Money and Monetary Policy

Chapter 3

The Concept of Money

Money allows people to specialize in what they do best, it removes problems associated with barter and increases trade and business transactions. Specialization allows more goods and services to be produced and exchanged, thereby increasing the standard of living for all. The primitive barter may not be able to support such system. The reason can be summarized below: Double coincidence of wants for example, furniture maker and poultry farmer.

Indivisibility of goods and services continue from the above example, the exchange ratio might not be acceptable to either or both the parties. Lack of an unit of account (common standard of value) as diversification of products grows, is that pricing.

The Concept of Money

A good monetary system is a mechanism by which markets are efficiently and perfectly cleared. If not people would resort for barter trade. For example, Malaysia resorted to barter trade due to a shortage of foreign reserves. Indeed, barter is practiced even in instances when the monetary exchange mechanism performs well, for example, as a means of avoiding taxes. Modern money essentially performs with more efficiency and effectiveness and nothing more than tools for facilitating exchange and might be described as the mechanism by which markets are perfectly cleared or a mechanism which speeds up and simplifies the process of producing and exchanging goods and services. Money has evolved from items like cowry shells, stones, leather etc. to gold and silver, to paper currencies and electronic money.

Functions of Money
Functions of Money

Medium of Exchange

Unit of Account

Store of Value

Standard of Deferred Payment

Functions of Money

To solve the problems of barter trade, such as double coincidence of wants, indivisibility of goods and services, lack of a unit of account. Accordingly, the most important functions of money are to serve as:

Medium of exchange A unit of account Store of value Standard of differed payment

Functions of Money

Medium of Exchange

The most important function of money is its function as a medium of exchange.

Money as anything that is used as a means of making payments. If it is difficult and expensive to obtain money, it might be claimed that such a medium is not effective and efficient to perform the function as a medium of exchange. A good medium of exchange is one that allow everyone to exchange his or her goods and services fast at a minimum cost

Functions of Money

Unit of Account

In barter trade era, pricing is very cumbersome and makes exchange impractical and almost impossible in a market with a huge amount of goods and services. Thus, one of the most important functions of money lies in its role as a unit of account. A universal pricing tool and useful to obtain information from the market on the value of ones output. Therefore, a good unit of account is one which enables the market participants to express the value of their products and services in a way that reflects their relative desired value against other goods and services. Furthermore, a good unit of account is one which allow market participants to extract information on the current demand and supply situation.

Functions of Money

Store of Value

An item being used as money is indeed a temporary storage of value in the exchange process. For example, one transform the value of a chicken into monetary form and later he want to transform its value back into real goods and services. If the purchasing power of money is eroded over time, then that money has not been a good store of value. Since inflation is a measurement of the purchasing power of money, it is therefore used as a measure to estimate the performance of money as a store of value. For example, if the general price level is stable, which equivalent to low inflation, we can say that money has been a good store of value and vice versa. For example, previously we can buy a cup of tea for 30 cents but now we can only get a cup of plain water.

Functions of Money

Standard of Deferred Payment

Money is not only useful for spot transactions, but also in specifying future payments for current purchases, i.e., buying now and paying later. This function is the result of the role of money as a unit of account and store of value.

Types of Money
Types of Money

Commodity Money/Commodity Monetary Standard

Metallic Money

Fiat Money

Types of Money

Commodity Money or Commodity Monetary Standard

Commodity monies might be defined as commodities which are used to facilitate the exchange process. In such a monetary arrangement, it would be either the commodity such as rice, tobacco itself that circulates and exchanges hands (and hence the term as commodity money), or notes that are being issued against, and are redeemable for a particular commodity (what is termed as commodity monetary standard). The redeemable function is important for this purpose. Disadvantages:

The expense involved and transportation issue Storage costs and the variation in the qualities of money (quality of rice or tobacco to settle obligations).

Types of Money

Metallic Money

Gold and silver were commodity found very desirable to play the role of money (medium of exchange, a unit of account, store of value, and standard of deferred payment). Gold and silver have the following characteristics to become a good money:

Divisible Fungible (equivalent in value) Weighable, measurable, or countable Stable in value over time Durable Homogeneous Mobile

Types of Money

Fiat Money as a Commodity

Conventional banks are not allowed to utilize money created by them for their own purposes, but the newly created money can only be lent out to third parties.
Therefore, every conventional banks lends out the created money, its profits coming not from the seigniorage but from the interest earned on the lending principal amount. Then how are Islamic banks make profits? Through equitybased and debt-based instrument, but, most Islamic banks preferred to utilize the debt-based instrument due to the less risky than the equity-based instruments.

Types of Money

Fiat Money as a Debt Certificate

Money is not a commodity at all, but just a debt recording mechanism. All holders of monetary notes would become creditors and those who borrowed the money would be creditors.
Read the example of the JAK Medlemsbank interest free co-operative bank. The bank does not increase the amount of credit in circulation without the corresponding savings or the credit expansion takes place only with the consent of the savers, who are creditors in the system.

