Chapter 4 Money and Monetary policy

Reading Textbook:
Content
I Overview of money
II Banking system and money supply
III Central bank and tools to control money supply
IV The theory of liquidity preference and monetary policy
 I Overview of money
Definition
Money is any object or record that is generally accepted
as payment for goods and services and repayment
of debts in a given socio-economic context or country.
In other words, money is a set of assets in an economy
that people regularly use to buy goods and services
from other people
The functions of money
- Medium of exchange: Item that buyers give to sellers
when they want to purchase goods and services
- Unit of account: Yardstick people use to post prices
and record debt
- Store of value: Item that people can use to transfer
purchasing power from the present to the future
 I Overview of money
The kind of money
- Commodity money: money that takes the form of a
commodity with intrinsic value (Item would have value even
if it were not used as money)
- Fiat money: money without intrinsic value used as money
because of government decree
Measuring money volume
M0: Currency - Paper bills and coins in the hands of the public
M1: M0 and demand deposit (depositors can access on
demand by writing a check)
M2: M1 and timely deposit (depositors in principle can access
to the money as maturity elapses)
The differentiation in measuring money volume bases on the
gradual decrease of liquidity (liquidity is the ease with which
an asset can be converted into the economy’s medium of
exchange)
 II Banking system and money supply
Money creation: fractional reserve banking
After receiving money from clients, banks have to lend
or invest the money to make profit so that it can
primarily pay back interest rate. However to secure
liquidity and system stability, banks have to reserve
money from clients’ deposit. Banks hold only a fraction
of deposits as reserves
Desired reserve rate/ratio (rr) is the fraction of deposits
that banks hold as reserves. It has two components
+ Required reserve rate (rrr): Bank must hold at the
Minimum level set by country’s central bank
+ Excess reserve rate (err): Bank may hold additional
excess reserves
→ rr = rrr + err
II Banking system and money supply
Money creation: fractional reserve banking
We examine an example to see how banking system
create more money (money as definition) for the
economy
The example has two assumption:
+ People don’t hold money in hand but deposit all to
the banks
+ Desired reserve rate of each bank is similar (rr%)
The evolution: there is 1 unit value of money deposited
in bank1. Bank 1 reserves rr and lends (1- rr) to
people. People as assumed don’t hold money and
deposit to bank 2. Bank 2 reserves (1-rr).rr and lends
(1-rr)^2 to people. Then the process continues. The
total deposits’ value of the economy increase from the
action of depositing 1 unit value of money at the
beginning is magnificent.
Central bank printed 1000$, then this money goes to public,
+ Hold nothing, deposit to bank 1: 1000$
@ Bank 1: issues money valued 1000$, then reserve 100$ and lend 900$ to
public
+ Hold nothing, deposit to bank 2: 900$
@ Bank 2: issue money valued 900$, then reserve 90$ and lend 810$ to
public
+ Hold nothing, deposit to bank 3: 810$
@ Bank 3: issue money valued 810$, then reserve 81$ and lend 729$ to
public
………..
1.000 x 1/0.1 = 10.000
1/0.1 = 10 money multiplier
 II Banking system and money supply
Money creation: fractional reserve
banking
Banking Desired reserverate
Deposits Lending
system (rr)
Bank1 1 1.rr (1-rr)
Bank2 (1-rr) (1-rr).rr (1-rr)2
Bank3 (1-rr)2 (1-rr)2 .rr (1-rr)3
... ... ... ...
Bank(n+1) (1-rr)n (1-rr)n .rr (1-rr)n+1
n 1 n 1
2 n 1  (1  rr ) 1  (1  rr )
D 1  (1  rr )  (1  rr )  ...  (1  rr ) 1 1
1  (1  rr ) rr
1 0 1 1
D 1
0 < rr < 1 => 1  10
rr rr 0,1
 II Banking system and money supply
Money supply model
+) Money supply: money as the most wide
scope of understanding (M2)
MS(M) = Cu + D
where Cu currency circulated outside banks and D
deposits in bank
+) Monetary base (basic money, high powered
money): money as cash printed by central bank
(M0)
B (Ho) = Cu + R
where Cu currency circulated outside banks and R
currency reserved by banks
 II Banking system and money supply
Money supply model
Monetary multiplier (mM) is the fraction between MS and B

Denote Cu/D = cr (currency over deposit ratio)

R/D = rr (reserve ratio) (see the example)
MS cr  1 cr  1
→ mM   
B cr  rr cr  (err  rrr )
II Banking system and money supply
Money supply model
Conclusions
- Central bank cannot control entirely money supply due to
cr (decided by payment behavior of people) and err
(decided by each bank)
- Monetary multiplier has negative relationship with both rr
(rrr) and cr
Period 1996-1997 2000-2001 2006-2007 2009-2010

