MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUEDâ€¦â€¦.)

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Introduction to Economics ECO401

Lesson 13.2

MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUED.......)

Balance Sheet of State Bank:

Any balance sheet has two sides: assets and liabilities, and the totals of the two must balance.

On the assets side of SBP's balance sheet, we have (1) the country's foreign exchange

reserves (foreign currencies, gold and silver reserves; either held domestically or invested

abroad); (2) credit to government: this would include any SBP lending to government,

including in the form of any outstanding (i.e. yet to mature) treasury bonds and bills lying with

the SBP; and (3) credit to banks: this would include any advances (another name for loans)

extended by SBP to commercial banks. On the liabilities side, we have (4) notes and coins in

circulation (i.e. M0). Note that for a currency-issuer (SBP in our case), the currency is a

liability, not an asset; (5) government or banks' deposits: these would include any positive

account6 balances held by commercial banks and/or the government; (6) outstanding liquidity

paper issued: this would include any bills issued by the central bank for the purpose of

mopping up liquidity from the financial system.

Given the accounting requirement of (1)+(2)+(3) = (4)+(5)+(6), we can easily how any increase

on the LHS must be reflected by an increase on the RHS. However, only an increase in (4) will

cause the money supply (M2) to expand.

Let's simulate the effect of an increase in (1), caused by SBP's purchase of dollars from the

foreign exchange market. As we discussed before, when the government buys foreign

exchange, it must inject an equivalent amount of local currency liquidity into the economy. This

means an increase in (4). Thus, the size of balance sheet grows symmetrically on both sides.

Note, however, that SBP could technically issue liquidity paper (6) to help sweep up the

liquidity it injected when purchasing dollars from the market. If this is done, then the rise in (6)

will be mirrored by a fall in (4) and therefore the monetary implications of the foreign exchange

market intervention would stand neutralized. This process, by which the increase in (4) is

substituted by an increase in (6) is called sterilization, and is one of the policies resorted to by

countries facing large foreign exchange inflows while maintaining a fixed exchange rate.

This point in the discussion offers a natural launch pad for defining the instruments of

monetary policy available to a central bank. Earlier we talked about monetary policy but never

quite got round to defining the instruments thereof. Having developed an idea of the central

bank balance sheet, this is now straightforward to do.

Monetary Policy and its Instruments:

Monetary policy can be defined as the central bank's Programme, often changing on a daily

basis, regarding the direct or indirect control (through interest rates) of monetary conditions in

the economy with a view to managing aggregate demand and inflation. There are four major

instruments of monetary policy:

I. Reserve ratio and SLRs: the central bank can impose and alter a mandatory reserve

ratio for commercial banks, and through that, affect the money multiplier. By extension,

the central bank can force commercial banks to comply with additional statutory

liquidity requirements (SLRs) that work similarly to a the reserve ratio. SLRs require

commercial banks to invest in a certain quantity of T-bills and T-bonds. Since a large

stock of these is often held by the central bank as assets (credit to government), the

central bank can use SLRs to increase or run-down its holding of this stock, and thus

cause M0 to increase or decrease directly.

All licensed commercial banks and the government maintain accounts at the central bank which can be credited

(replenished) or debited (depleted) depending on the transaction. If a commercial bank withdraws cash from its

account with the central bank and lends that cash to some firm operating in the economy, then this transaction

would be a debit one, i.e., it will cause deposits to fall. You can predict the effect on M0. Yes, it will rise by the

same amount.

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II. Discount rate: As mentioned earlier, the central bank sometimes extends credit to

commercial banks on their request to meet their exigent liquidity needs.7 Such

borrowing is called borrowing from the discount window and the rate the central bank

lends at the discount window is called the discount rate. If the central bank increases

this rate, banks would be inclined not to borrow from the central bank and instead keep

a large reserve ratio as a cushion against a possible liquidity crunch. A higher discount

rate thus causes banks' voluntary reserve ratio to increase and the size of the money

multiplier to reduce.

