monetary policy

1.

Money and monetary
policy
Shomurodov Tokhir

2.

Look for
the
answers to
these
questions:
What assets are
considered
“money”? What
are the functions
of money? The
types of money?
What is Central
Bank?
What role do
banks play in the
monetary
system? How do
banks “create
money”?
How does the
Central bank
control the
money supply?
2

3.

The
connection
between
money and
prices
• Inflation rate = the percentage increase
in the average level of prices.
• price = amount of money required to
buy a good.
• Because prices are defined in terms of money,
we need to consider the nature of money,
the supply of money, and how it is controlled.
slide 3

4.

Without money
What
Money Is
and Why
It’s
Important
• Trade would require barter: the exchange
of one good or service for another.
• Requires a double coincidence of wants:
unlikely occurrence that two people each
have a good the other wants.
• Waste of resources: people spend time
searching for others to trade with
Using money
• Solves those problems
4

5.

Money:
definition
• Money is the stock
of assets that can be readily
used to make transactions.​
slide 5

6.

Money:
functions
1.
medium of exchange
we use it to buy stuff
2.
store of value
transfers purchasing power
from the present to the future
3.
unit of account
the common unit by which
everyone measures prices and
values
4.
Standard of deferred
payments
slide 6

7.

Money: types
1. fiat money
• has no intrinsic value
• example: the paper currency we use
2. commodity money
• has intrinsic value
• examples: gold coins,
cigarettes in P.O.W. camps
slide 7

8.

Discussion
Question
Which of these are money?
a.
Currency
b.
Checks
c.
Deposits in checking accounts
(called demand deposits)
d.
Credit cards
e.
Certificates of deposit
(called time deposits)
slide 8

9.

The money
supply &
monetary
policy
• The money supply is the quantity
of money available in the
economy.
• Monetary policy is the control
over the money supply.
slid
e9

10.

The Money
Supply
• The money supply (or money stock):
• Quantity of money available in
the economy
• Currency:
• Paper bills and coins in the
hands of the (non-bank) public
• Demand deposits:
• Balances in bank accounts that
depositors can access on
demand by writing a check
10

11.

Money supply measures Billions UZS, January 2023
including:
of which:
of which:
Foreign
currency
Other
deposits
deposits in in national
national
currency
currency equivalent
Broad
money
(М2)1)
Money
supply in
national
currency
Narrow
money
(М1)2)
Currency
in
circulation
(М0)
Transfarable
deposits
2=3+8
3=4+7
4=5+6
5
6
7
8
1/1/2023 189,085
138,832
84,046
42,206
41,840
54,786
50,253
Date
1
Statistics - The Central Bank of the Republic of Uzbekistan (cbu.uz)
slide
11

12.

Central Banks & Monetary
Policy
Central bank:
• Institution that oversees the banking
system and regulates the money supply
Monetary policy:
• Setting of the money supply by
policymakers in the central
• The central bank of the Uzbekistan
12

13.

The central bank
• Monetary policy is conducted by a
country’s central bank.
• 1991-1992 years became a turning
period of banking operation.
• 1995 year was characterized by
improvement of banking legal system.
slid
e 13

14.

Definitions of money supply
1) Broad money (M2) is calculated based on positions of liabilities of Central bank
and other depository corporations (commercial banks), in accordance with the
concepts and definitions of the Monetary and Financial Statistics Manual and
Compilation Guide, IMF 2016 (MFSMCG 2016). M2 includes cash in circulation
(outside banking system), transferable, saving and time deposits in national and
foreign currency of other financial corporations, public nonfinancial corporations,
private sector and households (except for deposits not included in the broad
money according to the MFSMCG 2016).
2) Narrow money (M1) includes cash in circulation and transferable deposits in
national currency.

15.

The Quantity Theory of
Money
A simple theory linking
the inflation rate to
the growth rate of the
money supply.
Begins with a concept
called “velocity”…
slide 15

16.

Velocity
• basic concept: the rate at which
money circulates
• definition: the number of times
the average dollar bill changes
hands in a given time period
• example: In 2001,
• $500 billion in transactions
• money supply = $100 billion
• The average dollar is used
in five transactions in 2001
• So, velocity = 5
slide 16

17.

Velocity, cont.
• This suggests the following definition:
T
V
M
where
V = velocity
T = value of all transactions
M = money supply
slide 17

18.

Velocity, cont.
• Use nominal GDP as a proxy for total
transactions.
Then,
P Y
V
M
where
P = price of output
(GDP deflator)
Y = quantity of output (real GDP)
P Y = value of output
(nominal GDP)
slide 18

19.

The quantity equation
• The quantity equation
M V = P Y
follows from the preceding definition of
velocity.
• It is an identity:
it holds by definition of the variables.
slide 19

20.