This is in total contrast to the general practice of today in which many parties end up as chronic net debtors, a phenomenon which happens due to the absence of consent of the creditors, leading to a disproportionate allocation of credit, income, and wealth.

Time Value of Money

A basic concept in finance, today money is worth more than tomorrow money. A today RM100 has more value than a RM100 in the future. There are 3 reasons why this is so.

Money loses its value over time due to inflation of economy.

Money has opportunity costs due to not be able to invest the money and get return from its.
Uncertainty of future cash flows due to some circumstances they may not happen.

Monetary Policy Instruments

Monetary Policy Instruments

Required Reserve Ratio

Discount Rate

Open Market Operations

Monetary Policy Instruments

Required Reserve Ratio (RR)

Required reserve ratio as demanded by the Central Bank (Bank Negara Malaysia) have a direct impact on the banking system excess reserve to be lent out. For example, the total deposit in the banking system is RM4 billion and the required reserve ration is 10 percent, then the total required reserve ratio is RM400 million and the remaining RM3.6 billion is excess reserves, which the banking system can use it to be lent out. Thus, the Central Bank can use this instrument to increase or decrease the banking system excess reserves in conducting the country monetary policy. How to increase the excess reserves in the banking system?

Monetary Policy Instruments

Discount rate

In this situation the Central Bank serves as the bank for financial intermediaries and extend loans to banks that need funds. The interest rate charge to banks is termed as discount rate. Normally, the central bank will use the discount rate to signal its monetary intention, whether to expand or contract the stock of monetary supply. For example, if central bank lowering its discount rate, the central bank intend to expand the stock of monetary supply, thus, increase the banking system credit availability and therefore, more loans can be made out (credit expansion) and vice versa.

Monetary Policy Instruments

Open Market Operation (OMO)

The purchases and sales of government securities by the central bank in the open market. The exchanges of financial assets and monetary assets between the central bank and the publics.
For example, central bank buy back government securities from the banking system this action increases the credit availability in the banking system and vice versa.

This actions by the central bank can expand or contract the stock of monetary supply in the banking system.

Islamic Monetary Policy Instruments

Do the following instruments comply to Islamic principles? And can they serve as Islamic monetary policy instrument? Required Reserve Ratio

May be as its use may reflect both monetary control and a prudential measure to safeguard depositors funds. Disadvantages: lack of flexibility, resulted in wide swings in the stock of money supply thus affect price and financial stability. May still be used to increase credit availability in the banking system however, the discount rate needs to be abolished so that the lending activities are Shariah compliance. Can be used as long as the government securities traded in the transactions are Islamic securities thus, the need to develop Islamic capital markets is a must so that these instruments can be effectively used.

Discount Rate or Discount Window

Open Market Operations

Money Supply Process

Simple Monetary Supply Process

One of the banking system function is to extending credits to the private sector and this lead to multiple money creation. The bank credits availability is affected by the monetary policy instruments as described before. We use the simple T-account to illustrate the money supply process and how monetary instruments can affect the stock of money supply. Assuming that the money supply is in the form of bank deposits and banks do not keep excess reserves. All excess reserves are extended as loans. Refer to the following T-account of the banking systems, assuming the required reserve ratio is 10% of total deposits of 2 billion. The assets of the banking system is RM200 million; RM1.3 billion loans and advances, and RM500 million in government securities. The banking systems liabilities stand at RM2 billion.

Table 1 Reserves Loans Securities

Money Supply Process

Liabilities (RM million) Bank Deposits 2,000 200 1,300 500

Assets (RM million)

Suppose that the government purchases back its securities from the banking system at RM200 million. This action reduces the securities held by the banking system to RM300 million. As a payment, the central bank increases the banking reserves to RM400 million. Refer to the following table. Table 2 Assets (RM million) Reserves 400 Liabilities (RM million) Bank Deposits 2,000

Loans
Securities

1,300
300

Money Supply Process

Now the banking system had an excess of reserve of RM200 million and would be able to lent out to say Mr. Ahmad, who than deposits the RM200 million in the banking system. Thus, will increase the bank total deposits of RM2,200 million. With the new loans, now the banking system loans increase to 1.5 billion. Table 3 Assets (RM million) Reserves Loans Securities 200 1,500 500 Liabilities (RM million) Bank Deposits 2,200

From Table 3 above, through the lending of RM200 million, money supply increases to RM2,200 million. Thus, money supply is created through lending. But money creation will not stop here, there will be multiple creation of money supply.

