Chapter 3 Money and Monetary Policy

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Money and MonetaryPolicy

Chapter 3


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The Concept of Money

Money allows people to specialize in what they do best, itremoves problems associated with barter and increases tradeand business transactions.

Specialization allows more goods and services to be produced

and exchanged, thereby increasing the standard of living for all. The primitive barter may not be able to support such system.

The reason can be summarized below:

Double coincidence of wants for example, furnituremaker and poultry farmer.

Indivisibility of goods and services continue from theabove example, the exchange ratio might not be acceptableto either or both the parties.

Lack of an unit of account (common standard of

value) as diversification of products grows, is that pricing.


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The Concept of Money A good monetary system is a mechanism by which markets are

efficiently and perfectly cleared. If not people would resort forbarter trade.

For example, Malaysia resorted to barter trade due to a shortage

of foreign reserves. Indeed, barter is practiced even in instanceswhen the monetary exchange mechanism performs well, forexample, as a means of avoiding taxes.

Modern money essentially performs with more efficiency andeffectiveness and nothing more than tools for facilitating

exchange and might be described as the mechanism by whichmarkets are perfectly cleared or a mechanism which speeds upand simplifies the process of producing and exchanging goodsand services.

Money has evolved from items like cowry shells, stones, leatheretc. to gold and silver, to paper currencies and electronic money.


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Functions of Money

Medium of Exchange

Standard of DeferredPayment

Store of Value

Unit of Account

Functions of Money


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Functions of Money

To solve the problems of barter trade, such asdouble coincidence of wants, indivisibility of goodsand services, lack of a unit of account.

Accordingly, the most important functions ofmoney are to serve as:

Medium of exchange

A unit of account

Store of value

Standard of differed payment


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Functions of Money

Medium of Exchange

The most important function of money is its function as amedium of exchange.

Money as anything that is used as a means of makingpayments.

If it is difficult and expensive to obtain money, it might beclaimed that such a medium is not effective and efficient to

perform the function as a medium of exchange.

A good medium of exchange is one that allow everyone toexchange his or her goods and services fast at a minimumcost


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Functions of Money

Unit of Account

In barter trade era, pricing is very cumbersome and makesexchange impractical and almost impossible in a marketwith a huge amount of goods and services.

Thus, one of the most important functions of money lies inits role as a unit of account.

A universal pricing tool and useful to obtain informationfrom the market on the value of ones output.

Therefore, a good unit of account is one which enables the

market participants to express the value of their productsand services in a way that reflects their relative desiredvalue against other goods and services.

Furthermore, a good unit of account is one which allowmarket participants to extract information on the current

demand and supply situation.


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Functions of Money

Store of Value An item being used as money is indeed a temporary storage

of value in the exchange process. For example, onetransform the value of a chicken into monetary form andlater he want to transform its value back into real goods

and services. If the purchasing power of money is eroded over time, then

that money has not been a good store of value.

Since inflation is a measurement of the purchasing power ofmoney, it is therefore used as a measure to estimate the

performance of money as a store of value. For example, if the general price level is stable, which

equivalent to low inflation, we can say that money has beena good store of value and vice versa.

For example, previously we can buy a cup of tea for 30cents but now we can only get a cup of plain water.


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Functions of Money

Standard of Deferred Payment

Money is not only useful for spot transactions, but also inspecifying future payments for current purchases, i.e.,buying now and paying later.

This function is the result of the role of money as a unit ofaccount and store of value.


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Types of Money

Commodity Money/CommodityMonetary Standard

Fiat Money

Metallic Money

Types of Money


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Types of Money Commodity Money or Commodity Monetary

Standard Commodity monies might be defined as commodities which

are used to facilitate the exchange process.

In such a monetary arrangement, it would be either thecommodity such as rice, tobacco itself that circulates andexchanges hands (and hence the term as commoditymoney), or notes that are being issued against, and areredeemable for a particular commodity (what is termed ascommodity monetary standard). The redeemable function

is important for this purpose.

Disadvantages: The expense involved and transportation issue

Storage costs and the variation in the qualities of money(quality of rice or tobacco to settle obligations).


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Types of Money

Metallic Money

Gold and silver were commodity found very desirable toplay the role of money (medium of exchange, a unit ofaccount, store of value, and standard of deferred payment).

Gold and silver have the following characteristics to becomea good money:

Divisible

Fungible (equivalent in value)

Weighable, measurable, or countable

Stable in value over time Durable

Homogeneous

Mobile


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Types of Money

Fiat Money as a Commodity

Conventional banks are not allowed to utilize money createdby them for their own purposes, but the newly createdmoney can only be lent out to third parties.

Therefore, every conventional banks lends out the createdmoney, its profits coming not from the seigniorage but fromthe interest earned on the lending principal amount.

Then how are Islamic banks make profits? Through equity-based and debt-based instrument, but, most Islamic bankspreferred to utilize the debt-based instrument due to theless risky than the equity-based instruments.


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Types of Money

Fiat Money as a Debt Certificate Money is not a commodity at all, but just a debt recording

mechanism. All holders of monetary notes would becomecreditors and those who borrowed the money would becreditors.