III. Open market operations (OMOs): Central banks conduct OMOs on a frequent basis.

An OMO typically involves the central bank buying or selling government securities (T-

bills and bonds) to commercial banks. As mentioned in i) above, the central bank can

build or run-down its stock of government securities and affect M0. In contrast to i,

however, it is not implemented as a mandatory requirement, rather the central bank

conducts an OMO in auction style in which all banks are free to bid. The price of the

securities (and therefore the yield or interest rate they offer) is determined by the

degree of interest in the auction. If for instance, the central bank wants to buy

securities and there are very few willing sellers, then the sellers will demand a higher

price for the securities. This will push the yield (or return) on the securities down. By

contrast, if there were a large number of willing sellers, they would compete ferociously

with each other to sell their stock to the central bank. In this case, the securities' prices

are likely to be bid down, to the advantage of the central bank. In both cases, however,

the money supply will expand, as the central bank injects new currency into the

economy in exchange for the securities. In the reverse case, when the central bank

sells securities in the market, the money supply contracts.

IV. Foreign exchange market interventions: As discussed earlier in the context of

balance of payments, a purchase or sale of foreign exchange by the central bank has

an ipso facto effect on the money supply because the central bank has to pay local

currency in order to buy the foreign currency. In balance sheet language, it can be

seen that a central bank purchase of foreign exchange, will cause the bank's foreign

exchange reserves (item 1 on the balance sheet) to increase. Unless sterilized (by

issuing central bank liquidity paper or OMOs) such an increase will cause an increase

in M0, which through a multiplier effect causes M2 (or money supply) to increase.

Functions of Central Bank:

Let us conclude our discussion here with a word about the functions of the central bank.

Monetary policy is just one of the functions of the central bank. There are at least three more

functions central banks serves:

a. As lender of last resort, it must bail (or help) out commercial banks facing temporary

liquidity shortfalls;

b. As supervisor of the financial system, it must ensure its good health by monitoring

commercial banks' lending (risk-taking), capital adequacy, and liquidity positions. The

central bank is also a monitor of the management and governance of financial

institutions and of any other threats to the stability of the financial system;

c. As the biggest intervener in the foreign exchange market (and/or setter of the

exchange rate), it is responsible for exchange rate policy and the balance of payments,

per se.

Whether the central bank fulfils these functions independently and autonomously or under

instruction by the government (Minster of Finance) depends very much on whether the central

bank is de facto autonomous or not. In most HICs, central banks enjoy a fair degree of

autonomy (and this is cited as one reason for the stability of their monetary and financial

The central bank is obliged to provide such credit in its capacity as lender of last resort. Any bank in trouble (i.e.

in need of cash) can go to the central bank discount window and borrow. As such the central bank provides an

extra cushion to the banking system, whose stability is essential for a smooth payments system in the economy.

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sectors) but in LICs, governments often intervene heavily in the functions of the central bank

preventing it from achieving its mandated objectives of financial sector health, monetary and

BOP stability, and low inflation.

Why People Hold Money:

We can now move on to money demand (denoted by Md or L), and the question of why people

hold money? Economists have identified three broad motives:

a. The transactions motive: People need to make day-to-day transactions (buy food,

clothes etc.) and therefore need to hold cash in their hands. Of course, the increasing

spread of plastic money (credit cards) has considerably reduced the transactions

incentive for holding money. Assuming no plastic money, an individual's transactions

demand for money is likely to increase with his/her income, as s/he is more likely to

make more transactions if he feels richer.

b. Precautionary motive: In addition to money held for making transactions, people

sometimes hold money for precautionary purposes as well: i.e. to meet any urgent or

unexpected expenditure needs, or to "snatch a bargain" that might be taken by

someone else. Again, precautionary demand for money is likely to increase with

income

c. Assets motive (also called speculative or investments motive): In addition to a and

b, people might wish to keep some cash to switch between various investments. So

consider a person who owns some land, holds some bonds, and has some stock

market investments. Let's say he spots a good investment opportunity on the stock

market but doesn't have instant buyers for the land or bonds he holds. In this situation

some spare cash in hand would have helped him acquire the equity asset. The assets

demand for money is likely to increase with income (for reasons similar to those for a

and b) and decrease with interest rates (because the interest rate is the opportunity

cost of holding cash in your hands).

