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Money and Stabilization Policy
KW Chapter 30
Money
• Money is a tool for conducting transactions and, like
all tools, is subject to technological advance.
• Barter was replaced by commodity money, precious
metal with intrinsic value. (China ca. 1400 B.C.).
• Commodity money was replaced by commoditybacked paper notes like gold certificates. (600 AD in
China, 1650 in Sweden)
• Commodity-backed paper notes are replaced by fiat
money whose only value comes from the
governments declaration of it as legal tender. (China
800 AD.; France, USA 1700’s)
Role of Money
• Money has 3 roles
1. Medium of Exchange – Money is a
technology for engaging in transactions.
2. Unit of Account – Value of most goods
and assets is measured in money.
3. Store of Value – Money is an asset. It can
be exchanged for goods in the future.
Two categories of money
1. Monetary Base: Money that can be used
immediately for transactions without
conversion to more basic forms of money.
–
Currency+ Reserve accounts
2. Broad Money Supply: A set of assets, typically
some form of bank deposit, which can be
easily converted to definitive money.
–
Checking Accounts, Savings Accounts, Liquid Time
Deposits and CD’s
Money Supply The stock of the medium of exchange
supplied by the central bank.
Types of Financial Assets
M1
Currency in Circulation [C] + Demand Deposits [D]
M2
M1 + Savings Deposits + “Small” Time Deposits +
[Liquid Money Market Instruments inc/ “Small” NCD’s]
M3
M2 + LTD [“Large” Time Deposits and NCD’s]
Categories
of Broad
Money
M1
M2
M3
M1 Currency
+ Checking Acct.
M2 +Savings Acct.
+ “More Liquid”
Time Deposit
M3 + “Less Liquid”
Time Deposit
Mpney Types in HK
M3
M1
M2
Incremental M3 is trivial in HK
Source: HKMA, 2006
HK$ Money Categories
Source: HKMA http://www.info.gov.hk Million HK$ 2006
Legal
tender notes
and coins
in hands
of public
Demand
deposits
with
licensed
banks
M1
145,852
207,444
353,297
Savings
deposits
with
licensed
banks
Time
deposits
with
licensed
banks
NCDs
issued by
licensed
banks
and held
by public
M2
788,211
1,288,193
76,342
2,506,043
Central Bank
• Governments in most countries create quasigovernmental semi-independent organization
called Central Bank
–
–
–
–
Hong Kong: Hong Kong Monetary Authority
USA: Federal Reserve Bank
Bank of England, Bank of Japan, Bank of Canada etc.
European Central Bank
• Central Bank will typically print banknotes
• Central Bank accepts deposits (clearing balances)
by private sector banks. These accounts are used
to clear
The Central Bank controls Monetary Base
Changing the Monetary Base
•
Monetary Base is changed by the central bank
through transactions which change the level of
liabilities and assets of central bank.
1. Open Market Operations: Central Bank buys or
sells securities in financial markets.
2. Currency Market Intervention: Central Bank
buys or sells currency.
T-Accounts
• T-Accounts are a handy tool for examining
the effects that any transaction has on
balance sheets.
• A bank transaction will change both
liabilities and assets (and possibly net
worth). The total change in liabilities plus
net worth must always equal the total
change in assets.
Open Market Purchase:
The Fed Purchases $100 of T-Bills from Bank A
Fed Balance Sheet
• Fed credits the reserve
Assets
accounts of Bank A which
increases its liabilities and +100 T-Bills
takes possession of an
equal value of securities as
assets.
Liabilities
+ 100 Reserves
Bank A Balance Sheet
• Bank A gets an extra
amount of reserves and
loses an equal amount of
securities.
Assets
+100 Reserves
-100 T-Bills
Liabilities
Open Market Operations
• Central banks typically (though not in HK) change
the money supply through open market operation
(OMO). An OMO is the purchase or sale of
government bonds by the central bank.
• In an open market purchase, the central bank
prints new money and uses it to buy bonds from
banks. This increases the supply of money in the
short run.
• In an open market sale, the central bank sells some
of its stock of bonds and receives existing money
in exchange. This reduces the supply of money in
the short run.
Currency Board
• Central bank in HK adjusts the monetary base
automatically through a currency board.
• When banks want to hold more HK dollars, the
central bank will sell them as many clearing
balances as they would like at fixed exchange rate.
