BUS1614 Macroeconomics

Banking, Money,
Interest rates and
Monetary Policy
After this chapter, you will be able to: CHAPTER 1
 Define money and describe its functions
 Describe the function of the central bank and commercial
banks
 Explain factors that determine money supply and money
demand
 Explain supply & demand for money, relationship between
interest rates & asset prices and the money market.
 Explain changes to money market equilibrium and the
effect of interest rates on real GDP and price levels
 Describe the objectives of monetary policy and the framework
for setting and achieving them
 Explain how the central bank makes its interest rate decision
and achieves its interest rate target
 What is Money?
Money is any commodity or token that is generally
acceptable as a means of payment.

– A means of payment as a method of settling

a debt.
– Money has three other functions:
 Medium of exchange
 Unit of account
 Store of value
 Medium of Exchange
– A medium of exchange is an object that is generally
accepted in exchange for goods and services.
– In the absence of money going back thousands of
years, people would need to exchange goods and
services directly, a system called barter.
• Barter requires a double coincidence of wants, which is
rare, so barter is costly.
– Commodity money e.g. gold & silver coins, rice,
copper, even cigarettes – not portable, indivisible.
– Fiat money, money declared legal tender
 Unit of Account and Store of Value
• Unit of Account
– A unit of account is an agreed measure for stating
the prices of goods and services.

• Store of Value
– As a store of value, money can be held for a time
and later exchanged for goods and services.
– Or money can be stored in the form of wealth e.g.
bonds, & other assets.
 What is Money?
Money as we know today consists of
The notes and coins held
– Currency by the general public
M1 – Deposits at banks and other depository
institutions

money because
Current deposits owners can write
(kept in checking checks on a/c to
or current a/c) make payments
 Official Measures of Money
– The figure illustrates RM millions
the composition of
M2 989,343
M1 and M2 in Dec
2009 102,268 Savings
– It also shows the
relative magnitudes
of the components. 437,562 Fixed deposits

24,719 Money market instruments

Forex & other deposits

223,878
M1 200,917
43,439 Currency in circulation

157,477 Demand Deposits

Source: BNM
 Are M1 and M2 really money?
– All the items in M1 and M2 are although M1 is
more liquid (narrower) than M2 (is broader)
– E.g. saving deposits in M2 are liquid assets.
instantly convertible into a means of
payment with little loss of value
– Deposits are money, but checks (cheques) are
not–a check is an instruction to a bank to transfer
money.
– Credit cards are not money. A credit card enables
the holder to obtain a loan.
 Depository Institutions
A depository institution is a firm that takes deposits from
households and firms and makes loans to other
households and firms.

– The institutions in the banking system are divided into:

 Commercial banks eg Maybank Major focus

 Investment banks (former merchant banks) eg RHB Sakura

Merchant Bank now called RHB Investment Bank
 Other financial (thrift) institutions eg BSN
 Money market instruments (treasury bills, bankers
acceptances, certificates of deposits, etc – usually 30 -90
days discount bills)
 What institutions like commercial
banks do?
– The goal of any bank is to maximize the wealth of its owners.
– To achieve this objective, interest rate at which it lends must
exceed the interest rate it pays on deposits.
– But the banks must balance profit with prudent banking
practices:
 banks accept deposits
 Banks lend and loans generate profit.
 But depositors must be able to obtain their funds when they
want them.
 So banks cannot lend out all and must keep some in reserve

Called a reserve requirement –

in Malaysia called the SRR, 4%
of total reserves
 The Central Bank
– Bank Negara Malaysia (BNM) is the central bank of Malaysia.
– A central bank is the public authority that regulates a nation’s
depository institutions and controls the quantity of money.
– BNM’s goals are to keep inflation in check, maintain full
employment, moderate the business cycle, and contribute
toward achieving long-term growth.
– In pursuit of its goals, BNM pays close attention to the
overnight policy rate—the interest rate that banks charge
each other on overnight loans.
In practice, the governor of BNM (since May 2000 Zeti Akhtar
Aziz) is the largest influence on central bank’s policy.

She controls the agenda of the Bank, is the BNM’s spokesperson

and point of contact with the federal government and with
foreign central banks and governments.
The Central Bank’s Monetary Policy Tools
– To achieve its objectives, the Central Bank uses
three main policy tools:
 Liquidity reserves ratio: minimum percentage of
deposits that banks hold as reserves SRR (statutory
reserve ratio) 4% in
 Discount loans – overnight last resort
Malaysia
loans
 Open market operations: the purchase or sale of
government securities
Our main focus on
monetary policy
 Required Reserves
– A bank’s actual reserves consists of notes and
coins in its vault and its deposits at the central
bank.
– The fraction of a bank’s total deposits held as
reserves is the reserve ratio.
– The liquidity (or required) reserve ratio is the
ratio of reserves to deposits that a bank wants to
or has to (by law) hold.
– Excess reserves equal Total reserves minus
required reserves.
E.g. Suppose a bank has total deposits of $100 million. If the law
requires that it must maintain a Required Reserve ratio of 10%:

