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  • Money and monetary policy

    TEACHER: This module starts with a subject that fascinates most people: Money!

    We will discuss the nature of money and the workings of the banking system.

    STUDENT: I agree that money is a fascinating commodity, but... the banking system? Banks and bankers are rather boring, aren’t they?

    TEACHER: Not really once you understand the important functions of the banking system, one of which is the creation of money. Most people don’t know this, but if you allow me to continue, I will elaborate on this rather intriguing effect of the banking system.

    What is Money?

    Student, do you want to try and define money?

    STUDENT: Well, these printed paper bills I have in my pocket are certainly money.

    TEACHER: And how can you be so sure of that?

    STUDENT: Because in my experience any person or institution in this country will accept them in payment of purchases or cancellation of debts.

    TEACHER: You have given me the best possible definition of money. "Money is whatever commodity people accept as such". Roman soldiers were paid their wages with salt (this is the origin of the word salary). Historically many different things have been used as money.

    Naturally in modern economies money is a more subtle commodity. Paper bills and coins are money, of course, but there are other forms such as bank deposits.

    We will define money by describing its uses rather than its many different physical forms.

    Medium of Exchange

    The best known use of money is its acting as medium of exchange. Firms and persons exchange their goods and services for something called money, and they do this because they have faith that this money will in turn be accepted by other firms and persons in exchange for goods and services. Can you thing of an alternative to the use of money in commerce?

    STUDENT: The only alternative would be barter, the direct exchange of goods and services for other goods and services. Definitely not a very practical alternative.

    TEACHER: True. Only very primitive economies could subsist without some type of money.

    Standard of Value and Store of Value

    We say that money acts as a standard of value because all prices are expressed in a given quantity of money. Assuming our money is the US dollar, we can find out the price of any good or service in US dollars. Money prices indicate the relative value of goods and services. If a suit costs $200 and a pair of shoes $100, we immediately notice that the value of a suit is twice the value of a pair of shoes.

    Money also acts as a store of value. People hold money because they intend to buy goods and services in the future.

    STUDENT: You mentioned the US dollar as an example of money. I can think of many other "currencies", such as the Euro, the Yen, etc. These types of money are accepted by millions of people. But do they have a "real", objective value?

    TEACHER: No. Money is a social invention. Only because they were scarce, metals such as gold and silver were used as money for many centuries. Paper money was first invented only as a convenience: instead of having to carry metallic coins, people used a paper "receipt" that could be exchanged for a given quantity of metal. In other words, paper currency was backed by metal, normally gold or silver.

    But nowadays practically no money has any specific backing other that the faith people have on the issuer of the money, normally the government of a country through a national "central bank". It is "fiat" money.

    STUDENT: I thought Fiat was a car manufacturer.

    TEACHER:. Very funny. I am sure you know that "fiat" means "faith" in Latin. And if you didn’t... now you know!

    The Supply of Money

    It is rather difficult to define exactly what is and what is not money. But we can easily state a "narrow definition" of money, because all people and firms accept that coins, paper money, checking accounts and other demand deposits are money.

    STUDENT: Demand deposits? Please clarify the concept.

    TEACHER: A bank deposit from which any part of the balance can be withdrawn immediately just by demanding it, without any delay or condition.

    Now let me say that the aggregate amount of coins, bills, demand deposits and checking accounts is the supply of money, "narrowly defined".

    Let me give you a rough estimate of the relative weight of each of these types of money in a typical industrial economy:

    1. Demand deposits: 36%
    2. Bills and coins 25% (not held by commercial banks or the Central Bank)
    3. Checking accounts 38%
    4. Other (traveler’s checks, etc.) 1%

    Naturally these proportions change over time and from one economy to the other. In the US the quantity of money has increased very year, at rates varying form 5 to 10% a year.

    STUDENT: Since you have explained the narrowly defined money supply, I am sure there is also a "broadly defined" money supply. Right?

    TEACHER: That is correct. Let me tell you that the former is called M1 and the latter M2. M2 includes M1 plus Certificates of Deposit (CDs), money market bank balances and money market fund balances. You can see that we have added to M1 (money instantly usable) other types of money which can not be used instantly. CDs and money market funds can only be used at a certain future date, or after a specific waiting time after requesting it.

    STUDENT: I would say the M2 minus M1 is "almost money". It can not be used to make purchases at will, but it is still money because it can be used as such in the future.

    TEACHER: Yes. You probably also noticed that the definitions of M1 and M2 are arbitrary. We could include other types of assets in M2; but in most countries M1 and M2 are defined as described above. We will in the future refer to M1 as the "money supply" in an economy.

    The Banking System

    As promised, I will now discuss how banks operate. There are different types of banks. But we will look at the ones most influential in the workings of the monetary system:

    Commercial Banks

    These banks have two basic functions. They:

    1. Hold demand deposits and allow checks to be written against these deposits.
    2. Lend money to persons and firms

    There are also other types of institutions with different names whose functions overlap with those of commercial banks to a significant degree: savings and loan associations, building societies, consumer finance companies, insurance companies, etc. All of them basically act as intermediaries between economic actors who "save" (defer the spending of the money) and others who demand money for immediate consumption or investing.

