Monetary Policy and Institutions

Chapter 5

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. 

Main Functions of Money-a medium of exchange; -a unit of account; -a store of value; and, -occasionally in the past, a standard of deferred paymentAny kind of object or secure verifiable record that fulfils these

functions can be considered money.

Concept of Money

Money is historically an emergent market phenomenon establishing commodity money, but nearly all contemporary money systems are based on fiat money. Fiat money, like any check or note of debt, is without intrinsic use value as a physical commodity. It derives its value by being declared by a government to be legal tender; that is, it must be accepted as a form of payment within the boundaries of the country, for "all debts, public and private". Such laws in practice cause fiat money to acquire the value of any of the goods and services that it may be traded for within the nation that issues it.

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A. Concept of Money

The money supply of a country consists of currency (banknotes and coins) and bank money(the balance held in checking accounts and savings accounts). Bank money, which consists only of records (mostly computerized in modern banking), forms by far the largest part of the money supply in developed nations.

Money is any asset that is acceptable in the settlement of a debt. For an asset to be widely used as money, it should be portable, divisible, durable and stable in value.

Some assets fulfil the role of money much better than other ones. Gold and silver have frequently been used as money, given their divisibility into bars and coins. The introduction of paper money by the Chinese marked a significant development in the evolution of money, especially given the ease with which different denominations could be created, and the portability of paper money in comparison with gold or coinage. 

The advent of money as a medium of exchange replaced the need for exchange through barter and enabled producers and factor owners to specialise and sell their output for money. The money earned could then be used to trade with other producers and factor owners. It is clear that the evolution of money as a medium of exchange, and as a store of wealth, had a considerable impact on the development of modern economic commerce, international trade, and global prosperity.

In modern economies, notes and coins represent only a small fraction of the total money supply, with most money being in the form of digital bank accounts.

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B. Monetary Policy Defined

Types of Monetary Policies

Inflation Targeting

Inflation targeting revolves around meeting publicly announced, preset rates of inflation. The standard used is typically a price index of a basket of consumer goods, such as the Consumer Price Index (CPI) in the United States. It intends to bring actual inflation to their desired numbers by bringing about changes in interest rates, open market operations, and other monetary tools.

Price Level Targeting

Price level targeting involves keeping overall price levels stable, or meeting a predetermined price level. Similar to inflation targeting, the central bank alters interest rates to be able to keep the index level constant throughout the years. Flourishing and advanced economies opt not to use this method as it is generally perceived to be risky and uncertain.Monetary Aggregates

This approach focuses on controlling monetary quantities. Once monetary aggregates grow too rapidly, central banks might be triggered to increase interest rates, because of the fear of inflation.

Fixed Exchange Rate

Fixed exchange rate is also often called “Pegged Exchange Rate”. Here, a currency’s value is pegged to the value of a single currency, or to a basket of other currencies or measure of value, such as gold. The focus of this monetary system is to maintain a nation’s currency within a narrow band.

Gold StandardIn Gold Standard, the government allows

its currency to be converted into fixed amounts of gold, and vice versa. This may be regarded as a special kind of Fixed Rate Exchange policy, or of Price Level Targeting. This monetary policy is considered flawed because of the need for large gold reserves of countries to keep up with the demand and supply for money.

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C. Monetary Theories

Monetary theory suggests that different monetary policies can benefit nations depending on their unique set of resources and limitations. It is based on core ideas about how factors like the size of the money supply, price levels and benchmark interest rates affect the economy.

Money supply

Money can be created in a number of ways:

1. Money is created whenever banks give new loans to customers, triggered by new cash deposits in their bank.  New bank deposits can create a multiple credit expansion throughout the banking system, increasing liquidly and enabling fresh loans to be made as a multiple of the original deposit.  In effect, money increases when fresh loans are advanced to customers. The formula to calculate how much extra credit can be given is called the credit multiplier and is:

1/Cash Ratio.

Money supply

2. Secondly, issuing Treasury bills can also add to the money supply, and this happens when the government borrows from the money market by issuing Treasury bills. Banks treat these bills as being 'as good as cash', and continue to make the same amount of loans to their customers. This is despite the fact they have lost liquidity by buying bills from the Treasury. The net effect is that money supply in the economy increases.

Money supply

3. Thirdly, the central bank, the Bank of England, can print new money if the normal flow of liquidity is disrupted, as in the recent financial crisis. The Bank can use this new money to buy up existing government debt, including bonds held with private firms, so injecting new liquidity into the system. This process is called quantitative easing.

The demand for money

According to Keynes’ Liquidity Preference theory, people demand money, that is liquidity,  and hold their wealth in a monetary form for three reasons:

1. To engage in real transactions2. As a precaution in the event of unexpected

spending3. To engage in speculative transactions

The demand for money

The different components of the demand for money can be plotted against interest rates. Together, they represent the demand for money, which may also be called 'liquidity preference'.

Money supply

If we add the money supply, we can find the equilibrium interest rate. In simple Keynesian theory, the supply of money is unaffected by interest rates, so the money supply curve (M) is vertical, as shown below. Money market interest rates will be the rate that brings demand and supply into equilibrium. For example, the money market will clear when interest rates are 5% - with the supply of money (M) equalling the demand for money (L).

The supply of money

The different components of the demand for money can be plotted against interest rates.

