MONETARY POLICY

What is Money?

Money is any good that is widely used and accepted in transactions involving the transfer of
goods and services from one person to another. It is anything that is universally accepted in
exchange for goods and services.

Economists differentiate among the three different types of money:

1. Commodity money – is a good whose value serves as the value of money e.g. gold coins
2. Fiat money – is a good, the value of which is less than the value it represents as money
e.g. dollar bills as their value as slips of printed paper is less than their value as money.
3. Bank money – consists of the book credit that banks extend to their depositors.
Transactions made using checks drawn on deposits held at banks involve the use of bank
money.

Definitions of the Money Supply

There are several definitions of the money supply:

1. M1 – is the narrowest and most commonly used and includes all currency (notes and
coins) in circulation, all checkable deposits held at banks (bank money) and all travelers
checks
2. M2 – includes all of M1 plus savings and time deposits held at banks
3. M3 – includes all of M2 plus large denomination, long term time deposits, e.g.
certificates of deposit in amounts over $100000

1 includes only the most liquid instruments and M3 relatively illiquid instruments.

Narrow and Broad Money

Narrow money is physical money such as currency and coins

Broad Money is a measure of the money supply that includes more than just physical money
such as currency and coins (narrow money). It generally includes demand deposits at commercial
banks, and any monies held in easily accessible accounts. Components of broad money are still
very liquid, and non-cash components can usually be converted into cash very easily.
CENTRAL BANK

The central bank fulfils 2 vital roles:

1. To oversee the whole monetary system and ensure that banks and other financial
institutions operate as stably and as efficiently as possible. Due to its special position at
the center of the monetary system.
2. It acts as the government’s agent, both ass its bankers and in carrying out monetary
policy.

Its main functions are:

1. It issues notes – the central bank is responsible for the issue of banknotes, which largely
depends on the demand for notes.
2. It acts as a bank :
a. To the government – it is the banker to the government and agent to the government for
sales of government debt.
b. To the banks – this refers to the cash reserve ratio that commercial banks leave at the
central bank. This is used for clearing purposes between the banks and to provide them
with a source of liquidity.
c. To overseas central banks – these are deposits of local currency held by overseas
authorities as part of their official reserves and/or for purposes of intervening in the
foreign exchange market in order to influence the exchange rate of their currency
3. It manages the government’s borrowing program – whenever the government runs a
budget deficit, it will have to finance that deficit by borrowing. It can borrow by issuing
bonds, national savings certificates or treasury bills. The central bank organizes this
borrowing.
4. It oversees the activities of banks and other financial institutions – it advises banks on
good banking practices. It transmits government policy with the commercial banks and
reports back to the government. It requires all recognized banks to maintain adequate
liquidity – prudential control.
5. It provides liquidity to banks – it ensures that there is always an adequate supply of
liquidity to meet the legitimate demands of depositors in recognized banks. It may also
come to the rescue of ailing banks.
6. It operates the government monetary and exchange rate policy –
a. Monetary policy – the central bank manipulates interest rates and influences the size
of the money supply.
b. Exchange rate policy – the central bank manages the country’s foreign currency
reserves. By buying and selling foreign currencies on the foreign exchange market,
the central bank can affect the exchange rate.
COMMERCIAL BANKS

Functions:

1. Attract deposits – commercial banks attract current account (sight accounts) deposit
account (time deposits) and large –fixed term deposits. The banks offer higher rates of
interest on large sums of money deposited for fixed periods of time
2. Lending – retail banks are profit seeking firms and their main source of income is the
interest they charge on their loans. Commercial banks lend to all types of industry, the
government and other public authorities, personal loans.
3. Money transmission services – banks provide a range of ways in which people can make
and receive payments e.g. cheques, standing orders, direct debit and credit cards.
4. Other services – the banks provide a wide range of other financial services, such as the
provision of foreign currency, investment advice, management of funds, executor and
trustee services, insurance services and unit trusts.

CREDIT CREATION

Assumption: One Commercial bank in the economy.