Generally, then, money demand Md increases with income levels and falls with interest rates.

Note that we refer to real income (which measures purchasing power) and real interest rates

(which measure real return on invested money), and not their nominal counterparts. Thus the

demand for money we refer to is the demand for real money. Contrast this with what have

been talking about earlier: nominal money supply i.e. what the central bank controls through

its various instruments. Whether nominal and real money supply are equal or not depends

much on the assumption regarding prices. If prices are assumed fixed, then the two are equal,

otherwise not.

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END OF UNIT 13 - EXERCISES

Assume that the government cuts its expenditure and thereby runs a public-sector

surplus.

a) What will this do initially to equilibrium national income?

b) What will it do to the demand for money and initially to interest rates?

c) Under what circumstances will it lead to (i) a decrease in money supply; (ii) no

change in money supply?

d) What effect will (i) and (ii) have on the rate of interest compared with its original

level?

a) Injections will fall. The J line would shift downwards, causing a multiplied fall in national

income.

b) This will cause a reduced transactions demand for money. The L curve will shift to the

left, causing a fall in interest rates.

c) If the reduced expenditure causes a reduction in government borrowing from the banking

sector in such a way as to cause a reduction in banks' liquidity, there will be a multiple

contraction of credit. If, however, the government simply reduces the total number of

outstanding bonds, then money supply will be little affected.

d) If money supply is reduced, then interest rates will fall less than in (b) above.

Would it matter if it was easy to forge a £10 note but cost £15 to do so?

No. It would not be `profitable' for forgers to produce such notes.

Why may money prices give a poor indication of the value of goods and services?

· Money prices may be distorted by monopoly power.

· They ignore externalities.

· Simply adding up the money incomes of individuals in order to get a measure of their total

incomes ignores questions of the distribution of income.

· The value of money is eroded over time by inflation. Thus nominal prices would have to be

converted to real prices in order to compare the values of goods at different points in

time.

What effects do debit cards and cash machines (ATMs) have on (a) banks' prudent

liquidity ratios; (b) the size of the bank multiplier?

Debit cards: (a) Reduce it (there is less need for cash); (b) Increase it (the liquidity ratio is

smaller).

Cash machines: (a) Increase it (there is a greater need for cash); (b) Reduce it (the cash ratio is

larger).

If the government borrows but does not spend the proceeds, what effect will this have on

the money supply if it borrows from (a) the banking sector; (b) the non-bank private

sector?

a) Little or no effect, if it simply replaces one liquid asset by another; but reduce it, if it

involves reducing the liquidity of the banking sector (e.g. by the sale of bonds).

b) Reduce it. The liquidity of the banking sector will be reduced (when people pay for the

securities with cash withdrawn from the banks, or cheques drawn on the banks).

Under what circumstances are cheques more efficient than cash and vice versa? Would

you get the same answer from everyone involved in transactions: individuals, firms and

banks?

Cheques are more efficient than cash for large transactions, or when there is a danger of theft of

the cash. Cheques are less efficient than cash for small transactions: these have a low value

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relative to the cost of processing a cheque; also cash transactions are quicker than transactions

by cheque.

The above points apply generally, but sometimes, what may be in the interests of one party to a

transaction may not be in the interests of the other(s). For example, a shop may prefer to

receive cash on occasions where it is more convenient for a customer to write out a cheque

(because that saves a visit to the bank or cash machine).

Buying something like a car is at the other end of the spectrum from holding cash. A car

is highly illiquid, but yields a high return to the owner. In what form is this `return'?

The utility per period of time from using it.

Would the demand for securities be low if their price was high, but was expected to go on

rising?

No. The demand would be high. People would want to hold the securities, so that they could

benefit from the anticipated capital gain.

Which way is the L (money demand) curve likely to shift in the following cases?

a) The balance of trade moves into deficit.

b) People anticipate that foreign interest rates are likely to rise relative to domestic

ones.

c) The domestic rate of inflation falls below that of other major trading countries.

d) People believe that the rupee is about to depreciate.

a) To the left. A deficit on the balance of trade will cause the exchange rate to depreciate.

