Topic no. 13: Monetary Policy Flashcards
Understand: - What the functions of money are - credit creation process - know role of central bank - how Monetary Tools work - how money market works - Monetary policy
What is money?
Medium of exchange. Anything that is generally acceptable by society in exchange for goods and services.
What are the four functions of money?
a) Medium of exchange/Means of payment
[Accepted for settling all transaction]
Barter trade: goods are exchanged for goods, without money. ‘Double coincidence of wants’ to be effective.
[Money helps to eliminate barter trade → money is lubricant in economy as it makes exchange of goods and services easier]
b) Unit of account/Standard of value
[Money provides a convenient and consistent way of measuring value of goods and services]
c) Store of value
[Any good that can be kept and later exchanged for goods or services]
d) Standard of deferred payment
[Agreed measure by which contract can be written for future receipts and payments]
What is the creation of money?
Process by which banks increase the amount of funds in current account/demand deposits when they use their excess reserves to make bank loans.
How do banks go about creating money?
By making loans with the funds deposited with them.
What is fractional reserve banking system?
Banks holding a certain fraction of depositors’ money as depositors’ do not withdraw all their deposits at the same time.
Money supply = Currency in active circulation + demand deposits of the private sector
What are the different types of reserves?
i) Required Reserves (RR)
[Minimum amount of reserves banks are LEGALLY required to hold to back up its deposits]
Reserve requirement ratio (RRR):
[Amount banks have to hold depends on RRR]
RRR = (Require reserves (RR) [$] ÷ Bank’s total deposits [$]) x 100%
ii) Excess Reserves (ER)
Whatever deposits banks have available to LEND after setting aside the RR
What are the mechanisms of the Credit Creation Process?
Money multiplier: Amount by which an increase in bank reserves is multiplied to calculate the effect of the increase in reserves on total bank deposit.
Formula: MM = 1/RRR
Change in Money Supply: Effect of excess reserves(ER) on the money supply to be computed using:
△ MS = Initial ER (IER) x MM
What is the role of central bank?
A national bank that provides financial and banking services for its country’s government and commercial banking system, as well as implementing the government’s monetary policy.
Monetary Authority of Singapore (MAS): Promote sustained and non-inflationary economic growth and to foster a sound and progressive financial sector in Singapore.
What is monetary policy?
Discretionary control of the economy’s money supply by the MAS that is designed to affect overall performance of the economy.
What are the 4 monetary tools?
- Reserve Requirements
[Amounts of reserves that MAS requires a bank to keep to back up its deposits]
- MAS vary MS by ↑/↓ RRR
[↑ RRR: Shortage of reserves for banking system → reducing amount of bank lending put upward pressure on interest rates → increased % of bank’s liabilities in reserve → some ER become RR → ↑ RR, ↓ MM → bank’s ability to loan is reduced → rate of growth money supply is restricted]
[↓ RRR → ER loaned out → money created → money multiplier process initiated → MS ↑] - Discount rate or bank rate
[interest rate, MAS stands ready to lend reserves to commercial bank]
(signal of policy goals & borrow)
[↑ Discount rate → costly to borrow reserves for commercial banks → banks less aggressive making loans → ↓ impact of MM and MS → ↑ pressure on interest rates]
[↓ Discount rate → commercial bank borrow more reserves → banks become aggressive making loans → ↑ impact of MM and MS → ↓ pressure on interest rates] - Open Market Operations
[Selling govt securities: MAS slow MS → MAS sell govt securities in open market → individuals, business or banks get govt securities; MAS gets money (from bank deposits and reserves) → lower reserves, bank cut lending → multiple contraction of money supply and interest rate ↑]
[Buying govt securities: MAS ↑ money supply → MAS buy govt securities in open market → MAS receive govt securities; individual, business or banks get money → ↑ bank reserves → banks ↑ lending → banking system starts multiple money expansion process and interest rates fall] - Exchange rate policy
[Buy S$ MAS buy S$ → more S$ with MAS, no longer in circulation → money supply ↓ → ↑ interest rate]
[Sell S$: MAS sell S$ → more S$ in circulation → ↑ MS → ↓ interest rate]
What is the money market?
Consists of demand and supply for money.
Demand for money: Individuals and firms (nonbank public) who wants to hold cash or checking account deposits.
→ ↑ interest rate, ↓ quantity of money to hold
→ ↓ interest, ↑ quantity of money to hold
Supply of money available at a point of time - controlled by MAS.
[Demand and supply determine price of money. i.e. interest rate]
How is the money market graph?
The equilibrium in money market is attained when demand for money curve intersects money supply curve.
What are the types of monetary policy?
Expansionary MP:
[MS curve shifts right → Interest rate ↓ → Consumption and investment ↑ → AD ↑ → Output ↑ by a multiple]
Contractionary MP:
[MS curve shift left → Interest rate ↑ → consumption and investment ↓ → AD ↓ → Output ↓ by a multiple
What is the effect of a change in interest rate?
i) Investment
Investment ↑ → Money supply ↑→ Interest rate ↓ → ↑ Interest → AD ↑ → Output ↑ by a multiple
ii) Consumption
Consumption ↑ → AD and GDP ↑
[Use monetary tools → ↑MS → ↓ Interest rate → ↑C → ↑AD → ↑ output by a multiple]
Effects of expansionary monetary policy:
Money supply ↑ → Interest rate ↓ → Consumption and Investment ↑ → AD↑ → GDP ↑ by a multiple
