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Functions of Money 1- Medium of exchange Used to buy/sell goods 2- Unit of account Goods valued in dollars 3- Store of value - Transferring purchasing power from present to future. - Money is used to store value because it is the most liquid asset. LO1 30-3
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Money and Banking
31,32,33
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Definition of Money
What is Money ?
Anything that performs the functions of money is money
LO1 30-2
Functions of Money1- Medium of exchange
Used to buy/sell goods
2- Unit of accountGoods valued in dollars
3- Store of value- Transferring purchasing power from present to future. - Money is used to store value because it is the most liquid asset.
LO1 30-3
Functions of Central Bank
1- Quasi Public BankNot deal with public only commercial banks
2- Bankers’ Banks- issuing a currency- acting as lender of last resort- accepting deposits from banks
LO1 30-4
Components of Money Supply
• Supply of Money: Measuring Money in the Economy
• Money supply is measured in two ways;• The narrowest definition of money supply
is M1• The broader definition of money supply is
M2
LO1 30-5
M1
M1= Currency + Checkable Deposit• Currency -Coins : All coins are “token money”
-Paper money• Checkable deposits
- Customers Deposits payable on demand- Checkable deposits are the largest component of M1
LO1 30-6
M2
M2 = M1+ SD + TD + MMMF• M1• Saving deposits• Time deposits• Money market mutual funds (MMMF)
LO1 30-7
Money Market
• Links the relationship between amount of money & interest rate in a graph.
• Why supply money (Ms)?- Central Bank only controls the Money Supply - Central Bank changes Money Supply when needed (using tools
of Monetary Policy)
• Why hold (Demand) money (Md)?1- Transactions demand(indicated by nominal GDP)2- Asset demand,(varies inversely with the interest rate)• Thus; Total money demand is function of GDP & interest rate
LO1 30-8
Money MarketTotal demand for money (Md) and supply of money (Ms)
LO1 30-9
5
50 100 150 200 250 300
Rat
e of
inte
rest
, i p
erce
nt
Amount of moneydemanded and supplied(billions of dollars)
Ms
Md
-Equilibrium i is 5%, -Equilibrium i changes with shifts in Md and Ms
Commercial Banks• Accept deposits from customers• Banks create money through lending• Banks lend excess reserves (How ??)
• Total Reserves consist of Required Reserves (at the central bank) & Excess Reserves ( available to banks)
• Required reserves= Checkable deposits x reserve required ratio
• Example:– Total Checkable deposits $1,000,000 at NBK, Reserve Required Ratio
= 20%, then NBK has to keep …….. at the central Bank of Kuwait, and lends up to ………
LO1 30-10
Tools of Monetary Policy
First Tool: Open market operations–Buying and selling of government securities (or bonds)–Commercial banks and the general public–Used to influence the money supply
• When the Central Bank sells securities, commercial bank reserves are reduced (Money supply decreases…why?)
• When the Central Bank buys securities, commercial bank reserves are increased (Money supply increases ..why?)
LO1 30-11
Tools of Monetary Policy
Second Tool : Reserve requirement Ratio (RRR)– part of the deposits at each commercial bank should
be kept at the central bank
• When the Central Bank increases RRR, commercial bank reserves are reduced (Money supply decreases…Why?)
• When the Central Bank decreases RRR, commercial bank reserves are increased (Money supply increases…Why?)
LO1 30-12
Tools of Monetary Policy
Third Tool : Discount Rate (Rd)– is the interest rate that the central bank charges to
commercial banks that borrow from the central bank.
• When the Central Bank increases Rd, commercial bank reserves are reduced (Money supply decreases…Why?)
• When the Central Bank decreases Rd, commercial bank reserves are increased (Money supply increases… Why?)
LO1 30-13
Monetary Policy• The monetary policy is the use of monetary
policy tools to affect the Aggregate Demand (AD).
• Expansionary monetary policy To increase AD, central bank aims to increase
Money Supply using:OMP, or lower RRR, or lower Rd• Restrictive(Contractionary)monetary policyTo increase AD, central bank aims to decrease
Money Supply using:OMS, or rise RRR, or rise Rd
LO1 30-14
Expansionary Monetary Policy
• Used to face Recession or Unemployment
• When: GDP (or Y) < AE• Need to increase the level of AE• Central Bank uses OMP, or lower RRR,
or lower Rd• This increases the level of Y (through
shifting AD to the right)
LO1 30-15
Expansionary Monetary Policy
Real GDP (billions)
Pric
e le
vel
AD2
AD1
increase inaggregate demand
AS
$510
P1
LO1 30-16
Contractionary Monetary Policy
• Used to face the inflation• When: GDP (or Y) > AE• Need to reduce the level of AE• Central Bank uses OMS, or rise
RRR, or rise Rd• This decreases the level of Y
(through shifting AD to the left)
LO1 30-17
Contractionary Monetary Policy
Real GDP (billions)
Pric
e le
vel
AD2
AD1
decrease inaggregate demand
AS
$522
P2a
bP1
LO1 30-18
Expansionary Monetary PolicyProblem: Unemployment and Recession
Central Bank buys bonds, lowers reserve ratio, lowers the discount rate,
Excess reserves increase
Money supply rises
Investment spending increases
Aggregate demand increases
Real GDP risesLO4
CA
USE
-EFF
ECT
CH
AIN
33-19
Restrictive Monetary PolicyProblem: Inflation
Central Bank sells bonds, increases reserve ratio, increases the discount rate
Excess reserves decrease
Money supply falls
Investment spending decreases
Aggregate demand decreases
Inflation declines
CA
USE
-EFF
ECT
CH
AIN
LO4 33-20