The Money Market & Interest Rate DeterminationCh 29 & Ch 30

Learning ObjectivesTo understand the functions of moneyTo describe how money is created in the economyTo assess the implications of the money multiplierTo understand the implications of the quantity theory of moneyTo analyse the main determinants of the demand for moneyTo understand how interest rates are determinedTo describe the main instruments of monetary policy

The Functions of MoneyMoney has three functions in the economy:Medium of exchangeUnit of accountStore of value

The Functions of MoneyMedium of ExchangeA medium of exchange is anything that is readily acceptable as payment.

The Functions of MoneyUnit of AccountA unit of account is the yardstick people use to post prices and record debts.Store of ValueA store of value is an item that people can use to transfer purchasing power from the present to the future.

LiquidityLiquidityLiquidity is the ease with which an asset can be converted into the economys medium of exchange.

The Kinds of MoneyCommodity money takes the form of a commodity with intrinsic value.Examples: Gold, silver, cigarettes.Fiat money is used as money because of government decree.It does not have intrinsic value.Examples: Coins, currency, current account deposits.

Money in the EconomyCurrency is the paper bills and coins in the hands of the public.Demand deposits are balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card.

THE ROLE OF CENTRAL BANKSA central bank is an institution designed to oversee the banking system and regulate the quantity of money in the economy. Whenever an economy relies on fiat money, there must be some agency that regulates the system.

THE ROLE OF CENTRAL BANKSThe money supply is the quantity of money available in the economy.

The regulation of the money supply is a crucially important task.

THE ROLE OF CENTRAL BANKSMonetary policy is the set of actions taken by the central bank in order to affect the money supply.

THE EUROPEAN CENTRAL BANK AND THE EUROSYSTEMThe European Central Bank is the overall central bank of the 18 countries comprising the European Monetary Union. The ECB was officially created on 1 June 1998 and is located in Frankfurt. It came into being because 11 countries of the European Union had decided that they wished to enter European Monetary Union and have the same currency circulate among them.

The EurozoneTo enter, countries had to meet certain criteria relating to inflation, interest rates, government borrowing and national debt.Initial Member countries (11): Austria, Belgium, France, Finland, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain.2001 Greece joined; 2007 Slovenia and 2008 Malta and Cyprus; Slovakia 2009, Estonia, 2011, Latvia 2014.18 Eurozone countriesUK, Sweden and Denmark decided to stay out.

THE EUROPEAN CENTRAL BANK AND THE EUROSYSTEMThe primary objective of the ECB is to promote price stability throughout the euro area.An important feature of the ECB and the Eurosystem is its independence.The Eurosystem is the system made up of the ECB plus the national central banks of the 18 countries comprising the European Monetary Union.

BANKS AND THE MONEY SUPPLYBanks can influence the quantity of demand deposits in the economy and the money supply.

BANKS AND THE MONEY SUPPLYReserves are deposits that banks have received but have not loaned out.In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

BANKS AND THE MONEY SUPPLYReserve RatioThe reserve ratio is the fraction of deposits that banks hold as reserves.

Money Creation with Fractional-Reserve BankingWhen a bank makes a loan from its reserves, the money supply increases.The money supply is affected by the amount deposited in banks and the amount that banks loan.Deposits into a bank are recorded as both assets and liabilities.The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.Loans become an asset to the bank.

Money Creation with Fractional-Reserve BankingThis T-Account shows a bank thataccepts deposits,keeps a portion as reserves, and lends out the rest. It assumes a reserve ratio of 10%.

Money Creation with Fractional-Reserve BankingWhen one bank loans money, that money is generally deposited into another bank.This creates more deposits and more money to be lent out. When a bank makes a loan, the money supply increases.

Money Creation with FRBAssets LiabilitiesCommercial Banks Balance SheetIncreases in round 1 2 3 Deposits 1 2 3Reserves100 90 81 1,000 900 810Loans 900 810 729

The Process of Money Creation with FRBRoundM1234.nTotal1,00090081072910,000

The Money MultiplierHow much money is eventually created in this economy?

The Money MultiplierThe money multiplier is the amount of money the banking system generates with each unit of reserves.

The Money MultiplierThe money multiplier is the reciprocal of the reserve ratio:M = 1/RWith a reserve requirement, R = 20% or 1/5,The multiplier is 5.

Quantity TheoryThis states that the larger the quantity of money in the economy, the higher the price level

MS x V =P x Real GDP

Keynesian Liquidity Preference Theory: Money DemandThree Reasons for Holding CashTransaction MotivePrecautionary MotiveSpeculative MotiveTransaction and Precautionary MotiveMD = f( Price, Real GDP)Speculative Motive with the object of securing profit from knowing better than the market what the future will bring forth

There is an inverse relationship between MD and interest ratesMD= f ( r) Combining Keynes three reasons for holding money, then the demand for money is given by:Md = f (P, Real GDP, r)

Fig 1:The Demand For MoneyInverse relationshipMd=f(P, Real GDP, r)rMr1M1r2M2

Fig 2: Determination of Interest RatesEquilibriumMSMS1rMrr1Md

Monetary PolicyThe Central Bank may influence the size of the money supply throughOpen Market OperationsChanges in Interest RatesChanges in Reserve RatiosOpen Market operationsbuying and selling of government stock on the open market to influence the money supplyIf CB buys gov stock : increase in MSIf CB sells gov stock: decrease in the MS

Setting Reserve RequirementIncrease RR: decrease in the MSDecrease in the RR: increase in the MSChanges in Interest Raterate at which the CB lends to the commercial banks ( main refinancing interest rate (MRIR)increase interest rate: decrease in MSdecrease interest rate: increase in MS

ReviewThe demand for money is determined by P, R. GNP and rThe equilibrium r is determined by MD and MSM.P is about controlling MSThere is a strong link between MP and FP

********************