Money and Stabilization Policy
Students should be able to:
• Distinguish between money base and other definitions of money, and
explain the relationship between the reserve ratio and the potential and
actual money multiplier.
• Describe the tools the central bank can use to change the monetary base
and the money supply.
• Discuss the determinants of velocity and money demand.
• Identify the equation of exchange and discuss its implications for long-run
inflation
• Compare and contrast the short-run and long-run impact of anticipated
and unanticipated monetary policy on prices output and real and nominal
interest rates.
• Compare the benefits and costs of activist vs. non-activist stabilization
policies.
• Discuss the benefits of a monetary regime that targets stable prices.
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.
• Problems (Issues) with commodity money
– Commodities used as money can‟t be used for other
purposes.
– Supply of money determined by availability of resources.
– Government must share the revenues from the creation of
money (Perhaps only a problem from governments point of
view).
Fiat Money
• Fiat money is intrinsically valueless commodity (typically
paper) widely accepted as payment rendered (by government
command.
• First paper money circulated in Szechwan province during the
Northern Sung dynasty. Szechwan had iron coins which are
heavy and rusty. Banks issued receipts for the coins called
chiao-tzu which circulated as the origins of paper money.
• In 1161, under the Southern Sung dynasty, the government
developed a paper called hui-tzu which eventually developed
into first nationwide paper money.
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.
Central Bank
• Governments in most countries create quasi-
governmental 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 currency and clear
check transactions.
• Central Bank accepts deposits (clearing
balances) by private sector banks that issue
checks.
Monetary Base
• Monetary Base is Cash + Bank Reserves
• Monetary Base is the cash directly under the
control of the central bank.
• Monetary Base is the money used for final
settlement.
– When the customer of Bank A receives (as
payment for goods) a check drawn on Bank B,
that transaction is finalized by debiting Bank B‟s
clearing balances in favor of Bank A‟s.
Monetary Base of HKMA
Jul-05
: Total Monetary Base 279682
: Cash (Certificates of Indebtedness) 146075
Coins 6768
Clearing Balances 1355
Exchnange Fund Bills 125484
Definitions
• Clearing Balances: The sum of balances
maintained by banks in reserve accounts and
clearing accounts at the central bank. In Hong
Kong, this refers to the sum of the balances in
the clearing accounts.
Definitions Pt. 2
• Certificates of Indebtedness Certificates issued
by the Financial Secretary to be held by note-
issuing banks as cover for the banknotes they
issue.
“When the three NIBs issue banknotes, they are required
to submit US dollars (at HK$7.80=US$1) to the HKMA
for the account of the Exchange Fund in return for
Certificates of Indebtedness (which are required by law
as backing for the banknotes issued).”
Certificates of Indebtedness:
Spike every January
HK: Monetary Base: Before Discount Window: Certificates of Indebtedness
HKD mn
140000
135000
130000
125000
120000
115000
110000
105000
100000
95000
90000
85000
80000
7-Sep-1999 19-Jan-2001 3-Jun-2002 16-Oct-2003
In HK, Secondary Reserves are
part of the monetary base.
• Exchange Fund Bills and Notes Debt
Instruments issued by the HKMA for the account
of the Exchange Fund. These instruments are
fully backed by Foreign Reserves. The HKMA
has undertaken that new Exchange Fund paper
will only be issued when there is an inflow of
funds.
Hong Kong Exchange Fund Bills
&Notes
Exchange Fund Notes
Nonbanks
HK$ Million
Banks Series1
Total
0 20000 40000 60000 80000 100000 120000 140000
Types of Money
1. Monetary Base: Cash + Bank Reserves
2. M1 – Cash + Demand Deposits
3. M2 – M1 + Savings Deposits & „Some‟
Time Deposits & CD‟s
4. M3- M2 + Other Time Deposits &CD‟s
Monetary Aggregates in HK
(Nov. 2002)
HK Money Supply Jun 2005
4500000
4000000
3500000
3000000
HK$ Million
2500000
2000000
1500000
1000000
500000
0
M1 M2 M3
Monetary Aggregates
• Real world Different assets
have different levels of
usefulness in transactions. Assets
• Money is measured in sums of M1 Currency in
these assets. Circulation+
Checking Deposits
• M2 & M3 include less liquid
assets and are called broad
money. M2 M1 + Other
Deposits (Savings,
• M1 is the most liquid type of
Time, CD‟s) at Fully
money and is sometimes
Licensed Banks
called narrow money.