Money demand and the quantity equation
M/P = real money balances, the
purchasing power of the money
supply.
A simple money demand function:
(M/P )d = k Y
where
k = how much money people wish
to hold for each dollar of income.
(k is exogenous)
slide
20

21.

Money demand and the quantity equation
money demand: (M/P )d = k Y
quantity equation: M V = P Y
The connection between them: k = 1/V
When people hold lots of money relative to their incomes (k
is high), money changes hands infrequently (V is low).
slide 21

22.

back to the Quantity Theory of Money
• starts with quantity equation
• assumes V is constant & exogenous:
V V
With this assumption, the quantity
equation can be written as
M V P Y
slide 22

23.

The Quantity Theory of Money, cont.
M V P Y
How the price level is determined:
With V constant, the money supply determines
nominal GDP (P Y )
Real GDP is determined by the economy’s supplies
of K and L and the production function
The price level is
P = (nominal GDP)/(real GDP)
slide 23

24.

The Quantity Theory of Money, cont.
• The quantity equation in growth rates:
M
M
V
V
P
P
Y
Y
The quantity theory of money assumes
V is constant, so
V
V
= 0.
slide 24

25.

The Quantity Theory of Money, cont.
Let (Greek letter “pi”)
denote the inflation rate:
The result from the
preceding slide was:
Solve this result
for to get
M
M
M
M
P
P
P
P
Y
Y
Y
Y
slide 25

26.

The Quantity Theory of Money, cont.
M
M
Y
Y
• Normal economic growth requires a certain
amount of money supply growth to facilitate
the growth in transactions.
• Money growth in excess of this amount leads
to inflation.
slide 26

27.

The Quantity Theory of Money, cont.
M
M
Y
Y
Y/Y depends on growth in the factors of
production and on technological progress
(all of which we take as given, for now).
Hence, the Quantity Theory of Money predicts a
one-for-one relation between changes in the money
growth rate and changes in the inflation rate.
slide 27

28.

In a fractional reserve banking system
• Banks keep a fraction of deposits as reserves and use the
rest to make loans.
Bank
Reserves
The CB establishes reserve requirements
• Regulations on the minimum amount of reserves that
banks must hold against deposits.
• Banks may hold more than this minimum
The reserve ratio, R
=fraction of deposits that banks hold as reserves
=total reserves as a percentage of total deposits
28

29.

Bank T-Account
• T-account: a simplified accounting
statement that shows a bank’s assets &
liabilities.
• Banks’ liabilities include deposits,
• Assets include loans & reserves.
• Notice that R = $10/$100 = 10%.
FIRST NATIONAL BANK
Assets
Reserves
$ 10
Liabilities
Deposits
$100
Loans
$ 90
29

30.

Banks and the Money
Supply: An Example
Suppose $100 of
currency is in
circulation.
To determine banks’
impact on money
supply, we calculate
the money supply in 3
different cases:
No banking system
100% reserve banking
system (banks hold
100% of deposits as
reserves, make no
loans)
Fractional reserve
banking system
30

31.

Banks and the
Money Supply: An
Example
Case 1: No banking system
• Public holds the $100 as currency.
• Money supply = $100.
31

32.

Banks and the Money
Supply: An Example
Case 2: 100% reserve banking system
FIRST NATIONAL BANK
Public deposits the $100 at First National
Bank (FNB).
Assets
• FNB holds
100% of
deposit
as reserves:
Reserves
Money supply
= currency + deposits = $0 + $100 = $100
Loans
0
Liabilities
Deposits
$1
00
$1
00
$
In a 100% reserve banking system, banks
do not affect size of money supply.
32

33.

Banks and the Money Supply: An Example
Case 3: Fractional reserve banking system
• Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL
FIRST NATIONAL
BANK BANK
Assets
Liabilities
Assets
Liabilities
$100 Deposits
$100
Reserves $10 Reserves Deposits
$100
Loans
$90 Loans
$
0
• Depositors have $100 in deposits, borrowers have $90 in
currency.
Money supply = C + D = $90 + $100 = $190 (!!!)
33

34.

Banks and the Money Supply: An Example
Case 3: Fractional reserve banking system
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
• $90 in currency—an asset counted in the money supply
• $90 in new debt—a liability that does not have an offsetting effect on the money
supply
A fractional reserve banking system creates money, but not wealth.
34

35.

Banks and the Money Supply: An Example
Case 3: Fractional reserve banking system
Borrower deposits the $90 at Second National Bank.
Initially,
SECOND
NATIONAL
BANK
SECOND
NATIONAL
BANK
SNB’s
Assets
Liabilities
Assets
Liabilities
T-account
Reserves
$90Deposits
Deposits $90 $90
Reserves
$9
looks like this: Loans Loans
$0
$81
• If R = 10% for SNB, it will loan all but 10% of the deposit.
35

36.

