European Central BankMoney and Monetary Policy
9.1 Meaning and functions of money
What is this thing called ‘money’?
Money is hard to define. Obviously it includes notes and coins which we use for many transactions (especially small). However it includes much more. For example if I pay by credit card or direct debit, I am not directly using cash.
So to define money properly we need to look at the functions of money
The functions of money
A medium of exchange
In a primitive economy people do not need money. Basically they try to produce goods and services for themselves and if they need anything else trade directly offering items in exchange. This is known as barter. Thus if you are producing eggs and I am growing wheat we could exchange eggs.
Barter still survives in many circumstances especially in rural areas for example in relation to building activity.
However barter becomes very inefficient in a highly specialised economy.
Therefore money acts as an indirect though universally acceptable means of exchange.
So when I go in the canteen for coffee I know that money will be acceptable.
This is because the person receiving it knows that in turn it can be used to buy goods (e.g. future food stocks).
A means of storing wealth
Money as we know can be saved thereby enabling the accumulation of wealth. However when the interest rate is low (as at present) and inflation higher, other assets (like houses) may be a better store.
A means of evaluation (unit of account)
Money can be used to provide a value of goods and services so that one can be compared with another. This is why a person’s wealth is customarily referred to in money terms.
A means of establishing the value of future claims and payments
Money can be used to denominate future payments e.g. debts and contracts.
What should count as money?
It all depends on how broadly money is defined. Notes coin would be included in all. However the borderline as to the inclusion (or exclusion) of other financial assets is difficult to draw.
Characteristics of a good money medium.
The key requirement of a good medium that it is liquid i.e. people readily accept it as a means of payment.
In the past commodity money (i.e. items which had inherent value such as scarce metals like gold and silver were used). Now fiat money (i.e. based on faith) is largely used. For example a €50 euro is merely paper (with practically no value). However it works as money as long as people are willing to accept it as such.
Other (secondary) aspects of a good money medium are
Portability i.e. should be easy to transport
Durability i.e. should last intact for some time. (There is a problem with bank notes in this respect!).
Homogeneous i.e. there should be just one system (usually controlled by Centarl Bank)
Divisible i.e. should be available in a number of denominations.
Financial System in Ireland
There are a number of institutions
Central Bank – this is the coordinating bank responsible for overall management of the system. It is now incorporated with the European System of Central Banks
Associated (Commercial) Banks – these are the general retail banks dealing directly with the public (Bank of Ireland, Allied Irish Banks, Ulster Bank and Irish National).
Merchant (Investment) Banks – these are wholesale business banks and often subsidiaries of the main Associated Banks (Investment Bank of Ireland, Allied Irish Investment Bank, Guinness Mahon etc.)
Finance (Industrial) Banks – these again are often subsidiaries of the main banks and deal with smaller business (Bank of Ireland Finance, Allied Irish Finance, UDT etc)
Other Financial Institutions – these are other larger amalgamation Permanent TSB, First Active (now taken over by Ulster Bank)
Building Societies (EBS) Many of these have now become more widely diversified financial companies.
Insurance Cos. These include general (e.g. Axa) and life (e.g. Norwich)
Post Office Savings Bank – deals with smaller savings
Credit Unions – operate on a voluntary basis
Central Bank
There are a number of functions:
General
- issuance of currency
The Central Bank normally has complete control over this function. However in some countries commercial banks also issue notes e.g. Northern Ireland and Scotland. This can lead to a problem where such notes are not recognised elsewhere in the UK.
- management of exchange rates
The Central Bank has power to (artificially) influence the exchange rate of a currency. For example if a currency e.g. sterling is deemed too weak, the Central Bank (Bank of England) could use other reserve currencies such as euros and dollars to buy sterling on the foreign exchange markets. This would increase the demand for sterling and thereby its price.