• The difference between M2
and M1 is called quasi-money. M3 M2 + Deposits at
Finance
Companies
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. Discount Window: A Loan of Domestic Currency to
Domestic Bank
3. Currency Market Intervention: Central Bank buys or
sells currency.
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 clearing balances as many
US dollars as they would like at fixed exchange rate.
• When banks want to hold fewer HK dollars, the
central bank will buy balances them in exchange for
HK dollars.
– In long term, the HKMA will convert clearing balances into
Exchange Fund paper and vice versa.
Money Multiplier
• The overall money supply is a multiple of the
monetary base.
• The central bank adjusts the monetary base
directly.
• A $1 adjustment in the monetary base will
result in a multiple of $1 adjustment in overall
money supply.
Fractional Reserve Banking
• Money supply mostly consists of bank
deposits.
• Since the earliest days of banking at the
armories of goldsmiths, bankers have kept
only a fraction of deposits as reserves and lent
out the rest.
• Define bank reserves to deposit ratio as rd.
Reserves
rd
Deposits
Money multiplier: Monetary Expansion
• A central bank buys government bonds from banks
increasing their reserves.
• They keep only a fraction and lend out the rest.
• Borrowers will spend the money which will (in large
part) then be put back into the banking system
creating additional bank deposits.
• This money will then be lent out again and money
will be returned to the banking system.
• The feedback loop will repeat ad infinitum
Monetary Feedback
Central Bank
Reserves
rd
Banks
Borrower
Depositor
Monetary Feedback
Central Bank
Reserves
rd
Banks
Borrower
Depositor
Monetary Feedback
Central Bank
Reserves
rd
Banks
Borrower
Depositor
Example: rd = .1, Cash holdings zero
• Central Bank increase reserves by $1.
• Step 1
• Bank lends $1. Comes back in deposits.
• Bank keeps $rd in reserves and lends out $1-
rd. Comes back in deposits. Bank keeps
$rd(1-rd) in reserves. Lends out (1-rd)^2.
Comes back in deposits.
Money Multiplier Process
OMO 1
Reserve Loan
1st Deposit 1 0.1 0.9
2nd Deposit 0.9 0.09 0.81
3rd Deposit 0.81 0.081 0.729
4th Deposit 0.729 0.0729 0.6561
5th Deposit 0.6561 0.06561 0.59049
6th Deposit 0.59049 0.059049 0.531441
Total Money 4.68559 Sun of Reserves +Final Loan
1
Process Keeps Going
Money Multiplier
(aka Deposit Multiplier)
• Money is generically cash plus bank deposits.
• Monetary base is cash plus reserves
• Money multiplier is determined by the reserve
ratio and the cash to deposit ratio.
Money Cash Deposits Cash
1
Deposits
Base Cash Reserves Cash
Deposits Reserve s
Deposits
• Both cash and reserves are leakages to money
multiplier process.
Monetary Feedback
Central Bank
Reserves
rd
Banks
Cash
Borrower
Depositor
Required Reserves
• In many banking systems (though not HK), the
bank regulators will require a minimum fraction
of reserves be kept for every $1 of deposits,
rr.
• Banks may keep excess reserves beyond
minimum requirements for their own reasons.
Excess Reserves
rd rr
Deposits
Potential Deposit Multiplier
• If no one holds any cash, the money/deposit
multiplier is 1
rr
• If the excess reserve ratio or the cash-deposit
ratio go up, the actual money multiplier will be
lower.