The bank has initial deposits of $10000 in cash, so it has $10000 in liabilities and $10000 in
assets. However only 1/10 of its deposits will be demanded in cash at any particular time so the
bank can lend $9000. The people, who borrow this $9000, spend it. The recipients of this $9000
spending put it into the bank so that $9000 is redeposited.

The bank lends out 9/10 = $8100 and keeps $900. The cycle repeats itself so that $8100 finds its
way back into the bank and 9/10 is lent out and 1/10 is kept back.

LIABILITIES $ LOANS AND ADVANCES $ ASSETS $

Initial deposit $10000 1st loan $9000 1/10 retained $1000
1st redeposit $9000 2nd loan $8100 1/10 retained $900
2nd redeposit $8100 3rd loan $7290 1/10 retained $810

TOAL LIABILITIES $100000 LOANS $90000 ASSETS $10000

At the end of the process, with a total cash of $10000 in the system and a cash ratio of 10% the
bank is able to make loans amounting to $90000.

Money multiplier - 1/cash reserve ratio (1/CRR)\

Total Assets = Initial deposit

Total loans and advances = total liabilities – total assets

Total liabilities = initial deposit x money multiplier

$100000 = $10000 x 1/10% = $10000 x 100/10 = $10000 x 10.

INTEREST RATE DETERMINATION

Interest rates can be determined using two theories:

1. Classical theory – Loanable funds theory

2. Keynesian theory – Liquidity Preference theory.

LIQUIDITY PREFERENCE THEORY.

Keynes stated that the rate of interest is determined by the demand and supply of money.
Liquidity preference theory refers to the demand for money as a desire to hold wealth in the form
of money. The preference for money over other kinds of assets is known as liquidity preference.
Liquidity describes the readiness with which an asset can be converted into cash without any
significant loss in value. People want to hold their wealth in liquid form
(cash/cheque/current/sight deposits). Wealth held in the form of money is readily convertible
into any other type of asset.

Money is one way in which an individual holds wealth. It can be held in the form of land,
buildings, shares and securities. The wealth of a person can be arranged from the most liquid –
cash and the least liquid being real physical assets e.g. Buildings. Holding cash gives certainty
and convenience, assets – income is gained but risk is increased. A selection of financial assets I
termed a portfolio and the distribution of assets within the portfolio is called a portfolio balance.

KEYNESIAN THEORY OF THE DEMAND FOR MONEY

Keynes argued that there were 3 motives for holding money:

1. Transactions
2. Precautionary
3. Speculative
 1. TRANSACTIONS MOTIVE

People held cash/money to carry on the everyday business life of purchasing goods and services.
The amount of money held depends upon the level of income, the movements in prices and the
frequency with which income payments are made. If income rises people hold larger transactions
balances, if prices rise the transactions balances are also high. The frequency with which income
is paid also influences the size of the average transactions balances.

Since people are paid weekly or monthly but spend daily they hold a proportion of their income
as money rather than in less liquid assets. This gives a pattern shown below where the peaks in
the money balance are salary inputs and the downward slope of the curve shows money being
spent over the month.

Money

1 2 3 4 5 6 7 8 9 10 11 12 time

The lower line shows weekly salary inputs. There is a higher velocity of circulation. Keynes
thought that the transactions demand for money is determined by the level of money and income.

2. PRECAUTIONARY MOTIVE.

Most people hold additional balances to deal with emergencies or to take advantage of some
unexpected bargain. The higher the level of income the larger will be the size of the
precautionary balances. Money held for transactions and precautionary motives is likely to be
spent in the near future and is referred to as the demand for active balances. The amount held for
these motives is not significantly influenced by the rate of interest – the motives are interest
inelastic.
 Rate of Interest

