money supply

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Instrument of Money Policy- India • Bank Rate:

– rate of interest at which the central bank lends to commercial banks. It is, in a way, cost of borrowing. Cheap credit promotes investment whereas dear money discourages it. In a situation of excess demand and inflationary pressure, central bank increases the bank rate. High bank rate forces the commercial banks to raise the rate of interest which makes credit dear. As a result, demand for loans and other purposes falls.

– Thus, increase in bank rate by the central bank adversely affects credit creation by commercial banks. A decrease in bank rate will have the opposite effect. Bank rate at which banks borrow from RBI is called repo rate and rate at which banks park their surplus funds with RBI is Reverse Repo Rate .

• Open Market Operations: – These refer to buying and selling of government securities by central bank. This is done to influence

money supply in the country. Mind, sale of government securities to commercial banks means flow of money into the central bank which reduces cash reserves. Consequently, credit availability of commercial banks is curtailed / controlled. When central bank buys securities, it increases cash reserves of the banks and their ability to give credit.

• Cash Reserve Ratio (CRR): – Commercial banks are required under the law to keep a certain percentage of their total deposits

with the central bank in the form of cash reserves. This is called CRR. It is a powerful instrument to control credit and lending capacity of the banks.

– To curtail the credit giving capacity of the banks, central bank raises the CRR but when it wants to enhance the credit giving powers of the bank, it reduces the CRR. Similarly, there is another measure called Statutory Liquidity Ratio or SLR, every bank is required to keep a fixed percentage (ratio) of its assets in cash called liquidity ratio. SLR is raised to reduce the ability of the banks to give credit. But SLR is reduced when the situation in the economy demands expansion of credit.

Problems

• The Central Bank’s control of the money supply is Not precise

• The Central Bank – Does not control the amount of money that

households choose to hold as deposits in banks – Does not control the amount that bankers choose

to lend

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Bank runs and the money supply • Bank runs

– Depositors suspect that a bank may go bankrupt • “Run” to the bank to withdraw their deposits

– Problem for banks under fractional-reserve banking • Cannot satisfy withdrawal requests from all depositors

• When a bank run occurs – The bank - is forced to close its doors until some

bank loans are repaid – Or until some lender of last resort provides it with

the currency it needs to satisfy depositors – Complicate the control of the money supply

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Bank runs and the money supply

• Great Depression, early 1930s – Wave of bank runs and bank closings – Households and bankers - more cautious – Households withdrew their deposits from banks – Bankers - responded to falling reserves

• Reducing bank loans, • Increased their reserve ratios • Smaller money multiplier • Decrease in money supply

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Bank runs and the money supply • Bank runs today

– Not a major problem • The federal / Central government

– Guarantees the safety of deposits at most banks • Deposit Insurance Corporation (DIC)

• No bank runs – Depositors are confident – DIC will make good on the deposits

• Government deposit insurance – Cost:

• Bankers - little incentive to avoid bad risks – Benefit:

• A more stable banking system 32

Call Rate

• Call Rate – Interest rate at which banks make overnight loans

to one another • Lender – has excess reserves • Borrower – needs reserves

– A change in call rate • Changes other interest rates

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016_The Monetory System

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