People, anticipating this, will want to hold smaller rupee balances.

b) To the left. People will want to switch to holding the other currencies where interest rates

are expected to rise.

c) To the right. People will expect an appreciation of the rupee as the lower inflation

causes the balance of payments to move into surplus. They will therefore want to hold

larger rupee balances.

d) To the left.

Trace through the effects on the foreign exchange market of a fall in the money supply.

· The shortage of money balances will lead to a reduction in the purchase of foreign assets

and hence a reduction in the supply of the domestic currency on the foreign exchange

market.

· The fall in money supply can be represented by a leftward shift in the Ms curve. This will

cause a rise in the rate of interest.

· The higher rate of interest will lead to a reduction in the supply of the domestic currency on

the foreign exchange market as people prefer to keep their deposits within the country

and earn the higher rate of interest. This effect will reinforce the first effect.

· The higher rate of interest will also increase the demand for the domestic currency on the

foreign exchange market as people abroad deposit more in this country to take

advantage of the higher interest rate.

· The increased demand for and reduced supply of the domestic currency will cause the

exchange rate to appreciate. This effect will be reinforced by speculation.

What effect would a substantial increase in the sale of government bonds and Treasury

bills have on interest rates?

It would drive them up. In order to sell the extra bills, the government would have to accept a

lower discount price (a higher rate of discount). In order to sell the extra bonds, governments

would have to offer them at a higher rate of interest, or at a lower price for a given interest

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payment (which amounts to a rise in the interest rate). These higher rates of interest on

government securities would have a knock-on effect on other rates of interest.

If banks choose to operate a 20 per cent liquidity ratio and receive extra cash deposits of

Rs.10 million:

a) How much credit will ultimately be created?

b) By how much will total deposits have expanded?

c) What is the size of the bank multiplier?

a) Rs. 40m

b) Rs. 50m

c) 5 (= 1/0.2)

If banks operated a rigid 5 per cent cash ratio and the government reduced the supply of

cash by Rs.1 million, how much must credit contract? What is the money multiplier?

Assuming that this resulted in Rs.1 million less cash being held in the banking system (i.e. that

the proportion of cash in circulation did not fall), then credit must contract by Rs.19 million, giving

an overall reduction in money supply of Rs.20 million (of which the Rs.1 million cash is 5 per

cent). The money multiplier is therefore 20 (i.e. 1/5%).

Explain how open-market operations could be used to increase the money supply.

The central bank could buy back bonds from the banking system before they reached maturity.

The banks' balances in the central bank would be credited, allowing the banks to create more

credit.

Why would it be difficult for a central bank to predict the precise effect on money supply

of open-market operations?

a) Banks may vary their liquidity ratio.

b) It is difficult to predict how much the holding of Treasury bills by the banks will vary, and

how much the banks will take this into account when deciding how much credit to grant.

Assume that the central bank of UK (called the Bank of England) wants to reduce interest

rates. Trace through the process during the day by which it achieves this.

The BoE's Monetary Policy Committee will announce a reduction in the rate of interest. BoE will

then conduct open market operations to back this up. This will entail making more liquidity

available to banks through gilt repos. Assuming that the reduction in the rate of interest was

announced the previous day, then early in the morning the BoE will forecast the day's shortage

of liquidity in the banking system (at the new lower interest rate) and will offer assistance to

banks through repos and rediscounting in order to meet the shortfall. By making additional

assistance available at further points during the day, the Bank can adjust liquidity as necessary

to maintain the rate of interest at the new level.

In what ways is the US Fed's operation of monetary policy (a) similar to and (b) different

from the Bank of England's?

a) The Fed, like the Bank of England, uses open market operations to influence the money

supply and thereby to make the announced discount rate the equilibrium rate. If the

discount rate is raised (just as when the Monetary Policy Committee of the bank of

England raises the rate of interest) then open market sales of bands and Treasury bills

are used to back this up.

b) Unlike the Bank of England, however, the Fed also from time to time alters the minimum

reserve ratio as a means of influencing bank lending.