Modern money marketsThe UK money market includes banks, building

societies, and specialist securities dealers who buy and sell money. The market is controlled by the Bank of England, and regulation is shared between the Bank of England, the Treasury, and the Financial Services Authority (FSA).

MonetarismMonetarism is closely associated

with Classical economics and is an economic philosophy which believes that economic prosperity depends upon understanding and manipulating the link between money and the real economy - that is, prices, output and employment. In addition, monetarism stresses the effective control of the money supply as the main method of stabilising the macro-economy.

Although monetarism dates back to English philosophers of the 18th Century, its modern origins can be traced to the work of Irving Fisher of Yale University, writing in the early 20th century. Modern quantity theorists, including Milton Friedman of Chicago University, developed Fisher’s work further.Monetarists, such as Friedman, believe that:1. Money can be defined - money is defined as

‘anything generally acceptable with which to settle a debt’.

2. Money can be controlled - monetary authorities can increase or decrease the amount of money in the economy.

3. Changes in money have a direct and measurable effect on the rest of the economy - indeed, the money supply has a significant effect on the spending of households and firms.

4. Inflation and deflation are always and everywhere a monetary phenomenon - changes in money are always the cause of price changes.

Money and inflation - The Fisher equationFisher proposed that there was a stable and

predictable relationship between the quantity of money in circulation in an economy, and the price level, using his famous equation:

MV = PT, where:M = the stock of money

V = the velocity of circulationP = average prices

T = the number of transactionsIf we assume V and T are constant, as the

economy approaches full employment, then changes in M must lead to the same proportionate changes in P.

The main policy implication is that the monetary authorities should ensure that money supply is effectively controlled, because controlling the money supply means that average prices can be stabilised.

Controlling the money supplyDespite the difficulties of directly manipulating

the economy through interest rates, especially in a recession, authorities usually find that, under normal economic conditions, it is easier and more effective to influence interest rates than control the money supply.

There are several reasons for this, including:1. Money is difficult to define and controlMoney is not always easy to measure, or at least it is not easy to agree which measure to use. Any asset could be used to settle debts, so new forms of money can be introduced that cannot easily be controlled.

2. Unpredictable effects Changes in the money supply, or a component

of the money supply, do not always have a predictable effect on the inflation rate. One explanation for this is contained in Goodhart’s Law. This states that, once a particular instrument is used for policy purposes, the relationship between the instrument, such as MO, and the objective, stable prices, begins to weaken. As soon as a monetary authority attempts to regulate the money supply to reduce inflationary pressure, the stable relationship that might have existed between money (M) and prices (P) will break down, and attempting to control M is likely to fail. Therefore, rather than control the money supply, which is perhaps uncontrollable, monetary authorities control monetary conditions by setting short term interest rates, which work via their effect on the demand for money, rather than supply.

Monetary instruments are stocks, bonds, treasury bills, bank drafts, promissory notes, and money orders, in bearer form or in such other form that title passes on delivery. They also include unsigned traveller's cheques and endorsed cheques.

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D. Monetary Instruments

The capital stock (or stock) of an incorporated business constitutes the equity stake of its owners. It represents the residual assets of the company that would be due to stockholders after discharge of all senior claims such as secured and unsecured debt. Stockholders' equity cannot be withdrawn from the company in a way that is intended to be detrimental to the company's creditors.

a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) or to repay the principal at a later date, termed the maturity. Interest is usually payable at fixed intervals (semi-annual, annual, and sometimes monthly). Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the secondary market.

Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the U.S. government to raise money from the public. In this tutorial, we are referring to T-bills issued by the U.S. government, but many other governments issue T-bills in a similar fashion. 

T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. This differs from coupon bonds, which pay interest semi-annually. 

Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, you'll receive the full amount of the security you want at the return determined at the auction. With competitive bidding, you have to specify the return that you would like to receive. If the return you specify is too high, you might not receive any securities, or just a portion of what you bid for.

A promissory note is a legal instrument (more particularly, a financial instrument), in which one party (the maker or issuer) promises in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms. If the promissory note is unconditional and readily salable, it is called a negotiable instrument.

Referred to as a note payable in accounting (as distinguished from accounts payable), or commonly as just a "note", it is internationally defined by the Convention providing a uniform law for bills of exchange and promissory notes, although regional variations exist. Bank note is frequently referred to as a promissory note: a promissory note made by a bank and payable to bearer on demand. Mortgage notes are another prominent example.

A money order is a payment order for a pre-specified amount of money. Because it is required that the funds be prepaid for the amount shown on it, it is a more trusted method of payment than a cheque.

Endorsed ChequeA cheque on which the person the cheque is made out to has written someone else's name so that the other person can receive the money. 

A traveller's cheque (also traveller's cheque, travellers cheque, traveller's check or traveller's check) is a pre-printed, fixed-amount cheque designed to allow the person signing it to make an unconditional payment to someone else as a result of having paid the issuer for that privilege.

They were generally used by people on vacation instead of cash as many businesses used to accept traveller's cheques as currency. If a traveller's cheque were lost or stolen, they could be replaced by the issuing financial institution. Their use has been in decline since the 1990s as alternatives, such as credit cards, debit cards, and automated teller machines became more widely available and were easier and more convenient for travellers.

Presented by:

Dennis Jr O. AmuguisMar Jhon SalavariaJoycelle RapadasLealyn BorjaJanela Mangulabnan

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