CHAPTER 7 MONETARY AND FISCAL POLICY Presenter’s name Presenter’s title dd Month yyyy
1. INTRODUCTION Monetary Policy • Set of activities of a nation’s central bank that are intended to affect the money supply and the credit in the economy Fiscal Policy • Set of activities of a nation’s government, including taxation and spending, that can affect the economy Copyright © 2014 CFA Institute 2
2. MONETARY POLICY • Money is a medium of exchange that can be used to purchase goods and services and to repay debts. • Qualities necessary for money to be a medium of exchange: 1. Readily acceptable 2. Known value 3. Easily divisible 4. High value relative to its weight 5. Difficult to counterfeit • Money has importance in an economy because it -. acts as a medium of exchange, -. provides a way of storing wealth, and -.provides society with a convenient measure of value and a unit of account. Copyright © 2014 CFA Institute 3
CREATING MONEY • The reserve requirement is the percentage of deposited funds that a bank must keep in reserve (that is, not lend out). • The amount of money in the banking system is a function of the reserve requirement: - The higher the reserve requirement, the less funds available to lend. - The lower the reserve requirement, the more funds available to lend. • The effect of the reserve requirement on the money supply is summarized with the money multiplier : - If the reserve requirement is 5%, the money multiplier is 20 times. - If the reserve requirement is 10%, the money multiplier is 10 times. Copyright © 2014 CFA Institute 4
PROCESS OF MONEY CREATION Assume that banks must keep 5% of deposits in reserve Money multiplier = 1/0.05 = 20 times Copyright © 2014 CFA Institute 5 Money Supply Bank Assets Bank Liabilities Step 1: Person A deposits €100 in OneBank. • Person A has an asset at OneBank for €100. • OneBank has a liability to Person A for €100 and an asset of €100. €100 €100 €100 Step 2: OneBank loans €95 to Person B by putting it in a checking account. • Person B has a liability to OneBank for €95, and an asset of €95 in the checking account. • OneBank has an asset (loan) to Person B for €95 and a liability for the demand deposit of €95. €195 €195 €195 Step 3: Person B uses the €90 to buy from Person C. • Person C deposits the funds in TwoBank. • TwoBank lends €85.5 to Person D. €280.5 €280.5 €280.5
DEFINITIONS OF MONEY • Money stock includes coins and currency in circulation, plus deposits in banks and other financial institutions, which can be used to make purchases of goods and services. - Narrow money includes notes and coins in circulation plus highly liquid deposits. - Broad money includes narrow money plus all liquid assets that can be used to make purchases. Copyright © 2014 CFA Institute 6
QUANTITY THEORY OF MONEY • The quantity theory of money states that total spending is proportional to the quantity of money.