- management of gold reserves
Though it is a relic of the past when commodity money was used Central Banks still have gold in their reserves which they are entrusted to guard safely
Government Bank
- holder of Government account
Just as a commercial bank acts for the public, the Central Bank acts for the Governement holding (and managing) its very large account
- management of debt
The Government will generally require to borrow money which can be raised through the issuing of various types of government securities (gilts). The Central Bank generally manage this function though for some years now in Ireland it has beencarried out by a specialist body - the NTMA (National Treasury Management Agency).
- advises on economic policy
A considerable amount of research into economic developments in the economy is carried out by the Central Bank. It then advises the Governement (usually advocating prudence and caution) in its conduct of economic policy. This advice (in Ireland) is contained in the Central Bank Bulletin (published each quarter).
Bankers Bank
- licensing and supervising authority
In order to operate a bank must obtain a license that is issued by the Central Bank which can be taken away in the case of misconduct. Also the Centarl Bank is generally entrusted with the day to day supervision of the financial system. In Ireland another special body - which is however closely associated with the Central Bank - has been set up for this purpose. It is called the Financial Services Regulatory Authority.
- hold deposits of financial institutions
Banks hold their own accounts with the Central Bank. At the end of each day they settle up their own debts with each other through cheques drawn on these accounts (clearing accounts).
Also for security reasons they need to minimise teh amount of cash kept on the premises. So most of this cash is held for safe keeping with the Central Bank.- sets reserve requirements
Though vital for meeeting customer requirements, the holding of cash is not profitable for banks. Thus theer is a need for reserve ratios whereby they are legally required to hold a certain percentage of their reserves in cash. This ratio is set by the Central Bank.
- provides lending facility
The Central Bank also provides a lending facility for the banks which enables them to abtain additional liquidity if in danger of running short of cash. The "Bank Rate" is the rate of interest charged by the Central Bank for this purpose and can represent an important use of monetary policy.
Though the Central Bank can act as "lender of last resort" in a dire emergency, normally this is not exercised.- apply additional measures when required
The Central Bank can call for additional deposits to be made with it (for example when too much credit is extended). Also in certain cases it may impose penalty restrictions on banks for extending too much credit.
Monetary Policy
The Central Bank is also responsible for exercising monetary policy
The key elements of monetary policy are
1. Control of money supply. It is important to control the amount of money in circulation. Though puuting extra money into circulation can stimulate economic activity, too much money can lead to inflation.
2. Changing the interest rate. Interest rates throughout the financial sector are closely related to each other. Therefore if The Central Bank lowers its own rate this usually leads to a general reduction in interest rates which stimulates economic activity (through additional investment and consumer spending).
3. Managing the exchange rate. The value of the exchange rate with other currencies is very important as it affects trade. For example due to the recent rise of the euro against the dollar, it is now cheaper to import goods from the US (and to visit there on holiday). However it is more expensive to sell goods into the US market. Though the Central Bank can affect the exchange rate, it generally does not intervene in this manner.
4. Other measures. Formerly credit controls were widely used in Ireland, though with the single financial market in Europe these are no longer used. However other measures such as reserve ratios and banking legislation can also impact on monetary policy.
Since 1998 all national Central Banks are part of the European system.
This federal arrangement is referred to as the European System of Central Banks (ECSB) with decisions taken by an executive board - referred to as the European Central Bank (ECB).Most of the traditional functions of national Central Banks are now controlled by the ECB.
- Currency i.e. the Euro is now issued through the ECB; our national Central Bank then acts as an agent for the ECB in printing notes and minting coins for the Irish economy
- The power to control exchange rates for Eurozone countries has now ceased
- The terms (interest rate) on which lending to other banks is now set is through the European Central Bank. Therefore the ECB can control the overall amount of credit extended
However the national Central Bank still can play a regulatory role though this now exercised through The Financial Services Authority of Ireland
- The European Central Bank also controls the reserve ratio of the banks
- The National Central Bank still acts a banker to the Government.
- However the amount which can be lent out (and the manner in which borrowing takes place) is again controlled at a European level
So overall now the role of the national Central Banks (within the EMU) is to carry out the policy that has been agreed at a European levelIn other words independent monetary policy - with respect to money supply, interest rates or exchange rates - has now ceased for Eurozone countries.
