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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.
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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.
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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.
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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?
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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.
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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.
Gayle AllardProfessor