Reserves = 10% @$100m = $10 million

Excess Reserves = $100m – $10m = $90 million
 Demand for Money
Otherwise called influences on holding money

1. Interest rates
2. Non interest rate determinants:
• Price levels (of goods & services)
• GDP
• Financial Innovation
Non interest rate determinants:
Price & Real GDP
Real GDP
An increase in real GDP increases the volume of
expenditure, thus increasing transaction demand for money.
The Price Level
– A rise in price will cause a fall in real value of money
– Real money equals nominal money ÷ price level.
– Sooooo….. a 10 percent rise in the price level increases
the quantity of nominal money demanded by 10 percent.
– To ensure we can afford to buy the same amount of
goods and services before prices went up.
 The Market for Money: Money
Non interest rates Demand
determinants

– Figure 25.4 Shifts in the

Demand for Money
Curve
 in GDP, price levels –
MD & MD curve shifts
left.
– An  in GDP & price
levels – MD & MD curve
shifts right.
 The Market for Money: Demand for Money
– Explaining the relationship between the quantity of money demanded and
interest rates
– We assume people keep money as money or as a store of value

People demand money to

hold assets (bonds, etc)
Asset Demand for Money (or the Speculative Motive for
Holding Money)
And interest rates level determines if
people will want to hold assets (bonds)

The interest rate being the opportunity cost of holding

money as in money rather than as in interest-bearing
assets (eg bonds).
 Asset Demand for Money
Opportunity cost of
– Diagram illustrates the demand holding money in
bonds rises as i rises
for money curve
–  in interest rates results in  in
the quantity of money
demanded because demand for
bonds  - prices of bonds .
–  in the interest rates results in 
in the quantity of money
Opportunity cost of
demanded because demand for holding money in
bonds  - prices of bonds  bonds falls as i falls

Quite apparent that:

•Interest rates and quantity demand for money are inversely related
•Interest rates and demand for assets are inversely related
•interest rates & prices of bonds are inversely related
 The Market for Money: Equilibrium
In the market for money an In the US, this overnight rate
interest rate called the is called the Federal Funds
overnight policy rate can be Rate
controlled by central bank

• Money Market Equilibrium

• Suppose that the central bank
(BNM) interest rate target is 5
percent a year.

The BNM adjusts the quantity

of money each day to hit its
interest rate target
 How does the Money Market find
equilibrium
– If the interest rate exceeds the target
interest rate, Opportunity
cost of holding
– the quantity of money that people are money in bonds
willing to hold is less than the quantity falls as i falls
supplied (MD < MS) – surplus
– This lowers the interest rate.
– “Excess” money is resolved as lending
rises - people hold money to buy
bonds (asset demand for money ) to
take advantage of higher bond prices

Bond buyers
are lenders
 The Market for Money
– If the interest rate is below the Opportunity
target interest rate cost of holding
money in
– the quantity of money that people bonds rises as
want to hold exceeds the quantity i rises
supplied (MD > MS) – shortage
– This raises the interest rate.
– Shortage of money is solved when
higher interest rates force demand
for bonds to fall as people sells
lower interest-yield bonds to avoid
falling bond prices
Bond sellers
are borrowers
 The Money Market:
Changes to Equilibrium
 in GDP - Transaction demand for money
Interest At i0 MD > MS (shortage)
MS
rates %
 i to i2
r1 b people short of money will borrow /sell
bonds (& other liquid assets)
r0 a Asset demand for money 
Money market settles at new
equilibrium at higher interest rate r 1
MD0 MD1
Real money ($
billions)
 The Money Market:
Changes to Equilibrium
Central bank  money supply by buying securities (bonds)
in open market operations (OMO) -  banks’ reserves
Interest
MS0 MS1
rates % At r0 MS>MD (surplus)
r to r2
Opportunity
a Banks with excess reserves will
r0 cost of holding
money in bonds
falls as r falls
lend & buy bonds (& other assets)
r1 b Asset demand for money 
MD0 Money market settles at new
equilibrium at lower interest rate
Real money ($ r1
billions)
 Monetary Policy
Defined as the actions of the central bank to manage money supply
and interest rates to achieve macroeconomic policy goals.
(Hubbard, 2015)

In Malaysia, it is the Monetary Policy Committee (MPC)

headed by the governor of Bank Negara Malaysia (BNM),
Dr Zeti

Bank of England’ – a similar named Monetary Policy

Committee meets to set the interest rates.