mM of 1,6-1,7 2,3-2,5 3-3,5 5-5,2

Vietnam
 Math problems
1) Data have given as follows cr = 20% rr = 10% MS = 2000.
Find B ?
2) Data have given as follows rr = 15%, MS = 3000, B = 500.
Find cr ?
3) Data have given as follows cr/rr = 4, MS = 2000, B = 200.
Find cr, rr ?
4) Data have given as follows cr + rr = 40%, MS = 1500, B = 500.
Find cr, rr ?
5) A person deposited cash of 200 in a bank, given that cr = 20%
rr = 20%. How much money supply increase ?
6) State bank of Vietnam (SBV) printed more cash of 1000, given
that cr = 0% rr = 10%. How much money supply increase ?
III Central bank and tools to control money
supply
Central bank
Central bank is the institution designed to oversee the
banking system and regulate the quantity of money in the
economy by monopolistic ability of printing money
(monetary policy). Central bank also regulates foreign
reserve of a country and represents the country in
international monetary organization or monetary agreement
Central bank could be a body of government but it could be
independent from government. Each type of organizational
structure has advantage and disadvantage
 III Central bank and tools to control
money supply
Tools to control money supply
1. Open-market operations: Purchase and sale of
government bonds by central bank
To increase the money supply: central bank buys
government bonds
To reduce the money supply: central bank sells
government bonds
2. Reserve requirements: Regulations on minimum amount of
reserves that banks must hold against deposits
An increase in reserve requirement: Decrease the money
supply
A decrease in reserve requirement: Increase the money
supply
3. The discount rate: Interest rate on the loans that central
bank makes to commercial banks
Higher discount rate: Reduce the money supply
Smaller discount rate: Increase the money supply
 IV The theory of liquidity preference
and monetary policy
The theory of liquidity preference (money
market)
This is Keynes’s theory which indicates that
interest rate will adjust to bring money supply
and money demand into balance (we see nominal
interest rate instead of real interest rate; moreover in
Money supply Money demand
short run due to fixed price nominal and real interest
Controlled by central Money – most liquid asset
rate are not different)
bank (liquidity preference)
Quantity of money Interest rate (i) –
supplied fixed by opportunity cost of
central bank therefore holding money. Income (Y)
doesn’t vary with is the most determinant
interest rate of money demand
Money supply curve - Money demand curve –
vertical downward sloping
IV The theory of liquidity preference and
monetary policy
The theory of liquidity preference
(money market)
Equilibrium in the money market: Equilibrium
interest rate will bring Quantity of money
demanded = quantity of money supplied
IV The theory of liquidity preference and
monetary policy
The theory of liquidity preference (money
market)
If interest rate > equilibrium: Quantity of money
people want to hold less than quantity supplied →
People holding the surplus buy interest-bearing
assets → Lowers the interest rate → People - more
willing to hold money until equilibrium

If interest rate < equilibrium: Quantity of money

people want to hold more than quantity supplied
→ People - increase their holdings of money by
selling interest-bearing assets → Increase
interest rates until equilibrium
IV The theory of liquidity preference and
monetary policy
The theory of liquidity preference (money
market)
Change in money supply derived from
+ monetary policy of central bank: increase or
decrease money supply
+ change in price level (with real money supply)
Change in money demand derived from
+ change in national income
+ change in price level (with nominal money
demand)
+ financial market stability
+ payment technology
…
 IV The theory of liquidity preference and
monetary policy
(a) The Money Market (b) The Aggregate-Demand Curve
Interest 2. . . . the increase in Price
rate Money 1. When an increase in government purchases
level
supply spending increases increases aggregate demand . . .
money demand . . .
4. . . which in turn
3. . . . which increases partly offsets the
r2 $20 billion
the equilibrium interest initial increase in
rate . . . aggregate demand.

r1
MD2

AD2
AD3
Money demand, MD1 Aggregate demand, AD1

0 Quantity fixed Quantity 0 Quantity

by the Fed of money of output
Panel (a) shows the money market. When the government increases its purchases of goods and services, the
resulting increase in income raises the demand for money from MD 1 to MD2, and this causes the equilibrium
interest rate to rise from r1 to r2. Panel (b) shows the effects on aggregate demand. The initial impact of the
increase in government purchases shifts the aggregate-demand curve from AD 1 to AD2. Yet because the interest
rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services
demanded, particularly for investment goods. This crowding out of investment partially offsets the impact of the
fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD 3.
IV The theory of liquidity preference
and monetary policy
Monetary policy
+ Expansionary monetary policy: central bank increases the
money supply → Money-supply curve shifts right → Interest rate
falls → At any given price level increase in quantity demanded
of goods and services → Aggregate-demand curve shifts right →
output rises (unemployment rate decreases), price increases
Using expansionary monetary policy when economy is in crisis
+ Contractionary monetary policy: central bank decreases
the money supply → Money-supply curve shifts left → Interest
rate increases → At any given price level decrease in quantity
demanded of goods and services → Aggregate-demand curve
shifts left → output falls (unemployment rate increases), price
decreases (inflation rate falls)
Using contractionary monetary policy when economy is in boom
 Expansionary monetary policy

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
rate Money supply, level
MS1 MS2
1. When the Fed
increases the
r1 money supply . . .
P

r2

AD2
Money demand Aggregate
at price level P demand, AD1
0 Quantity 0 Y1 Y2 Quantity of output
2. . . . the equilibrium of money 3. . . . which increases the quantity of goods and
interest rate falls . . . services demanded at a given price level.

In panel (a), an increase in the money supply from MS 1 to MS2 reduces the equilibrium interest
rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate
raises the quantity of goods and services demanded at a given price level from Y 1 to Y2. Thus, in 22
panel (b), the aggregate-demand curve shifts to the right from AD to AD .
Monetary policy vs fiscal policy
1. Monetary policy focuses on investment (I) in GDP, fiscal
policy focuses on government spending (G) in GDP
2. More open the economy is, more influence monetary
policy is. More severe economic downturn is, more
influence fiscal policy is
3. Inside lag of monetary policy is smaller than fiscal policy
but outside lag of monetary policy is larger than fiscal
policy
Key concepts
- Money, fiat money, commodity money
- Liquidity
- Monetary multiplier
- Required reserve rate, excess reserve rate, desired
reserve rate
- Money supply
- Money demand
- The theory of liquidity preference
- Central bank
- Open market operation, reserve rate requirement,
discount rate
- Expansionary monetary policy, contractionary
monetary policy