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If the Bank of England issues £1 million of extra bonds and buys back £1 million of

Treasury bills, will there automatically be a reduction in credit by a set multiple of £1

million?

No. It depends on the proportion of the £1 million of bills that were held by the banks (since only

by reducing these will there be a reduction in banks' liquidity). It also depends on banks'

willingness to vary their liquidity ratio. Finally, it depends on banks' use of repo and

rediscounting facilities available through the Bank of England (if these are used by the banks as

a means of maintaining short-run liquidity, there is less pressure on them to reduce credit).

Trace through the effects of a squeeze on the monetary base from an initial reduction in

cash, to banks' liquidity being restored by the rediscounting of bills. Will this restoration

of liquidity by the Bank of England totally nullify the initial effect of reducing the supply of

cash? (Clue: what is likely to happen to the rate of interest?)

Banks, short of cash, will, in the last resort, acquire money from the Bank of England through gilt

repos or the rediscounting of bills. But the Bank of England will only do this at a penal rate,

thereby driving up interest rates (to its announced level, assuming that it has raised the rate of

interest) and thereby reducing the demand for money, and hence the quantity of credit supplied.

If the central bank wanted to achieve a lower rate of inflation and also a higher exchange

rate, could it under these circumstances rely simply on the one instrument of interest

rates?

A higher interest rate would help both to reduce inflation and push up the exchange rate. The

problem is that the desired magnitude of these effects may require a different sized increase in

interest rates. If this were the case, then again relying on one instrument alone would not be

sufficient.

Why does an unstable demand for money make it difficult to control the supply of

money?

Because the supply of money depends in part on the demand for money.

Assuming that real national output, Q, rises each year as a result of increases in

productivity, can money supply rise without causing inflation? Would this destroy the

validity of the quantity theory?

Yes. If V does not change, then for every one per cent that output (Q) rises, so M can also rise

by one per cent without causing the price level (P) to rise.

This does not destroy the validity of the quantity theory. Although the theory states that changes

in money supply will not cause changes in output, it still allows for changes in output occurring

independently of changes in money supply, in which case there can be an accommodating rise

in the money supply without it being inflationary.

Could production and consumption take place without money? If you think they could,

give examples.

Yes. People could produce things for their own consumption. For example, people could grow

vegetables in their garden or allotment; they could do their own painting and decorating.

Alternatively people could engage in barter: they could produce things and then swap them for

goods that other people had produced.

If we would all like more money, why does the government not print a lot more? Could it

not thereby solve the problem of scarcity `at a stroke'?

The problem of scarcity is one of a lack of production. Simply printing more money without

producing more goods and services will merely lead to inflation. To the extent that firms cannot

meet the extra demand (i.e. the extra consumer expenditure) by extra production, they will

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respond by putting up their prices. Without extra production, consumers will end up unable to

buy any more than previously.

What do you know about the leads and lags associated of monetary and fiscal policy?

Lead time, or the minimum time the government needs before invoking the policy. This is

obviously negligible for monetary policy, as the central bank can instantly take action to affect

money supply (either through direct or indirect means). Lead times for fiscal policy invocation,

however, can be quite substantial. Consider an economy where aggregate demand falls in

September, and the next budget is not due till June the following year. Here fiscal policy requires

a lead time of about 9 months! (a long enough time period for demand conditions to have

changed or evern reversed).

Lag time, or the time period taken for a policy change to have an impact, is quite small for fiscal

policy. Thus an increase in taxes will usually have an immediate demand-dampening effect, as

consumers feel the pinch on their disposable income. By contrast, a change in the money supply

takes a long time to have a demand impact. This is because the credit/investment channel for

monetary policy transmission takes about two years to act. For e.g., if money is tightened today

and interest rates rise, firms' response will be reflected in lower investment outlays in about two

years' time. The projects already underway or likely to come online inside two years cannot

usually be reversed and hence current investment spending will remain unaffected.

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