L1

Quantity of Money

SPECULATIVE MOTIVE

Households hold money in excess of the amounts needed for transactions and precautionary
purposes when they are convinced that it is more rewarding to hold money than financial or real
income earning assets due to changes in interest rates and the price of financial assets. Keynes
looked at the speculative motive in terms of the decision to hold wealth in the form of cash or
fixed income bonds where the price of bonds and the rate of interest are inversely proportional to
each other, e.g. a fixed income bond which yields an income of $5 per year. If the market rate of
interest is 10% the price of the bond will be $50. Investors had an idea of the normal rate on
interest. If the current rate of interest was below this people speculate by holding cash expecting
interest rates to rise and bond prices to fall. The lower the interest rates the more people expect
the price of bonds to fall and thus more people hold cash rather than bonds. So low interest rates
are associated with high speculative demand for money. If the rate of interest was high then the
price of bonds is low, then people buy bonds with the hope of making capital gains when the rate
of interest falls. High interest rates are associated with a low speculative demand for money. The
demand for money is elastic with respect changes in interest rates.
Rate of interest

L2

Quantity of Money

If the demand for active balances is added to the demand for speculative idle balances the total
demand for money is obtained. The curve, the Liquidity Preference curve, shows how the
quantity of money demanded varies s the rate of interest varies.

L2

L1

Quantity of Money
EQUILIBRIUM IN THE MONEY MARKET

Equilibrium will be where the demand for money L is equal to the supply of money Ms. The
supply of money is assumed to be fixed in the short run and is represented by a vertical line. The
rate of interest is determined by the intersection of the demand curve for money L and the supply
of money. It is given by r.

rate of interest Ms

M Quantity of money

If the rate of interest is above the equilibrium rate of interest then people would have surplus
money balances which they use to buy securities and other assets. These forces up the price of
securities and lower the rate of interest. This in turn causes a contraction in the money supply( a
movement down the money supply curve and an increase in the demand for money balances
especially speculative balances (at low interest rates, price of securities would be higher and
people would not want to buy securities) . Interest rates would fall until equilibrium. If the rate of
interest was below the equilibrium rate of interest then people would have insufficient money
balances so they sell securities lowering its prices and raising the rate of interest until
equilibrium is reached.
An increase in liquidity preference (that is a stronger desire to hold money) due to an increase in
income, or that prices in general are about to fall, will raise the liquidity preference curve and
the rate of interest goes from r1 to r2.

L1

rate of interest L Ms

r2

r1

M Quantity of money

An increased preference for money balances leads to an increase desire to sell securities, which
increases the supply of securities and lowers their prices. This causes the rate of interest to rise

If the money supply increases from Ms1 to Ms2 then some people will have excess money
balances (no change in Liquidity preference). They will have a greater proportion of their wealth
in money at the current rate of interest. They then redistribute their wealth among the different
types of assets and hence buy more bonds. This increase in demand for bonds increases their
price and lowers the rate of interest.
rate of interest Ms1 Ms2

r1

r2 L

M Quantity of money

An increase in the money supply where the demand for money is horizontal has no effect on the
rate of interest. This horizontal part of the demand for money curve is known as the liquidity trap
as it is not possible to lower the rate of interest by increasing the money supply. This is because
all the extra money will be held in idle balances in the in the expectation that the price of bonds
will fall in the future.

rate of interest Ms

M Quantity of money
EQUILIBRIUM IN BOTH THE MONEY MARKET AND NATIONAL INCOME

Changes in the money supply/demand affect national income via changes in the rate of interest.

rate of interest rate of interest

Ms Ms1

r1 r1

r2 r2

Md I

quantity of money I1 I2 investment

J,W

J1= I1+G+X

J=I+G+X

National Income

A rise in the money supply will lead to a fall in the rate of interest. The fall in the rate of interest
will lead to a rise in investment and other forms of borrowing. Since borrowing money will be
cheaper investment will cost less and so increase. A rise in investment will lead to a multiplied
rise in National income and aggregate demand(AD).
LOANABLE FUNDS THEORY.

The rate of interest is determined by the interaction of the demand for loanable funds and the
supply of these funds.

rate of interest Supply of Loanable funds

Demand for loanable funds

Q Quantity of loanable funds

DEMAND FOR LOANABLE FUNDS.