In the US, the Federal Reserve System is the central bank

responsible for monetary policy
 Monetary Policy Objectives and
Framework
– Goals of Monetary Policy
– Maximum employment and stable prices
– How does the central bank operate to achieve its
goals?
Bank of England Bank Negara Malaysia
sets the interest rate through prudent credit and
• Target rate of inflation banking policies
• Output and • Promote maximum
unemployment sustainable growth
• Exchange rate • Price stability
 Monetary Policy and Business Cycle
• Stable price is the common goal, attention is focused on the
state of business cycle:
– If the economy is in:
• Inflation gap – inflation is rising (& shortage of resources)
– central bank applies contractionary (tight) monetary
policy
• Recession gap - indicates unemployment above the
natural rate – expansionary (easy) monetary policy.

– Objective – to minimize the output gap and achieve low

inflation (and full employment)
 The Conduct of Monetary Policy
Choosing the appropriate monetary policy instrument

The monetary policy instrument is a variable that the central

bank can directly control or closely target.
1. Target a short-term interest rate OR
Monetary base = currency in Focus for this lecture –
circulation + banks’ reserves we assume central bank
adopts a targeting rule
2. Target the monetary base with a
required reserve ratio OR USA – Required reserve
ratio is 3% of deposits
3. Discount Loans through use of money Malaysia – SRR 4%
market intruments e.g. treasury bills, etc
 Short-run Interest Rates
Most central banks’ choice of policy instrument is a
short-term interest rate.

• Federal funds rate – US

• Overnight policy rate (OPR) – Malaysia
• Cash rate – Australia
• Official bank rate (BOEBR) – England

• The short-run interest rate is the interest rate on

overnight loans that banks make to each other.
 Targeting an Interest Rate with
OMO
• Open Market Operations (OMO) involves the purchase
or sale of government securities by the central bank
from or to commercial banks or the public.
Accounts for more than 70% of
monetary policy activities
• The most widely used method to alter the monetary
base. This then affects the amount of credit banks can
create (i.e. money banks can lend)
 Open –market operations
The sale or purchase of government securities
(bonds) by the Central Bank

a)If central bank wishes to reduce money supply, it sells more

securities. When people buy these securities through cheques
drawn on banks , bank balances (i.e. banks’ reserves) with the
central bank are reduced. Banks are forced to reduce lending –
Contractionary Monetary Policy

b) If central bank wishes to increase money supply, it buys

securities. The central bank pays for these securities by
crediting the account of banks with newly created reserves (i.e.
money) held by the banks – Expansionary Monetary Policy
Monetary Policy Transmission
• When the central bank targets a lower interest
rate:
– 1. The quantity of money supply increase.
– 2. short-term interest rates, r fall
– 3. Money supply increases further
– 4. The long-term real interest rates, i falls.
– 5. Normal targets – Consumption & investment ,
aggregate expenditure 
– 6. Aggregate demand 
– 7.  Real GDP growth (with some inflation )
 The Central Bank Fights Recession:
Effects of Expansionary Monetary Policy
Central bank targets a lower interest rate at r 1
To maintain at r1 Central Bank buys bonds in OMO
Money supply curve shifts right to MS 1 as
Interest
banks’ excess reserves 
rates % MS0 MS1
surplus MS > MD (+) at r0
 r :-
r0
 banks with excess reserves increases
lending (buys bonds)at lower r (bond
r1 ●b prices rise)
MD0 Surplus is resolved at lower interest
Real money balances
rates as money market clears at
new equilibrium at pt b
32
Targeted MS1 MS2 i%
interest
rate , r %
Other
r1 interest i1
rates fall
r2 i2
I
MD

Investment ($)
Price LRAS
Investment
increases
SRAS
P1 b
P0 a
Expansionary
Monetary Policy &
AD2 the Domestic
AD1
Y0 Y1 Y Economy
Goods & Services Market 33
 The Central Bank Fights Inflation :
Effects of Contractionary Monetary Policy
Central bank targets a higher interest rate at r1
To maintain at r1 Central Bank SELLS bonds in OMO
 banks’ excess reserves  & MS curve shifts left to MS1
Interest
rates %
Shortage of money MD < MD (-) at r0
MS1 MS0
 r:-
Opportunity
cost of holding
 Higher r force demand for bonds to fall
r1 - ●b money in & banks sells bonds to avoid losses
bonds rises as when bond prices fall
r rises
r0
Shortage is resolved at higher
interest rates as money market
MD0 clears at new equilibrium at pt b
Real money
34
balances
r, i% MS1 MS0 i%

Other
r2 b interest i2
rates rise
r1 i1

MD0 ID

Investment ($)
Price LRAS
level Investment
falls
SRAS0
P0
a
P1 b Tight Monetary Policy
• Central Bank announces
AD0 intention to interest rate
AD1 • Sells govt. securities
Y1 Y0
Real GDP
35
 NEXT WEEK

Relationship between the Money and

Goods Market [IS-LM Model]