Velocity/Liquidity
• Define the ratio of transactions to the supply of
money as „Velocity‟, the speed with which
money circulates.
• The value of transactions is nominal GDP.
• The inverse of velocity is the willingness to
hold money between transactions or the
willingness to hold a liquid position, L
Nominal GDP 1
V Money Demand Price GDP
Money Velocity
Equation of Exchange
• We can rewrite the definition of velocity as
Money Velocity Nominal GDP Price Quantity
• Quantity Theory of Money says that velocity is
constant.
Keynes Insight
• Demand for liquidity is determined by the interest
rate.
• If interest rate is high, the opportunity cost of holding
low interest paying liquid assets is high.
– Households are willing to give up the convenience of
money if transactions costs are high.
• If interest rate is low, low cost to hold non- interest
paying money.
• Velocity is an increasing function of the interest rate.
Money Demand
Q: Why does the money Q: What shifts the money
demand curve slope demand curve?
down? A: An increase in the nominal
GDP will increase the need
A: The greater is the for money for transactions.
nominal interest rate, This will shift the demand
the greater is the curve out. A reduction in
opportunity cost of nominal GDP will shift the
holding money. demand curve in.
Money Market
Money Supply
i
i*
Money Demand
L
Money*
Channel of Monetary Policy
• When the central bank increases the money supply,
banks have excess liquidity which they use to make
more loans.
• The supply of loanable funds increases pushing
down interest rates.
• Lower interest rates implies an increase in borrowing
and demand for consumer durables, housing and
capital goods.
• Aggregate demand shifts out. Given fixed input
prices this increase in demand stimulates output.
Dynamics of Monetary Transmission
• It is often said that there are long and variable
lags in the monetary transmission mechanism
in that it might take several quarters for the
strongest effects of monetary policy on
demand to appear plus it is difficult to predict
how long exactly it will take for monetary
policy to have its intended effects.
Money Market: Monetary Expansion
Money Supply
i
i* 1
2
i*
Money Demand
Money* Liquidity
Loanable Funds Market: Expansionary
Monetary Policy
i
LS
1
Holding
inflation
i* expectations
2 constant, real
interest rate
declines
LD
L* L
Short-run Response to a Positive Monetary Shock
Decline in real interest rate
GDPLR stimulates investment
spending.
P
AS
P** 2
PE
1
AD′
AD GDP
Q2
Interest Rate Policy
• Many central banks, including the US Federal
reserves set their policy in terms of interest
rate targets.
• The central bank uses its money printing
power to determine interest rates.
– When the central bank lowers the interest rate,
they engage in open market purchase.
– When the central bank raises the interest rate,
they engage in an open market purchase.
HK Monetary Policy
• Under HK‟s monetary policy of a fixed
exchange rate, the central bank commits to
keeping the interest rate at the level of the
US$.
• When demand for money in HK goes up,
HKMA must increase the money supply.
• When demand for money in HK goes down
HKMA decreases money supply.
HK Money Market: Money Demand
Expansion
Money Supply
i
iUS$
Money Demand
L
Money*
HK Money Market: Money Demand
Contraction
Money Supply
i
iUS$
Money Demand
L
Money*
HK Money Market: Money Demand
Contraction
Money Supply
i
iUS$
Money Demand
L
Money*
Long Run Effects
• With prices above the expectations that were priced
into input contracts, input providers are unhappy.
When they can redo their contracts, they will update
their expectations according to market conditions.
• Over time higher input prices will be priced into
output prices, resulting in less supply at any price.
• Price expectations keep rising as long as market
prices are greater than expected.
• SRAS keeps shifting up until price expectations are
in line with actual conditions.
Over time prices shift up and equilibrium output
reverts to trend.
P GDPLR
3
P3 AS
P2
2
PE2
PE
AD′
AD GDP
Q2
Ultimately, only an increase in the price level.
P GDPLR
∞
PE 4
3 AS
2
PE
1
AD′
AD GDP
Q2
Persistent Money Growth
• A government may persistently increase the
money supply. We know that perpetual
increases in money will lead to perpetual
increases in price levels.