Read the example of the JAK Medlemsbank interest freeco-operative bank. The bank does not increase the amountof credit in circulation without the corresponding savings orthe credit expansion takes place only with the consent ofthe savers, who are creditors in the system.

This is in total contrast to the general practice of today inwhich many parties end up as chronic net debtors, aphenomenon which happens due to the absence of consentof the creditors, leading to a disproportionate allocation ofcredit, income, and wealth.


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Time Value of Money

A basic concept in finance, today money is worth more thantomorrow money. A today RM100 has more value than aRM100 in the future. There are 3 reasons why this is so.

Money loses its value over time due to inflation of economy.

Money has opportunity costs due to not be able to invest themoney and get return from its.

Uncertainty of future cash flows due to some circumstances theymay not happen.


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Monetary Policy Instruments

Required Reserve Ratio

Open Market Operations

Discount Rate

Monetary PolicyInstruments


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Required Reserve Ratio (RR)

Required reserve ratio as demanded by the Central Bank(Bank Negara Malaysia) have a direct impact on the bankingsystem excess reserve to be lent out.

For example, the total deposit in the banking system is RM4billion and the required reserve ration is 10 percent, thenthe total required reserve ratio is RM400 million and theremaining RM3.6 billion is excess reserves, which thebanking system can use it to be lent out.

Thus, the Central Bank can use this instrument to increaseor decrease the banking system excess reserves inconducting the country monetary policy.

How to increase the excess reserves in the banking system?


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Discount rate

In this situation the Central Bank serves as the bank forfinancial intermediaries and extend loans to banks that needfunds.

The interest rate charge to banks is termed as discountrate. Normally, the central bank will use the discount rate tosignal its monetary intention, whether to expand or contractthe stock of monetary supply.

For example, if central bank lowering its discount rate, the

central bank intend to expand the stock of monetary supply,thus, increase the banking system credit availability andtherefore, more loans can be made out (credit expansion)and vice versa.


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Open Market Operation (OMO)

The purchases and sales of government securities by thecentral bank in the open market. The exchanges of financialassets and monetary assets between the central bank and

the publics.

For example, central bank buy back government securitiesfrom the banking system this action increases the creditavailability in the banking system and vice versa.

This actions by the central bank can expand or contract thestock of monetary supply in the banking system.


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Islamic Monetary Policy Instruments Do the following instruments comply to Islamic principles? And

can they serve as Islamic monetary policy instrument?

Required Reserve Ratio

May be as its use may reflect both monetary control and aprudential measure to safeguard depositors funds.

Disadvantages: lack of flexibility, resulted in wide swings inthe stock of money supply thus affect price and financialstability.

Discount Rate or Discount Window

May still be used to increase credit availability in the banking

system however, the discount rate needs to be abolished sothat the lending activities are Shariah compliance.

Open Market Operations

Can be used as long as the government securities traded inthe transactions are Islamic securities thus, the need todevelop Islamic capital markets is a must so that theseinstruments can be effectively used.


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Money Supply Process

Simple Monetary Supply Process

One of the banking system function is to extending credits to theprivate sector and this lead to multiple money creation. The bankcredits availability is affected by the monetary policy instrumentsas described before.

We use the simple T-account to illustrate the money supplyprocess and how monetary instruments can affect the stock ofmoney supply.

Assuming that the money supply is in the form of bank depositsand banks do not keep excess reserves. All excess reserves are

extended as loans. Refer to the following T-account of the banking systems,

assuming the required reserve ratio is 10% of total deposits of 2billion. The assets of the banking system is RM200 million; RM1.3billion loans and advances, and RM500 million in governmentsecurities. The banking systems liabilities stand at RM2 billion.


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Money Supply Process

Assets (RM million) Liabilities (RM million)

Reserves 200 Bank Deposits 2,000

Loans 1,300

Securities 500

Suppose that the government purchases back its securities from thebanking system at RM200 million. This action reduces the securities heldby the banking system to RM300 million. As a payment, the central bankincreases the banking reserves to RM400 million. Refer to the followingtable.



Loans 1,300

Securities 300

Table 1

Table 2


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Money Supply ProcessNow the banking system had an excess of reserve of RM200 million andwould be able to lent out to say Mr. Ahmad, who than deposits theRM200 million in the banking system. Thus, will increase the bank totaldeposits of RM2,200 million. With the new loans, now the bankingsystem loans increase to 1.5 billion.



Loans 1,500

Securities 500

Table 3

From Table 3 above, through the lending of RM200 million, money supplyincreases to RM2,200 million. Thus, money supply is created throughlending. But money creation will not stop here, there will be multiplecreation of money supply.


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Monetary Transmission Mechanism

Asset Price Channel Exchange Rate Effects

Profit-and-Loss Sharing ChannelCredit Channels

Asset Price Channel Equity Prices

MonetaryTransmissionMechanism


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Central bank control the economy money supply throughinjection of reserves in the banking system, thus allowing bankto extend credits to those who need funds.