The Supply of Money
The money supply represents the amount of money in circulation.There are different ways of measuring the amount of money.
1. M0 - the amount of cash (i.e. notes and coin).
2. M1 - the amount of cash + current accounts which is referred to as the narrow money supply. Current accounts are included here as they provide the basis for payment by cheque, debit (e.g. laser) or credit card.
3. M3 - Added now to the previous total is the amount held in demand accounts in banks (which earn a small rate of interest). This is referred to as the broad money supply. With ATM machines one can readily withdraw cash from such accounts making them very liquid.
However there are many other definitions of the money supply depending on which finacial assets are included. For example building society accounts are now very liquid and one can withdraw cash from them through the ATM machines. These are included in an even wider definition of money (M4).
The importance of the money supply is that there is very close link between it and the inflation rate (the quantity theory of money).
If too much money is in circulation prices will rise.
By the same token if the money supply is reduced this should help to reduce the level of inflation.
Measures to reduce money supply generally operate by decreasing the amount of liquidity (i.e. cash) in the banking system. Because of the reserve requirments legally imposed on the banks this means that they can create less credit (thereby reducing the amount of money in circulation).
The usual way of changing this liquidity is through open-market operations (ie. the buying and selling of government securities).
When these are sold to the banks they have to part with cash (which reduces liquidity).
In reverse manner when these are bought back from the banks it increases liquidity leading in turn to more money in circulation.
Credit Creation
Banks can in fact create money. This is due to the fact that they are required to keep only a small amount of what is deposited with them in teh form of cash.
Imagine for example a monopoly bank, where all money that people receive is deposited in a branch of this bank. Also assume for conveninece that the reserve requirement (i.e. the proportion which must be kept in cash) is 10%.
Theerfore if €100 is deposited in a branch the bank can lend out €90 which is then deposited in some other branch. 90% of this deposit can in turn be lent out (€81) which is again deposited and then in turn 90% of the resulting deposit and so on.
It can easily be proved that ultimately €1000 will be generated as a result of this initial deposit.
So the credit multiplier here 10 i.e. 1/(1/10) which is one divided by the original fraction which must be saved.
However in practice the credit multiplier would not be so large.1) People do not necessarily deposit money received in banks. Some for example may be hoarded or other money go into non-bank institutions.
2) Money can leak out of the banking system to be deposited in institutions abroad.
3) Banks do not in fact lend out all spare money in possession. Indeed nearly half typically goes into a range of financial investements.
4) The Central Bank will tend to regulate the overal amount of credit created.
5) The credit multiplier can work downwards as well as upwards i.e. when the amount of deposits placed in banks falls.
The Demand for Money
As we know there is a demand for goods and services which is related to their price.
Likewise there is a demand for money which is related to its price (i.e. the interest rate).
Thus as the interest rate rises, the demand for moneywill decrease; conversely, when the rate of interest falls, the demand for money will increase. In other words there is not much of an incentive to invest in other financial assets when the interest rate (as at present) is very low.People have a demand for money (i.e. a desire to hold cash rather than other financial assets) arising from three motives
1. Transactions motive: there is a need for cash to carry out transactions at the consumer, firm and governmental level.
2. Precautionary motive: there is a need for cash to carry out unexpected expenditures.
3. Speculative motive: there is a need for cash - especially in banks and insurance cos. - to buy financial assets (such as government bonds) at the appropriate time.
Just as the equilibrium price of goods and services is determined where supply = demand, likewise the equilibrium price of money (i.e. the interest rate) is determined where the supply of money = the demand.
Again just a change in the supply (or demand) of a good will change its price, likewise a change in the supply (or demand) for money will change the interest rate.
If the supply of money for example is increased, this will result in a fall in the interest rate. Lower interest rates then will tend to stimulate investment and consumer spending leading to expansion in the economy and growth in employment.
If the supply of money is reduced e.g. to bring down inflation, this will lead to a rise in the interest rate which unfortunately may lead to a slowdown in economic growth.
Thus it can be difficult to control inflation and maintain employment at the same time.