    STUDENT: I am looking forward to your explanation of how banks can create money!

    TEACHER: To be more precise, it is the banking system rather than individual banks that creates money. The key to this mechanism is "fractional-reserve banking". Imagine that you deposit $1,000 in a commercial bank. The bank will keep a fraction of your deposit (say $200) as reserve, and lend the remaining $80. The minimum percentage of deposits commercial banks must keep as reserves is usually fixed by the Central Bank: the legal reserve requirement.

    STUDENT: I guess the basic reason for a legal reserve requirement is to make sure the bank does not fail.

    TEACHER: Only partially. A badly run bank may fail even with a 25% reserve while a well run bank may operate safely with just a 2% reserve. One important reason for legal reserve requirements is to control the supply of money.

    STUDENT: Fine, but I still do not see how banks... sorry, the banking system, can create money.

    TEACHER: OK, here we go.

    How the Banking System creates Money

    The process by which the banking system creates money is called the multiple expansion of deposits.

    Many individual bankers deny that banks can create money. After all, they truly claim that they can lend only a fraction of the money they receive in deposits.

    But let’s see what happens if Mr. Jones has just received $1000 in cash as interest on a government bond. Mr. Jones goes to bank A and deposits this amount.

    Assuming the legal reserve is 20% of deposits, Bank A can now lend $800 to Mr. Smith. Bank A has already increased the money supply by $800: now Mr. Jones still has access to his $1000, and Mr. Smith can spend his $800 loan.

    STUDENT: This means that an individual bank can create money after all!

    TEACHER: Yes. But the process goes on. No one takes a loan to leave the money in the bank. Most likely Mr. Smith will spend his $800 and the recipients will in turn deposit them in some bank. For simplicity, let’s assume the full amount is deposited in Bank B. This bank can now expand its lending by the 80% of 800, or $640. If it lends $640 to Miss Petersen, the money supply has increased by

    * $800 to Mr. Smith
    * $640 to Mr. Petersen

    that is, by a total of $ 1440.

    STUDENT: But there must be a limit to this, otherwise the money supply would expand indefinitely.

    TEACHER: Right. Let’s look at:

    The Multiple Expansion Of Bank Deposits And Its Limits

    In an economy where most money is kept in banks rather than in cash, the described process will continue to a certain point. In our example where the legal reserve requirement is 20%of deposits, each of the intervening banks can increase the money supply by 20% less than the previous one. If we make the calculation, we will find out that the initial deposit of $1000 in new money can expand the money supply by a maximum total of $5000.

    It’s not a miracle, nor a mysterious process. It is the result of fractional reserve banking and the intensive use of banking by the public.

    And now, let’s move on to discuss monetary policy.

    The Central Bank (Federal Reserve or Fed in the US) and Monetary Policy

    Monetary Policy is the sum of actions the Central Bank takes to control the supply of money and interest rates.

    Changing the Money Supply

    The money supply has influence on the GDP and the general level of prices. Can you guess what the effect of these changes is?

    STUDENT: I think so. Increases in the money supply should tend to rise both the real GDP and the price level, while a reduction on the money supply should have the reverse effect. But my concern is... to what extent will an increase in the money supply push the real GDP up, and to what extent will it only push up prices?

    TEACHER: In the short run the result depends on the slope of the aggregate supply curve: the steeper it is, the greater the effect on prices and the smaller on real GDP. In the long run the effects of changes in the money supply only affect the price level, not the real GDP.

    When a recession seems imminent and business is soft, the central bank usually increases the money supply and pushes down interest rates. That is, it "eases credit" or "eases money," as the common expression is. On the other hand, when the economy is in danger of overheating and inflation threatens, the central bank often pushes up interest rates. That is, in common language, it "tightens credit or "tightens money."

    In designing monetary policy, the government’s objectives generally are to attain or maintain reasonably full employment at moderate inflation.

    Nor all economists agree that the discretionary policies described above are the best to achieve these objectives. But we shall postpone a discussion of this controversy.

    STUDENT: I know there is not total agreement on how to best use monetary policy. But in any case it is useful for me to know how the central bank can make changes in the money supply.

    TEACHER: Right. The monetary authorities can influence the money supply by managing the reserves of the banking system. Imagine this: the monetary authorities want to increase the money supply more rapid1y than they would normally. How can they attain this objective?

    STUDENT: Let me guess. By providing the banks with plenty of excess reserves, true?

    TEACHER: Correct. Excess reserves enable the banks to increase the money supply, as we have seen when discussing how banks create money.

    How the monetary authorities can increase the reserves of the banking system will be discussed later on.

    Now suppose that the Federal Reserve decides to reduce, or slow the rate of growth, of the money supply. It can do so by slowing down the rate of increase of bank reserves.

