MONEY, CENTRAL BANKING AND MONETARY POLICY

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Introduction to Economics ECO401

UNIT - 13

Lesson 13.1

MONEY, CENTRAL BANKING AND MONETARY POLICY

The Concept of Money:

Money or paper currency serves at least three functions: it is a medium of exchange, a store of

value and a unit of account. Before paper money (and we are talking of not so long ago!),

people used coins which had intrinsic value (gold, silver, bronze). Before that (and now we are

talking of very long ago!) there was barter trade, where goods and services were exchanged

for goods and services and there was no monetary medium of exchange, per se.

Money Supply and Its Various Definitions:

There is a process by which money is created the money supply process, and there are

ideas about why people hold money money demand theories. We'll tackle these in order and

then develop an understanding of money market equilibrium.

Before getting a handle of the money supply process, we must understand the various

definitions of money supply (denoted by Ms). At this introductory stage, we'll introduce only

three definitions:

a. M0: also called base money, high powered money or the monetary base. M0 is the

value of all the currency notes and coins that are in circulation in the economy. Note

that any currency or coins lying with the central bank (which in Pakistan's context,

would be the State Bank of Pakistan) does not count as M0, as it is not in circulation.

b. M1: is M0 + all current (or checking) deposits held with commercial banks. Checking

deposits are accounts from which the holders can withdraw money at any time.

c. M2: is M1 + all time deposits. Time deposits are accounts from which holders can

withdraw money only after giving the banks some notice (usually a few months). When

talking about money supply, this is the measure we often refer to. The relationship

between M2 and M0 is the key to unraveling the money supply process. If you are

wondering how money supply can be greater than M0, consider one simple answer (in

QTM vein). A 100 rupee note counts as Rs. 100 only for M0; but if that note goes round

the economy and changes hands 5 times in a year, then the value of that 100 rupee

note is Rs. 500 in an M2 context. From the definition of M2 and M0, however, it is clear

that there is something commercial banks do which causes the value of that 100 rupee

note to rise from Rs. 100 to Rs. 500.

What do commercial banks do?

They take deposits (i.e. borrow money) and make loans (i.e. lend money). The interest rate

they pay on deposits is lower than the interest rate they charge on their loans. The difference

covers their overhead costs and profits.

If banks on-lend all the money they receive as deposits, they would not be able to give any

money back to depositors who come to withdraw money from their accounts. On the other

hand, if banks on-lent nothing and kept all the money they receive as deposits in a locked

safe, then there is no profit they will make. There is thus a trade-off between liquidity (having

cash at hand) and profitability. Banks often resolve this trade-off by maintaining cash reserves

which are a small ratio of total deposits. Thus if deposits are Rs. 100, banks might decide to

keep Rs. 10 of that money in the form of a liquidity reserve (to meet the needs of depositors

who might come to withdraw money on any particular day) and lend the remaining Rs. 90 as

loans to businesses. In this case the reserve ratio is 10% (i.e. 10/100). Sometimes this reserve

ratio is imposed as a central bank requirement that commercial banks must fulfill.

The Money Creation Process:

We can now study the money supply or creation process. Imagine the government wishes to

buy pencils worth Rs. 10 for its officials. The supplier firm is called S and has a deposit

account with Bank A. In order to buy the pencil, the government asks the central bank to print

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Introduction to Economics ECO401

a 10 rupee note and give it to the government.5 This action causes M0 to expand by Rs. 10.

Now the government pays this amount to S (in exchange for the pencils) who in turn deposits

the money into his account in Bank A. What does A do? Assuming it operates a safety cushion

or reserve ratio of 10%, A will add Re. 1 to its liquidity reserve and lend Rs. 9 to firm T. Firm T,

takes the Rs. 9 and deposits it in another Bank B. B acts in a similar way: it adds 90 paisa

(10% of Rs. 9) to its existing liquidity reserve and lends the remaining Rs. 8.1 to firm Z. The

process goes on, the amount lent falling each time by a factor of 10%.

If the money creation process is set up as an infinite series (starting from the central bank

printing the ten rupee note), we will have 10 + 10*(90%) + 10*(90%)*(90%) +

10*(90%)*(90%)*(90%) + ....... which is an infinite converging series with a first term of 10 and

a convergence factor of 0.9 (or 90%). The sum to infinity of this series is 10/(1-0.9) = 100.

Thus, an initial M0 expansion of Rs. 10 has a total money supply (or M2) impact of Rs. 100,

thanks to the intermediation of commercial banks. There is a money multiplier (MM) at play of

magnitude 10.

The Money Multiplier:

If you look carefully, the money multiplier is nothing but the inverse of the reserve ratio. Thus,

we can write MM = 1/rr, where rr is reserve ratio. Generally, in stock terms we can write, M2 =

MM*M0 = (1/rr)*M0; and in flow terms we can write, ΔM2 = (1/rr)*ΔM0. The higher the reserve

ratio, the higher the leakage, so to speak, from the money creation process and thus the lower

the money multiplier. In the extreme, when rr = 100%, MM is 1, and M2 = M0.

To complete our understanding of the money supply process let us now zoom in on the central

bank's balance sheet. To keep things simple, we'll consider the balance sheet of the State

Bank of Pakistan, SBP, abstracting from the more complicated ones held by the U.S. Federal

Reserve Bank, the European Central Bank or the Bank of England. The choice of SBP is,

however, for illustration purposes only and does not reflect on SBP's actual financials.

Note that we use the terms government and central bank to mean two distinct entities. By government, we mean

the Ministry of Finance, or the Treasury. The central bank, although a part of the broader definition of

government, is a separate entity in an accounting and administrative sense. As such, in this discussion of the

monetary sector, we consider the central bank as an entity separate from, and lying outside, the government.

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