Monetary Transmission Mechanism

Monetary Transmission Mechanism
Asset Price Channel Exchange Rate Effects Asset Price Channel Equity Prices

Credit Channels

Profit-and-Loss Sharing Channel

Monetary Transmission Mechanism

Central bank control the economy money supply through injection of reserves in the banking system, thus allowing bank to extend credits to those who need funds. Now we need to understand the process or mechanism by which the use of monetary instruments and subsequent changes in the money supply are transmitted to final objectives. The traditional monetary transmission mechanism in the conventional banking system is through the changes in interest rate as follow: Traditional Monetary Transmission Mechanism Policy instrument Money Supply Interest rate Investment & Consumption Real Output/Price Level

Monetary Transmission Mechanism

By increasing credit or loan supply, the price (borrowing interest rate) of loans decreases. This will affect private expenditures (private investment & consumption of durable goods). Thus, alter aggregate demand and will influence both real activity and price level & vice verse. However, the above channel of monetary transmission is not applicable in the Islamic financial system as the system is free from interest rate (riba). But, the changes in credit availability may influence the 4. PLS which, in turn, may affect financing and later real economic activity. Other channels that did not involve interest rate are asset price channels (1. exchange rate and 2. equity prices) and the 3. credit channel.

Monetary Transmission Mechanism

Asset Pricing Channel Exchange Rate Effects

Due to increase in global market integration and international trade leading to the influence of monetary policy on the economy through changes in the exchange rates. Exchange rate is influenced by capital flows across nations, driven by changes in interest rates. For example, changes in money supply lead to changes in the interest rate. Open-market purchase or reduction in discount rate and required reserve ratio, termed as expansionary monetary policy, the interest rate is lowered. As a result, domestic financial asset be less attractive, leading to an outflow of capital thus, domestic currency depreciates. Currency depreciation makes domestic goods and services more competitive and foreign goods and services more expensive for local residents. As a result, net export increase, leading to the increase in real activity.

Monetary Transmission Mechanism

Asset Price Channel Equity Prices

Monetary policies can also affect real activity through its effect on equity prices. Given money demand, the increase in money supply makes the economic agents realize that they have excess money. To make excess money to be equal to money demand, the economic agents spending part of it in the stock market. Thus, increase stocks demand which leading to increase in stock prices (Firms value increase). Firms are encouraged to issue more stocks to finance investments. In addition, the increases in equity prices raises financial wealth of consumers thus, stimulate consumer spending.

Monetary Transmission Mechanism

Credit Channels

The channels are bank-lending and firms balance sheet channel The contraction of bank deposits as a result of monetary policy may not limit loan supply if there is symmetric information in the market and financial assets are perfectly substitutable. Bank may be able to raise funds through other sources at the same cost. But due to asymmetric information, there is a wedge between alternative sources of funding. Facing higher cost to raise funds, banks are forced to contract loan supply. At the same time firms may also face higher costs by raising funds on their own thus, limit the firms investments and real output. Two essential conditions for this lending channel to be operative: (1) monetary policy influence on loan supply and (2) substantial number of firms that are dependent on bank loans.

Monetary Transmission Mechanism

PLS Channel

The potential influences of monetary policy on the PLS ratio of Islamic banks. Monetary policy action may alter the PLS ratio, in the process, encourage and discourage firms from seeking financing for its investment activities. For example, denote R to be an expected return from investment. The expected return realized would thus be sR, where s is the share of profits that goes to the firms. Monetary policy can influence on the profit share of the firms. For instant, suppose that money supply increases and banks find their excess reserves to be more than the level targeted, which leads to offer financing at a lower sharing ratio going to them. Therefore, a project that has lower expected return (lower R) will now be viable to the firm. Thus, the investment by firms will be stimulated.

Economic Agents in Monetary Policy

Economic Agents in Monetary Policy

Economic Agents and Monetary Supply Process

Fairness in Monetary Policy

Economic Agents in Monetary Policy

Economic Agents and Money Supply Process

Economic agents also play a role in affecting liquidity in the market for example, the behavior of banks and individuals in the forms of their excess reserve ratio and currencydeposit ratio respectively. Therefore, understanding the contributing role of economic agents in money creation and how it may affect real activity will be essential for economy well-being. We may start from the demand and supply of money and economic cycles. For example, during recessionary periods, financial markets tend to be riskier thus, individuals and banks prefer to hold currency. Therefore, money supply drops even if the monetary authority is passive and real activity declines as well.

Economic Agents in Monetary Policy

Fairness in Monetary Policy

Economic agents are not only at the contributing end but also are at the receiving end of the monetary supply process. Therefore, the issue of the final outcome of monetary policy action is not non-discriminatory (sectoral or distributional consequences). It is clear that monetary policy will not have the same effect on individuals and firms. For example, in the face of monetary contraction, household and small firms may be held out from loans. Relationship lending is common among banks and large firms.

Issues in the Conduct of Islamic Monetary Policy

What are the characteristics of the Islamic financial markets that are pre-requisite to the effective use of Islamic monetary policy? We may acknowledge the importance of the markets at the developed stage characterized by:

Diversified financial instruments Liquidity Transparency Effective enforcement mechanisms

These characteristics are essential to make the transmission of monetary policy effective and to alleviate the problem of asymmetric information in the markets.

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