    Functions of a Central Bank

    As we have seen, in the US the functions of a Central Bank are performed by the Federal Reserve. Every major country or economic area has a Central Bank; the bank of England, the Bank of Japan, the European Central Bank.

    The basic responsibilities of a Central Bank are:

    * Holding the reserves of commercial banks.
    * Performing the collection of checks between banks ("clearing").
    * Issuing money in the form of coins, bills, or bank deposits.
    * Supervising commercial banks.


    Government securities constitute a large proportion of the assets held by the Federal Reserve Banks in the US. Similar situation exists in other major central banks. The market for government securities is huge and well developed. The Federal Reserve is part of this market and whether it is buying or selling-and how much- can have a heavy impact on the quantity of bank reserves. Actually the most important means the Central Bank has to control the quantity of bank reserves (and thus the quantity of excess reserves) are the open market operations, which is the name given to the purchase and sale by the Federal Reserve of U.S. government securities in the open market.

    STUDENT: I read that the Bank of England also buys and sells "gilt edged" securities. What are they?

    TEACHER:. As you know, the Bank of England is the central bank of Great Britain (at least while the UK does not become part of the Euro region). The Bank buys and sells not only government securities but also securities issued by top private companies; these are called "gilt edged" securities.

    Now let me elaborate on the effect of the central bank’s open market operations.


    Suppose that the Federal Reserve buys $10 million worth of government securities in the open market and that the seller is IBM.

    In this transaction, the Fed receives $10 million in government securities and gives IBM a check for $10 million. When IBM deposits this check to a Bank, the bank's demand deposits and reserves increase by $10 million. Obviously the consequence is an increase in the money supply.

    The contrary effect is achieved by selling securities in the market. When the central bank sells securities, it delivers say bonds and receives money in payment. This money is withdrawn from the banking system and the "creation of money" effect works in reverse; the money supply falls.


    We said that open market operations are the Fed's most important method for controlling the money supply. The Fed adds to bank reserves when it buys government securities and reduces bank reserves when it sells them. Obviously, the extent to which the Federal Reserve increases or reduces bank reserves depends in an important way on the amount of government securities it buys or sells. The greater the amount, the greater the increase or decrease in bank reserves.

    In the US the power to decide on the amount of government securities the Fed should buy or sell at any given moment rests with the Federal Open Market Committee. This group wields an extremely powerful influence over bank reserves and the nation's money supply. Every three or four weeks, the Federal Open Market Committee meets to discuss the current situation and trends and gives instructions to the manager of the Open Market Account at the Federal Reserve Bank of New York, who actually buys and sells the government securities.


    Open market operations are not the only means the Federal Reserve has to influence the money supply. Another way is to change the legal reserve requirements. In other words, the Federal Reserve Board can change the amount of reserves banks must hold for every dollar of demand deposits.

    The effect of an increase in the legally required ratio of reserves to deposits is that banks must hold larger reserves to support the existing amount of demand deposits. This in turn means that banks will have to sell securities, refuse to renew loans, and reduce their demand deposits to meet the new reserve requirements.


    Another way that the Federal Reserve can influence the money supply is through changes in the discount rate. Commercial banks can borrow from the Federal Reserve when their reserves are low (if the Fed allows it).

    This is one of the functions of the Federal Reserve. The interest rate the Fed charges the banks for loans is called the discount rate, and the Fed can increase or decrease the discount rate whenever it chooses. Increases in the discount rate discourage borrowing from the Fed, while decreases in the discount rate encourage it.

    The discount rate can change substantially and fairly often.

    When the Fed increases the discount rate (relative to other interest

    rates), it makes ¡t more expensive for banks to augment their reserves by borrowing from the Fed; hence it tightens up a bit on the money supply.

    On the other hand, when the Fed decreases the discount rate, it is cheaper for banks to augment their reserves in this way; hence the money supply eases up a bit.

    The Fed is largely passive in these relations with the banks. It cannot

    force the banks to borrow. It can only set the discount rate and see how many banks show up at the "discount window" to borrow. Also, the Fed will not allow banks to borrow on a permanent or long-term basis. They are expected to use this privilege only to tide themselves over for short periods, not in order to re-lend at a profit. To discourage banks from excessive use of the borrowing privilege, the discount rate is kept relatively close to short term market interest rates.

    Monetary Policy and the Aggregate Demand Curve

    Monetary policy has an important effect on the aggregate demand curve, as we mentioned before.

    Please take a look at this picture:

    When aggregate demand is AD1 at price level P0 we have an inflationary gap and price level will soon push upwards till it reaches P1. At this point the central bank reduces the supply of money and the aggregate supply curve shifts to the left to AD2. In this was the inflationary gap is reduced and the new equilibrium price will be P2, closer to the current price level P0.

    Here as usual the problem is how much to tighten the money supply to stay as close as possible to full employment and avoiding inflation without overshooting and causing a recession.

    We have covered the subject matter of this Module. Go to the Q&A part when you are ready.


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