Banks and the Money Supply: An Example
Case 3: Fractional reserve banking system
SNB’s borrower deposits the $81 at Third National
Bank.
THIRD NATIONAL BANK
Initially,
Assets
Liabilities
TNB’s
Reserves $ $81
8.10 Deposits
$81
T-account
Loans
$72.90
$0
looks like this:
• If R = 10% for TNB, it will loan all but 10% of the
deposit.
36

37.

Case 3: Fractional reserve banking system
Banks and
the Money
Supply: An
Example
The process continues, and money is created with
each new loan.
Original deposit
= $100.00
FNB lending
= $ 90.00
SNB lending
= $ 81.00
TNB lending
= $ 72.90
…
…
Total money supply
= $1,000.00
In this example, $100 of reserves generates $1,000
of money.
37

38.

The Money
Multiplier
• Money multiplier = 1/R
• Amount of money the banking
system generates with each
dollar of reserves
• In our example, R = 10%
• Money multiplier = 1/R = 10
• $100 of reserves creates $1,000
of money
38

39.

Type of liabilities
Reserve requirement normatives
1
2
Deposits of legal entities in national currency*
4%
Deposits of legal entities in foreign currency
18%
Deposits of individuals in national currency*
4%
Deposits of individuals in foreign currency
18%
* The average coefficient (0,8) is applied to these types of liabilities
• Statistics - The Central Bank of the Republic of Uzbekistan (cbu.uz)

40.

Active Learning 1
Banks and
the money supply
While cleaning your apartment, you look
under the sofa cushion and find a $50 bill
(and a half-eaten taco). You deposit the
bill in your checking account.
The CB’s reserve requirement is 20% of
deposits.
A.
What is the maximum amount that
the
money supply could increase?
B.
What is the minimum amount that
the
money supply could increase?
This Photo by Unknown author is licensed under CC BY-NC-ND.
40

41.

The CB’s Tools of Monetary Control
Earlier, we learned
money supply = money multiplier ×
bank reserves
The CB can change the money supply by
• Changing bank reserves or
• Changing the money multiplier
41

42.

How the CB Influences Reserves
Open-Market Operations (OMOs):
• The purchase and sale of U.S. government bonds by the CB.
To increase bank reserves and the money supply:
• The CB buys a government bond from a bank
• Pays by depositing new reserves in that bank’s reserve account.
• With more reserves, the bank can make more loans, increasing the money
supply
42

43.

How the CB Influences
Reserves
The CB makes loans to banks, increasing
their reserves
• Traditional method: adjusting the
discount rate (interest rate on loans
the CB makes to banks) to influence
the amount of reserves banks borrow
• New method: Term Auction Facility
(the CB chooses the quantity of
reserves it will loan, then banks bid
against each other for these loans.)
The more banks borrow,
• The more reserves they have for
funding new loans and increasing the
money supply.
43

44.

How the CB Influences
the Reserve Ratio
• The CB sets reserve requirements:
• Regulations on the minimum
amount of reserves banks must
hold against deposits.
• Reducing reserve requirements
would lower the reserve ratio and
increase the money multiplier.
• Raising this interest rate would
increase the reserve ratio and lower
the money multiplier.
This Photo by Unknown author is licensed under CC BY-SA.
44

45.

45
Problems
Controlling
the Money
Supply
• The CB does not control:
• The amount of money that households
choose to hold as deposits in banks
• The amount that bankers choose to
lend
Yet, the CB can compensate for household and
bank behavior to retain fairly precise control
over the money supply

46.

• A run on banks:
• When people suspect their banks are
in trouble, they may “run” to the bank
to withdraw their funds, holding more
currency and less deposits.
46
• Under fractional-reserve banking
• Banks don’t have enough reserves to
pay off ALL depositors, hence banks
may have to close.
• Also, banks may make fewer loans and
hold more reserves to satisfy
depositors.
• These events increase R,
• Reverse the process of money creation,
cause money supply to fall.
Bank Runs and
the Money
Supply

47.

47
The Funds
Rate
• The CB funds rate
• Interest rate at which banks
make overnight loans to one
another
• Lender – has excess
reserves
• Borrower – needs
reserves
• A change in federal funds rate
• Cause changes in other
rates and have a big
impact on the economy.

48.

Summary
Money serves three functions: medium of exchange, unit of account,
and store of value.
There are two types of money: commodity money has intrinsic value;
fiat money does not.
The Uzbekistan uses fiat money, which includes currency and various
types of bank deposits.
48

49.

Summary
In a fractional reserve
banking system, banks
create money when they
make loans.
Because banks are highly
leveraged, a small change in
the value of a bank’s assets
causes a large change in
bank capital.
Bank reserves have a
multiplier effect on
the money supply.
To protect depositors
from bank insolvency,
regulators impose
minimum capital
requirements.
49

50.

• The CB controls the money supply
50
mainly through open-market
operations.
• Purchasing government bonds
increases the money supply,
selling government bonds
decreases it.
Summary