The demand for loanable funds was assumed to come entirely from firms seeking investment
funds. Firms invest because they expect to earn profits. Firms anticipate this newly created
capital will yield a series of returns during its lifetime which will exceed the costs incurred in its
purchase and maintenance. The expected net annual receipts can be expressed in the form of a
percentage annual return on the initial outlay. This percentage wield is the productivity of
capital.

Not

Not only do firms borrow, but also households to buy houses and consumer durables, to buy
assets ; the government. Households and firms demand for loanable funds is affected by the rate
of interest which both move in opposite directions. This gives a downward sloping demand curve
for loanable funds.

SUPPLY OF LOANABLE FUNDS.

The main determinant of the supply of loanable funds (funds for loans) is the current rate of
saving. To correct savings into loanable funds savers have to be willing to lend their saving by
being compensated with interest. Interest allows a higher level of consumption in the future. The
higher the rate of interest, the more they are likely to be willing to lend and so the supply curve
of loanable funds slopes up from left to right.

MONETARY POLICY

Monetary policy refers to the attempts to manipulate either the rate of interest or the money
supply so as to bring about desired changes in the economy. Any attempt to control the money
supply must be directed at controlling the banking sector’s ability to lend or to influencing firms
and households willingness to borrow. A central bank can either fix the quantity of money or its
price. It cannot fix both simultaneously. If the demand for money does not change, changes in
the money supply will alter the rate of interest.

TOOLS OF MONETARY POLICY

1. Rate of interest – central bank can encourage economic activity by lowering the cost of
borrowing and increasing the demand for loans. Conversely raising interest rates
discourages borrowing. The interest rate is influenced by the central bank as a buyer and
seller in the money market. It can keep the banking system short of money and then lend
the required amount at an interest rate which it decides.
2. Open market operations – central bank can affect the supply of financial assets in the
banking system by means of its activities in the markets for securities, by buying and
selling securities (government bonds and other government securities) in the open
market. If there is a shortage of funds in the money market, the central bank purchases
government securities to increase funds. If it wishes to restrict bank lending it will sell
securities. (The banks and other buyers pay for these securities with cheques drawn on
their accounts in the central bank. The debts will be settled by a reduction of the banker’s
deposits at the central bank. A fall in these deposits represents a reduction in the banks
liquid asset ratio and they reduced the level of their total deposits to restore the required
ratio of liquid assets to deposits provided they don’t have a surplus of liquid assets.)
3. Special deposits – central bank can instruct commercial banks to place some of their
liquid assets with it. This reduction in liquid assets may mean that they will have to
reduce their bank lending. If central bank wishes to encourage bank lending it can release
any special deposits it is holding and thus increase the commercial bank’s supply of
liquid assets.
4. Funding – this is a way of reducing the supplies of liquid assets available to the banking
system. This entails the conversion of short term government debt (short term securities/
 treasury bills ) into longer term debt. This makes the banks more vulnerable to open
market operations and calls for special deposits because Treasury Bills are liquid assets
and long term securities are not
5. Quantitative and qualitative controls – central bank can make use of quantitative controls
(limits on bank lending) and qualitative controls (directives on who should receive loans)
6. Moral suasion – central bank may seek to persuade banks to lend less.
7. Exchange rate policy – government operate their own currencies and decides if it is fixed,
managed of floating. If fixed the government decides on the exchange rate and raises its
price to curb imports.

EFFECTIVENESS OF MONETARY POLICY

1. The effectiveness of monetary policy depends on the impact of changes in the rate of
interest on consumption and investment in the economy. If the demand for investment is
interest inelastic there would be no profound effect on investment. If consumers are
unwilling to lend, then monetary policy will also have little effect.
2. Excess reserves by central bank- if the cash reserve ratio is lowered, commercial banks
expand their lending and the money supply expands. If commercial banks are unwilling
to lend or there is no demand for borrowed funds by consumer then the money supply
will remain unchanged and monetary policy will have no effect.
3. If the money supply was expanded but consumers responded by holding more money
there would be a reduction in the circulation of money which will offset or frustrate the
effectiveness of monetary policy.