(S = 7.85)
• When banks want to hold fewer HK dollars, the
central bank will buy clearing balances from them in
exchange for HK dollars. (S = 7.75)
Convertibility Undertaking HK
• Whenever the price of US dollars goes
above 7.85, the central bank will sell US
dollars at S = 7.85.
– No one will ever pay more than 7.85HK$ per
US$
• Whenever the price of US dollars goes
below 7.75, the central bank will buy US$
at S = HK$7.75.
– No one will ever sell for less than 7.75HK$ per
US$.
Currency Market Intervention
Central Bank buys 100/S foreign currency from Bank.
• Central Bank
credits Bank A
reserves with 100
of domestic
currency.
• This will increase
Central Banks asset
holdings of foreign
reserves of 100/S.
• Bank A has 100
extra in reserve
assets but loses
100/S in foreign
currency
Central Bank Balance Sheet
Assets
Liabilities
+100 Foreign Reserves*
+ 100 Reserves
*100/S when measured in foreign currency
Bank A Balance Sheet
Assets
+100 Reserves
-100 Foreign Currency*
Liabilities
Fractional Reserve Banking
• Money supply is a multiple of monetary base.
• Money supply mostly consists of bank deposits
while monetary base includes only bank reserves.
• Bankers keep only a fraction of deposits on reserve.
Reserve to deposit ratio:
Reserves
rd 
Deposits
• Regulations may require some minimum fraction of
reserve holdings per dollar of deposits, rr.
Excess Reserves
rd  rr 
Deposits
Monetary Expansion Hong Kong
rd = .1
• Bob opens HK$1000 bank account at Bank of China by
depositing US$128.
• Bank of China buys additional clearing balances from
HKMA.
• Bank has $1000 extra deposits and needs only $100 in
extra reserves. Bank makes $900 loan to Jim.
• Jim deposits $900 at HSBC. HSBC keeps 90 on
reserves and lends out 810 in additional reserves.
• This money will then be lent out again and money will
be returned to the banking system. The feedback loop
will repeat ad infinitum
Money Multiplier Process
Step
#1
#2
#3
Deposits Reserves
Bank of China Increase
By 1000
HSBC
Increase
By 900
Bank of East Increase
Asia
By 810
Each dollar in bank reserves leads to
deposit
Increase
by 100
Increase
by 90
Increase
by 81
1
rd
……
increase in
Monetary Feedback
Reserves
Central Bank
rd
Banks
Borrower
Depositor
Monetary Feedback
Reserves
Central Bank
rd
Banks
Borrower
Depositor
Monetary Feedback
Central Bank
Reserves
rd
Banks
Borrower
Depositor
Money Supply vs. Monetary Base
Monetary
Base
*
Money
Multiplier
=
Money
Supply
Money Multiplier
• Money multiplier tends to be smaller than 1/rd
because some of any additional money holdings
will be held in terms of cash rather than in bank
deposits.
• Money held as cash does not circulate back into
the banking system and slows down the money
multiplier process.
• The greater is cash holdings relative to deposits,
the greater than the money multiplier.
Monetary Feedback
Central Bank
Reserves
rd
Banks
Cash
Borrower
Depositor
Balance Sheet of Bank of China.
• Commercial
Bank has
$10,000 in
deposits which
are there
liabilities. The
bank has $1000
in reserves and
10,000 in loans.
• Net worth is
$1000
Bank of China Balance Sheet
Assets
Liabilities
1000 Clearing Balances
10000 Loans
10000 Deposits
1000 Net Worth
Monetary Contraction Hong Kong
rd = .1
• Bob closes HK$1000 bank account at Bank of China by
withdrawing US$128.
• Bank of China cashes in clearing balances to get US$
from HKMA
• Bank has $9000 in deposits and no reserves. Need to
call in $900 in loans from Jim to top up reserves.
• Jim withdraws $900 at HSBC. HSBC had only 90 in
reserves backing up that loan and must call loans of
$810. ….Etc.
• For every $1 in reserves that the central bank cashes in,
a multiple of broad money contracts.
Learning Outcomes
• Distinguish the monetary base from the
money supply and explain two methods that
the central bank adjusts the monetary base.
• Identify 3 roles of money, 3 monetary
aggregates, and 3 advances in monetary
technology
• Explain the impact of reserve holdings and
cash holdings on the money multiplier.