Now we need to understand the process or mechanism bywhich the use of monetary instruments and subsequentchanges in the money supply are transmitted to finalobjectives.

The traditional monetary transmission mechanism in theconventional banking system is through the changes in interestrate as follow: Traditional Monetary Transmission Mechanism

Policy instrument Money Supply Interest rate Investment & Consumption Real Output/PriceLevel


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By increasing credit or loan supply, the price (borrowinginterest rate) of loans decreases. This will affect privateexpenditures (private investment & consumption of durablegoods). Thus, alter aggregate demand and will influence bothreal activity and price level & vice verse.

However, the above channel of monetary transmission is notapplicable in the Islamic financial system as the system is freefrom interest rate (riba).

But, the changes in credit availability may influence the 4.PLS which, in turn, may affect financing and later realeconomic activity.

Other channels that did not involve interest rate are assetprice channels (1. exchange rate and 2. equity prices) andthe 3. credit channel.


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Asset Pricing Channel Exchange Rate Effects

Due to increase in global market integration and internationaltrade leading to the influence of monetary policy on the economythrough changes in the exchange rates.

Exchange rate is influenced by capital flows across nations, driven

by changes in interest rates. For example, changes in moneysupply lead to changes in the interest rate.

Open-market purchase or reduction in discount rate and requiredreserve ratio, termed as expansionary monetary policy, theinterest rate is lowered. As a result, domestic financial asset beless attractive, leading to an outflow of capital thus, domesticcurrency depreciates.

Currency depreciation makes domestic goods and services morecompetitive and foreign goods and services more expensive forlocal residents. As a result, net export increase, leading to theincrease in real activity.


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Asset Price Channel Equity Prices

Monetary policies can also affect real activity through itseffect on equity prices.

Given money demand, the increase in money supply makes

the economic agents realize that they have excess money.To make excess money to be equal to money demand, theeconomic agents spending part of it in the stock market.Thus, increase stocks demand which leading to increase instock prices (Firms value increase).

Firms are encouraged to issue more stocks to financeinvestments.

In addition, the increases in equity prices raises financialwealth of consumers thus, stimulate consumer spending.


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Credit Channels The channels are bank-lending and firms balance sheet

channel The contraction of bank deposits as a result of monetary

policy may not limit loan supply if there is symmetric

information in the market and financial assets are perfectlysubstitutable. Bank may be able to raise funds through other sources at

the same cost. But due to asymmetric information, there isa wedge between alternative sources of funding.

Facing higher cost to raise funds, banks are forced tocontract loan supply. At the same time firms may also facehigher costs by raising funds on their own thus, limit thefirms investments and real output.

Two essential conditions for this lending channel to beoperative: (1) monetary policy influence on loan supply and(2) substantial number of firms that are dependent on bankloans.


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PLS Channel The potential influences of monetary policy on the PLS ratio

of Islamic banks. Monetary policy action may alter the PLSratio, in the process, encourage and discourage firms fromseeking financing for its investment activities.

For example, denote R to be an expected return frominvestment. The expected return realized would thus be sR,where s is the share of profits that goes to the firms.

Monetary policy can influence on the profit share of thefirms. For instant, suppose that money supply increases and

banks find their excess reserves to be more than the leveltargeted, which leads to offer financing at a lower sharingratio going to them.

Therefore, a project that has lower expected return (lowerR) will now be viable to the firm. Thus, the investment byfirms will be stimulated.


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Economic Agents in Monetary Policy

Economic Agents andMonetary Supply Process

Fairness in Monetary Policy

Economic Agentsin Monetary Policy


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Economic Agents and Money Supply Process

Economic agents also play a role in affecting liquidity in themarket for example, the behavior of banks and individualsin the forms of their excess reserve ratio and currency-

deposit ratio respectively. Therefore, understanding the contributing role of economic

agents in money creation and how it may affect real activitywill be essential for economy well-being.

We may start from the demand and supply of money and

economic cycles. For example, during recessionary periods,financial markets tend to be riskier thus, individuals andbanks prefer to hold currency. Therefore, money supplydrops even if the monetary authority is passive and realactivity declines as well.


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Fairness in Monetary Policy

Economic agents are not only at the contributing end butalso are at the receiving end of the monetary supplyprocess. Therefore, the issue of the final outcome of

monetary policy action is not non-discriminatory (sectoral ordistributional consequences).

It is clear that monetary policy will not have the same effecton individuals and firms. For example, in the face ofmonetary contraction, household and small firms may beheld out from loans. Relationship lending is common amongbanks and large firms.


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Issues in the Conduct of Islamic

Monetary Policy

What are the characteristics of the Islamic financialmarkets that are pre-requisite to the effective use ofIslamic monetary policy? We may acknowledge theimportance of the markets at the developed stage

characterized by: Diversified financial instruments

Liquidity

Transparency

Effective enforcement mechanisms These characteristics are essential to make the

transmission of monetary policy effective and toalleviate the problem of asymmetric information inthe markets.


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Chapter 3 Money and Monetary Policy

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