• Assume that money demand is proportional to
number of tranactions.
Money Demand = × Nominal GDP
• Given money supply is equal to money
demand Money = ×Price×Real GDP
When monetary expansion is expected it will only
lead to higher prices
P GDPLR
2
PE
AS
PE
1
AD′
AD GDP
Inflation and Money Growth
• In long run, the Quantity Theory tends to hold
true as velocity does not grow over time.
• Approximately speaking, the growth rate of a
product is equal to the sum of the growth rates
of a product.
Money Growth Rate = Inflation Rate+ Output Growth Rate
• Long-term inflation will keep up with money
supply growth.
Long Term Inflation & Money Growth
Cross Country Comparisons
Long Run Effects of Money Expansion
on Interest Rates
• In long run, since money demand increases
due to higher inflation, increasing money
supply does not increase funds available in
loanable funds market in long run but…
• High persistent inflation means high interest
rates due to high inflation and the Fischer
Effect
Rising Expected Inflation
LS
i πA πA
i*
πA
r* LD
L* L
Monetary Policy and Interest Rates
• In the short-run, an increase in the level of the
money supply will increase liquidity and push
down the nominal and real interest rate
(liquidity effect).
• In the long-run, persistent expansion in money
supply will lead to high inflation and inflation
expectations (Fisher effect).
Stabilization policy
• In an economy subject to shocks to aggregate
demand (animal spirit shocks, external shocks, asset
market shocks), the economy will have a self-
correcting mechanism.
• However, if this self-correction mechanism takes a
long time to work because contracts are long-lasting
or expectations take a long time to adjust to reality,
then central bank can use monetary policy to speed
adjustment.
Negative Demand Shock
GDPLR
P AD′
SRAS
PE 1
P2
2
AD
GDP
Q2
During the recession, the central bank expands
money supply.
GDPLR
P AD′
SRAS
PE 1,3
2
P2
AD′′
GDP
Q2
Expansionary Policy in Recessions
• By expanding the money supply when the
economy is below trend, the central bank will
stimulate investment when other types of
demand are low.
• The central bank can reduce unemployment
with out increasing long-term price
expectations and leading to long-term inflation.
Positive Demand Shock
GDPLR
P
SRAS
P2 2
PE
1
AD′
AD
GDP
Q2
During the boom, the central bank contracts the
money supply.
GDPLR
P
SRAS
P2 2
PE
1,3
AD′
AD′′
GDP
Q2
Contractionary Policy During Booms
• The job of the central banker is to take away
the punch bowl just when the party is getting
started.
• By raising interest rates when the economy is
booming the central bank can offset high
demand and avoid inflation.
Activism Debate
• Activists believe that the government should
examine the state of the economy and
conduct monetary policy.
• Nonactivists believe that the governments
power to intervene should be limited.
Non
Activists Activists
US Recessions are becoming shorter
as stabilization policies were adopted.
Average Length of Contraction
25
20
15
Months
10
5
0
1854-1919 1919-1945 1945-2001
Zero Lower Bound on Interest Rates
• Nominal interest rates cannot go below zero –
no one will lend money at an interest rate
below that of money itself.
• In Japan, central bank increased money
supply to get the economy out of a recession.
Pushed the interest rate to zero.
• Once the zero lower bound was reached
monetary policy has no effect.
Money Market
Money Demand Money Supply
i
1
i*
2 3
0
Money* Liquidity
Problems with Stabilization
• Monetary policy has effect with a lag. If lags
are long enough, they may act to destabilize
the economy.
– The economy is booming so the Central bank
contracts money supply.
– But the self-correction mechanism kicks in before
the effect on AD.
– Economy is sent into a recession
During the boom, the central bank contracts the
money supply.
GDPLR
SRAS′
2
P
SRAS
P2 1
3
PE
AD′
AD′′
GDP
Q4 Q3 Q2
Policy Lags
• There are a number of types of lags for
implementing monetary policy stabilization
1. Recognition Lags – It takes time for info about the
economy to be obtained to allow the central bank to
act.
