TopicChapter 10 Interest rates, money and inflation

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Topic/Chapter 10Interest rates, money and
inflation
Business EconomicsFor School of Management
StudentsSpring Semester 2008
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Topic/Chapter 10 Interest rates, money and
inflation

• Will cover
• 10.1 Money and banking
• 10.2 Interest rates and monetary policy
• 10.3 Inflation
• Not covered in lectures and omitting the
  quantity theory of money. Students should
  therefore read pages 258-264 of Begg (but
  omitting the short section on the Quantity Theory
  of Money pp. 258-259

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10.1 Money and bankingLearning outcomes

• By the end of this section, you should
  understand
• The functions of money
• How banks create money
• The money multiplier
• Different measures of money

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Money

• Money
• Any generally accepted means of payment for
  delivery of goods or settlement of debt
• It is the medium of exchange.
• Barter economy
• has no medium of exchange - goods are simply
  swapped for other goods
• Unit of account
• is the unit in which prices are quoted and
  accounts are kept
• Store of value
• Money is available for future purchases.
• Token money
• has a value as money that greatly exceeds its
  cost of production or value in consumption.
• IOU money
• is a medium of exchange based on the debt of a
  private bank.

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Modern banking

• Bank reserves
• cash in the bank to meet possible withdrawals by
  depositors
• Reserve ratio
• ratio of reserves to deposits.
• Banks assets
• mainly loans to firms and households, but also
  financial securities such as bills and bonds,
  issued by governments and firms
• Banks liabilities
• mainly sight and time deposits
• Sight deposits
• Where a depositor can withdraw money on sight
  with no notice (such as cheque accounts)
• Time deposits
• pay higher interest rates and need a period of
  notice before withdrawing money
• Banks make profits through the interest rate
  spread the amount by which interest rates on
  loans exceed interest rates on deposits

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Banks as creators of money 1

• Money supply
• Money in circulation (cash not in bank vaults)
  plus bank deposits on which cheques can be
  written
• How do banks create money?
• Note following extended explanation is not in
  Begg
• It is used here to aid exposition
• It shows the simplified process of how Banks
  create money
• Start by assuming Bank A has received cash
  deposit of 1000

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Banks as creators of money 2

• This is a very liquid but unprofitable position
  for Bank A, with a Reserve ratio of 10 it lends
  900 to White Ltd

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Banks as creators of money 3

• White Ltd. Spends the money and pays the money to
  Brown Ltd.

• Bank A is in equilibrium. The money is then
  deposited in Brown Ltd.s bank Bank B.

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Banks as creators of money 4

• This is a very liquid but unprofitable position
  for Bank B, with a Reserve ratio of 10 it lends
  810 to Black Ltd.

• Black Ltd. Spends to a firm with an account in a
  third bank (Bank C) so the Bank B is in
  equilibriumm.

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Banks as creators of money 5

• The process therefore continues and, as a result,
  of the initial cash deposit of cash there is an
  expansion of bank lending in the form of
• 1000 900 810 729 ......
• The sum being 10000
• Which shows that the ultimate effect that the
  money supply has gone up 10 fold from 1000 to
  10000 (with a Reserve Ratio of 10)

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Banks as creators of money 5

• This is summarised in Begg by the following

• From an initial cash deposit of 1000 deposits
  increase to 10000.
• The Money Multiplier is 10 given a Reserve Ratio
  of 10
• Calculated as 1/Reserve Ratio

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The monetary base and the money multiplier

• Monetary base
• Supply of cash, whether in private circulation or
  held in bank reserves
• Money multiplier
• the ratio of the money supply to the monetary
  base
• In example on previous slides
• cash was 1000
• money supply was 10 000
• so the money multiplier was 10
• If instead that banks operate on a 5 per cent
  reserve ratio
• When 1000 cash is paid into the banks, they now
  create an extra 19 000 of new loans and deposits
• Banks assets are 1000 cash 19,000 loans
• Their liabilities are 1000 deposits plus 19 000
  deposits
• Now a monetary base of 1000 leads to a money
  supply of 20,000
• The money multiplier has risen to 20.

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Measures of money 1

• Liquidity is the ease with which an asset can be
  turned into money
• the money supply consists of a spectrum of
  liquidity
• M0 (wide monetary base) all cash banks
  deposits with the Bank of England
• Wider measures ignore bank reserves (i.e.
  M0M0-Banks reserves) so that
• M1 M0 sight deposits of banks
• M3 M1 other bank deposits
• M4 (broad money) M3 building society deposits
  

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Measures of money 2
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10.2 Interest rates and monetary policy Learning
outcomes

• By the end of this section, you should
  understand
• How a central bank affects the money supply
• What determines the demand for money
• How a central bank sets interest rates

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Central bank

• Central bank
• responsible for
• printing money
• setting interest rates
• acting as banker to commercial banks and the
  government
• In the UK, the Bank of England fulfils these roles

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The bank and the money supply

