What is Money and What are Central Banks

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From the course by IE Business School

Understanding economic policymaking

648 ratings

IE Business School

Understanding economic policymaking

648 ratings

Course 1 of 3 in the Specialization Globalization, Economic Growth and Stability

This is the first of the three courses part of the Globalization, Economic Growth and Stability Specialization. This course will employ a non-technical approach to analyze how governments use policy to influence a country's economy. Upon completing the course you should be able to discuss national debts and deficits, examine fiscal and monetary policy and their appropriateness to the situation of an economy, and anticipate the results of fiscal and monetary policies and structural reform on a country. These concepts will give you the tools to develop your own position in many current economic debates, such as fiscal stimulus vs. austerity, the merits of quantitative easing, the need for higher interest rates or the future growth path of many modern economies.

From the lesson

Monetary Policy

Welcome to Module 4! This week we're tackling a fascinating issue, which is monetary policy, and I anticipate some very interesting debates. Monetary policy is the other main tool that governments can use to influence the economy. Monetary authorities work through the money supply and can use open market operations, their own lending rates and reserve or cash ratios to influence money markets and hence the real economy. Just as with fiscal policy, once the gap in the economy is identified, expansive monetary policy should be used in a recessionary gap and restrictive monetary policy in an inflationary gap. Monetary policy is superior to fiscal policy in many ways, but its greatest weakness is that it does not work nearly as well in recessionary gaps as in inflationary gaps. Keep up the good work!

What is Money and What are Central Banks8:46

Central Banks in the World7:55

What are the Tools of Central Banks?16:25

Meet the Instructors

Gayle Allard
Professor
Economics

[MUSIC]

To understand monetary policy, we first have to understand some of the

terms that we use, and the big one is, what is money?

We may just think, well, that's obvious right?

It's the cash you pull out of your pocket, but

the definition of money, can very widely, in general, we consider

anything to be money that you can use as a standard

of exchange, or you can use as a store of value.

So over history there have been a lot of different kinds of money ranging from

shells to the salt blocks that were used in Sub-Saharan Africa.

And when we talk about money in

our times, we're normally talking about different aggregates,

so we add up different kinds of money that are used in our cash-based economies.

The first one is something we call

M0, so we're working with concentric circles here.

M0 is all the currency and all the coins

that circulate in an economy at any given time,

and then we go a little bit wider and we go to M1, which is currency and coins,

plus the money we have in banks that we

can spend immediately, in what we call maybe demand

deposits or checking accounts, or site deposits, money that

you can actually spend using your debit card or writing

a check, or that you can withdraw from

the bank and then immediately spend in a store.

So this is M1, and then if we take this concentric circles out

further, we come to M2, and M2 includes, of course, all of the previous.

So it includes M1, which itself includes M0, plus savings

accounts which are accounts that where we put the money but we can't

spend it directly, so usually there's some sort of restriction on the account.,

You have to go to the bank and take it out and technically they could ask

you to wait up to three days, or maybe it's an account that you can only write

a number of checks on a month, so there's some kind of restrictions that make it

not as liquid as M1, and then we continue to move outward and we see other assets.

Each kind being a little less liquid.

The criterion is, can I spend this directly?

If so, it's M1.

If I can't spend it directly, how hard is it to convert it into M1 for spending?

And so, we move out.

To M2, M3, some countries track M4.

On this slide, here, you can see a picture

of these monetary aggregates in Europe up until the crisis.

Now, in the crisis, as we'll be seeing, a lot of interesting

things started to happen to money, so I've stopped it here just

as, as the crisis begins, but you can see on this chart,

the yellow line at the bottom is what we might call M0.

Alright, that's just cash and paper money and

currency circulating in the countries that form the Euro

zone, that share a currency in Europe, and so you can see M0 is actually very small.

Then the next area, which is sort of a purplish blue, is M1 or

the purple blue area plus the yellow is M1, so M1 again including not

only cash, but the money that we have in banks that we can spend immediately.

And then you can see when we add the red area to

the blue and the yellow, we get M2, and M2 includes deposits

with agreed maturity up to two years, plus deposits redeemable of a

period of notice up to three months as you see on the chart.

So this is, these are savings that can't be spent directly,

but can very easily converted into M1 to be able to spend.

And then you can see M3 which would be

the black, the red, the purple, plus the yellow,

and M3 has other kinds of, of money which

have to be converted before they can be spent.

So the idea is, authorities somehow have to keep track of how much

money is washing around in the economy, because it could be quickly spent.

If there's too much of it then probably

the number of goods being produced in the economy

can't rise fast enough to meet this amount of

money, and so we might have an inflation problem.

So with money supply, what the monetary authorities have to do is get

the amount right so that it's enough to buy our GDP, it's enough to allow

some growth, but it's not so much that inflation begins to accelerate.

Okay, so it's much harder than it seems to

get the money growth, or the money supply right.

So, who takes care of the money supply?

Well, we have some institutions, which are called central banks.

Now, in the United States, suddenly, there's

been a lot of conspiracy talk about

central banks, but in most countries, we don't know a whole lot about them.

Central banks are public institutions.

They're sometimes owned by the government, sometimes owned by the private sector, but

they are institutions that an easy way to think about it is, they do the same thing

for commercial banks, for the banks in our banking system, as those banks do for us.

In other words they lend them money when they need them.

They hold extra cash for these banks when these

banks don't need them, and they kind of keep

an eye on them to make sure that they're

following reasonable policies, that they're not being too risky.

In much the same way that a cen, a commercial bank might

watch us, and would lend money to us and take our deposits.

Now, one thing that's important about these central banks is that

they should be removed from politics we say that they're independent, alright?

What independence actually means is kind of tricky, and

so there's lots of literature on this of, you

know, which central banks are most independent, but in

general we consider a central bank to be independent.

Number one, if its leaders and its decision

makers are removed from the political cycle, so

they're appointed in time periods that don't coincide

with, say, presidential election or other national elections, right.

So they're out there and they have a long tenure, 14

years in the United States, and so they can think for themselves.

So that's one thing that makes them independent.

Another thing that makes them independent, and this

becomes very important when you think about our last

weeks session in monetizing the debt is, if

they're independent they cannot lend to the government, alright?

So they, the government cannot go to these central banks and say, I need some money.

Print it and send it to me for my spending needs.

They are separate.

The government doesn't talk to them.

They don't talk to the government.

And they certainly cannot lend to the government if they're independent.

So these are some important criterion for Central

Banks, criteria for Central Banks to be considered independent.

Another one, and here we see differences among some other Central Banks of

our time is, that they have some very independent target that they work with.

Now, in many cases, this target is the inflation rate.

Okay, so there are some central banks whose only job, according to their

charter, is to keep inflation low and stable in the countries that they oversee.

Now, not all central banks are like that, so we

have two different groups, we might say, of central banks.

One group has a single mandate, we say.

That means they only target inflation.

Now, the most prominent of those banks with a single mandate is

the European Central Bank that we'll be talking about in a moment.

There are another group of banks that we say have a dual mandate.

That means they target inflation, but they also target GDP

growth, and they think in some cases about the unemployment rate.

Now banks that are like that are, for example, the

Fed, which is the central bank of the United States.

Right now, they're actually targeting the unemployment rate in their policy-making.

The Bank of England is like that as well.

Which, these are banks that have sort of a

broader policy objective, than simply keeping inflation low and stable.

[MUSIC]

[BLANK_AUDIO]

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