rate of interest Ms1 Ms2

LP2

LP1

Quantity of money
4. Liquidity trap – the liquidity trap causes the rate of interest to remain unchanged even
though the money supply increases. This occurs when the demand for money is perfectly
interest elastic which occurs over the flat portion of the liquidity preference curve. This
occurs at very low rates of the rate of interest where speculators do not expect the rate of
interest to fall any further. No capital gain from holding financial assets are anticipated
when the rate of interest is at a low level. The demand for money becomes unlimited at
such low rates of interest. If the money supply increases the whole increase is added to
speculative balances and the rate of interest remain unchanged. Monetary policy is
ineffective in the liquidity trap region.
5. Currency substitution – in some countries both local and foreign currencies are held by
consumers so consumers hold foreign currencies when there is high domestic inflation
(purchasing power is eroded). To prevent this people hold foreign currency. Monetary
policy is only effective on the local currency held by consumers. Currency substitution
limits the government’s control over the domestic component of money and this reduces
the effectiveness of monetary policy.
6. Foreign investment and the money supply – open market operations aims to increase the
money supply to the public. If central bank purchases bonds and bond holders receive
money in exchange. As more money circulates the rate of interest falls. If however bond
holders deposit their money in a foreign account then monetary policy will be relatively
ineffective.
7. Time lags – if monetary policy is not well timed then the desired effect of the monetary
policy will not be achieved. Monetary policy may take a considerable length of time
before it has any effect on the economy. This is undesirable as by the time monetary
policy has its full effect the targeted variable of the policy may already have been
corrected by the natural workings of the economy e.g. the impact of expansionary
monetary policy in an economy with full employment would lead to inflation. Hence
monetary policy will be more volatile if it occurs at the wrong time.
THE QUANTITY OF MONEY

The classical economists (monetarists) based their analysis of inflation on the quantity theory of
money which in its simplest form states that the general level of prices (P) in the economy
depends on the Money Supply Ms.

P = Ms

So that the greater the quantity of money, the higher the level of prices. Inflation is simply
caused by a rise in the money supply. In its simplest form any measure of the money stock does
not equal GDP because each unit of the money supply is used several times in one year. The
number of times a unit of currency changes hands in a given time period is referred to as the
velocity of circulation. (V)

If we assume a simple economy with four individuals: A, B,C,D each making a living by selling
goods and services to each other. B producing what A wants etc. in each case the value of the
goods concerned is $1. The total value of goods exchanged is $4. The stock of money is $1.
Since A pays B who pays C etc the total income generated is $4 as income is a flow of money
with respect to time while the amount of money is a stock.

The total value of money changing hands to finance transactions can be calculated as:

The stock of money (M) x the velocity of circulation

M x V =$1 x 4 = $4

The same figure can be found by taking the general or average price level (P) e.g. $1 and
multiplying it by the number of transactions (T) e.g. $4. This gives $4

Thus M x V = P x T

This is the quantity equation or the equation of exchange and was first developed by Irving
Fisher, an American economist.

M x V – the total value of money changing hands in a given time period.

P x T – the total value of the transactions in the same time peiod.

Everytime there is a sale or transaction, it will be equal in value to the money changing hands.
What is true of each transaction is also true for the aggregate.
The theory was amended where M is the supply of money in the economy, V is the velocity of
circulation ie the number of times per year a dollar is spent on buying goods and services that
make up GDP. If each dollar worth of money is spent 5 times per year on goods and services and
the Money supply was $20 bn, then the total expenditure on GDP : (M x V) = $100 bn.

P is the general level of prices and Y is the real value of national income (GDP at base year) P x
Y = ‘nominal’ value of GDP.

Thus both MV and PY are equal to GDP as it represents total expenditure in the economy.

The Classical economists argue that both V and Y are determined independently of the money
supply so a change in the money supply would not lead to a change in V or Y. V was determined
by the frequency with which people were paid, the nature of the banking system and other
institutional arrangements for holding money. Y was maintained at the full employment level.

With V and Y as ‘constants’ with respect to M the quantity theory holds as they are unaffected
by changes in the money supply

MV = PY

It follows that a change in the money supply causes an equal percentage change in the price
level.