2. Administrative Lags – It takes time for the
institutional structure of the central bank to agree on
the policy and implement.
3. Impact Lags – Once interest rates drop it takes time
for firms and households to adjust investment
expenditure and housing investment. It takes time for
policy to have an effect on demand.
Reducing Recognition Lags
• Central Banks closely monitor economic conditions
to minimize time to recognize business cycle shocks.
• Central banks construct large computer models of
the economy in order to forecast the economy and
predict the effects of certain events.
• Central banks collect economic measurements of
various series. Movements in some series may be
good predictors of the economy.
Using financial market data to predict
business cycles
• It has been joked that stock markets have predicted
7 out of the last 5 recession.
(In fact there does seem to be a moderately strong, positive
correlation between cyclical variation in stock prices and
business cycles)
• In the USA, some financial market indicators have
been shown to predict business cycles.
– Default Spread : Interest rates on lower rated bonds vs.
Interest rates on better rated bonds.
– Term Spread: Interest rates on long-term bonds vs. short-
term bonds (when this is inverted, recession is likely)
Policy Mistakes
• During the 1960‟s and 1970‟s in USA and
elsewhere, the central bank habitually
underestimated the natural rate of
unemployment.
• Attempted policy interventions to stimulate
economy which resulted in accelerating
inflation.
When true potential output was below estimate
P True
6
PE↑ 5
AS
4
3
2
PE 1 AD′′′
AD′′
AD′
AD
GDP
Estimate
Discretion vs. Rules
• Some economists argue that policy makers
should have the freedom to set the best
possible policy at any point in time.
• Others argue that the government is likely to
abuse stabilization power for short-term
advantage. Therefore, government policy
should be bound by strict rules which limits its
freedom
Inflation Bias
• Government may want popularity in the short-
term, such as for an upcoming election.
• If popularity can be obtained through an
economic boom, there may be a tendency to
push up the economy which would be
inflationary.
Prices in the USA
US: Consumer Price Index: Urban
1982-84=100
200
180
160
140
120
100
80
60
40
20
0
Dec-1923 Dec-1943 Dec-1963 Dec-1983 Dec-2003
Rational Expectations Revolution
• Standard business cycle theory built around the idea that
price expectations and long-term contracts adapt over time to
observable business cycle conditions.
• Economist Robert Lucas argues that this assumption
underestimates the intelligence of people.
– If you observe the economy operating above full employment, you
know that prices will be accelerating in the future. You should take this
into account in setting your expectations.
– Self-correcting mechanism of the economy should kick in relatively
quickly.
– Systematic policies to expand the economy should be anticipated and
have no effect on output even in the short-run.
Under rational expectations, systematic policy to
expand demand should be fully anticipated.
GDPLR
P
2
PE
AS
Not rational
PE to expect
this price to
1 continue.
AD′
AD GDP
Inflation Targeting Rules
• In modern era, most central banks commit
themselves to price stability by announcing
predictable and low levels of target inflation.
• This is done explicitly by Bank of NZ, Bank of
England, ECB and implicitly by the US Federal
Reserve.
Advantages of Inflation Targets
• Price stability in effect acts as cyclical
stablization policy.
– When prices are pushed upward by business cycle
forces, the money supply contracts through an
inflation target policy and interest rates rise, pushing
aggregate demand down.
– When prices are pushed downward by business
cycle forces, the money supply expands as
• No inflationary bias.
• Financial markets find it easier to predict
inflation and less inflation risk in long-term
bonds.
Positive Demand Shock requires counter-veiling
policy to stabilize prices.
GDPLR
AD
P
SRAS
P2
2
Target
P=PE
1
AD′
AD
GDP
Q2
Negative Demand Shock requires counter-veiling
policy to stabilize prices.
GDPLR
AD
P
SRAS
P2
1
Target
P=PE
2 AD′
AD
GDP
Q2