• Three ways in which the central bank MAY
  influence money supply
• Reserve requirements
• central bank sets a minimum ratio of cash
  reserves to deposits that commercial banks must
  meet
• Discount rate
• the interest rate that the central bank charges
  when the commercial banks want to borrow
• setting this at a penalty rate may encourage
  commercial banks to hold more excess reserves
• Open market operations
• actions to alter the monetary base by buying or
  selling financial securities in the open market

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Lender of last resort

• The lender of last resort lends to banks when
  financial panic threatens the financial system.
• The Bank will therefore always lend to the
  banking system if the financial system is under
  threat
• this function can be used by the Bank when the
  financial system is not under threat to affect
  the money supply

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The demand for money 1

• Focus on three determinants of desired money
  holdings
• interest rates
• price level
• real income
• Assume that money pays no interest and bonds
  are all the other assets that pay interest
• How do people split their assets between money
  and bonds?
• Holding money means not earning interest from
  holding bonds instead
• The cost of holding money is the interest given
  up by holding money rather than bonds.
• People hold money only if there is a benefit to
  offset this cost
• So what is the benefit?

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The demand for money 2

• The demand for money is a demand for real money
  balances M/P.
• Transactions motive
• payments and receipts are not perfectly
  synchronized
• so money is held to finance known transactions
• depends upon income and payment arrangements
• Precautionary motive
• because of uncertainty
• people hold money to meet unforeseen contingencies

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The demand for money 3

• Asset motive
• In deciding in which assets to hold wealth to be
  spent at some distant date, a wise portfolio of
  assets will include
• some high-earning assets
• such as company shares
• but are potentially risky
• Plus some safer assets with a return that is
  lower on average
• but less volatile
• Holding some wealth in interest-bearing bank
  accounts is part of a well-diversified portfolio

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The demand for money 4

• In summary, the demand for money depends upon the
  motive for holding money
• people want money for purchases - transactions
  demand
• people want money as a precaution - precautionary
  demand
• people want money to buy assets - asset demand

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How much money willpeople hold? 1
Marginal cost, marginal benefit

• People will equate the MC and MB of holding money
  E
• Higher prices
• If all prices and wages double with interest
  rates unaltered - MC stays the same
• Real income unaltered so MB schedule is
  unaffected
• Desired holding of real money remains L
• People hold twice as much nominal money M when
  prices P double.
• Real income and real money M/P are unaffected.

E
MC
MB
L
Real money holdings
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How much money willpeople hold? 2
Marginal cost, marginal benefit

• Higher interest rates
• If interest rates on bonds rise, the cost of
  holding money rises
• marginal cost of holding money shifts up to MC
• Desired money holdings are now at the point E
• Desired real money holdings fall from L to L
• Higher interest rates reduce the quantity of real
  money demanded

E
MC
E
MC
MB
L
L
Real money holdings
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How much money willpeople hold? 3
Marginal cost, marginal benefit

• Higher real income
• As real income increases the desire to increase
  the demand for money due to the transaction and
  precautionary motive increases
• i.e. it raises the marginal benefit of money
• Hence, the MB schedule shifts up to MB
• At the original interest rate and marginal cost
  MC schedule, desired real money holdings are now
  L (at E)
• Higher real income raises the quantity of real
  money demanded

E
E
MC
MB
MB
L
L
Real money holdings
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Money market equilibrium 1
Other things being equal, the demand for real
money balances will be lower when the
opportunity cost (the rate of interest) is
relatively high.
Interest rate
r0
The position of this schedule depends upon real
income and the price level.
MD
When money supply is L0
L0
Real money holdings
Money market equilibrium occurs when the rate of
interest is at r0.
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Money market equilibrium 2

• The central bank can set an interest rate r0 by
  supplying a quantity of real money L0
• To set an interest rate r1
• the central bank simply raises the money supply
  to L1

Interest rate
r0
r1
MD
L0
L1
Real money holdings
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A rise in money demand

• A rise in money demand shifts MD up to MD
• With the real money supply unchanged the interest
  rate rises from r to r
• in order to reduce the quantity of real money
  demand back to the level of the unchanged real
  money supply.
• However, if the central bank wishes to maintain
  the interest rate at its original level r it
  undertakes an open market operation to raise the
  real money supply from L to L
• When the central bank wants to set interest
  rates, it therefore passively supplies whatever
  money is demanded at that interest rate.

Interest rate
r
r
MD
MD
Real money holdings
L
L
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Monetary policy

• Interest rates are the instrument of monetary
  policy
• The monetary instrument is the variable over
  which a central bank exercises day-to-day control
• The Bank of England has operational independence
  from government to set interest rates
• But the Chancellor has decided the Banks
  ultimate objective is to set interest rates to
  try to keep inflation close to 2 per cent a year

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10.3 InflationLearning outcomes

• By the end of this section, you should
  understand
• How inflation affects nominal interest rates
• Not covered in lectures
• The costs of inflation
• Not covered in lectures
• Why central banks were made independent
• Not covered in lectures
• Note this omits the Quantity Theory of Money, but
  does cover the three issues above.
• Students should therefore read pages 258-264 of
  Begg (but omitting the short section on the
  Quantity Theory of Money pp. 258-259)