Level 1 CFA® Exam:
Monetary Policy
Monetary Policy vs Fiscal Policy
Monetary policy is a central bank activity aimed at influencing the quantity of money in an economy. Expansionary monetary policy is about increasing the money supply, while contractionary policy consists in reducing the money supply in an economy.
Fiscal policy refers to changes in the level of government spending and taxes. If the level of government expenditure is greater than the tax revenue, we deal with a budget deficit. Otherwise, there is a budget surplus.
Functions of Money
To define money, we might say that it is a widely accepted medium of exchange that people use to pay for goods and services.
We may enumerate the following functions of money:
- Money is a medium of exchange in transactions involving a simultaneous mutual transfer of goods and money between the parties. Here money is a medium of payment thanks to which we can pay our dues.
- Money also serves as a store of value. This function of money is based on trust: as buyers, we believe that money retains value.
- Money is a measure of value – it’s a unit of account. Money forms the basis for defining the price, which is nothing else but the value of goods expressed in money.
Money measures are defined differently in different countries.
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Imagine that we have a bunch of customers and one bank.
If one of the customers decides to deposit a certain amount of money in a bank, the bank will not keep all this money. Usually, what the bank does is decide to lend almost all of this money to other customers. These customers will use the borrowed money to buy goods and services. If the sellers of these goods and services decide to deposit money in the bank, the bank will be again able to lend this money to other customers, and so on. The process continues.
Note that for security reasons the bank won’t lend all the money deposited by its clients. The so-called reserve requirement is the percent of bank deposits that the bank cannot lend.
The total possible amount of money that can be created in the process described above depends on the value of the reserve requirement. The total amount of money that can be created from a new deposit is calculated as follows:
The total amount of money equals the new deposit divided by the reserve requirement.
As you can see, the lower the reserve requirement, the more money can be created, and vice versa. The greater the reserve requirement, the less money can be created.
How many times is the amount of money created greater than a new deposit if the reserve requirement is equal to 20%?
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The money multiplier tells us how much money is created from 1 USD of bank deposit:
Quantity of money times velocity of circulation of money equals price level times real output:
The higher the velocity of circulation of money, the more often money changes hands.
According to this formula, if we assume that the velocity of circulation of money and real output are constant, the amount of money impacts the price level. So, if the amount of money increases, the price level will also increase and vice versa. If the amount of money decreases, the price level will also decrease.
Let’s describe the Fisher effect and compare the costs of expected and unexpected inflation. Look at the formula to be used in your level 1 CFA exam:
Nominal interest rate equals real interest rate plus the expected rate of inflation.
The Fisher effect refers to the fact that the real interest rate in the economy is constant over time, so changes in the nominal interest rate are due to changes in expected inflation.
In addition, you should also take into consideration the risk that the inflation rate will be different than expected. To compensate for this risk, investors expect a risk premium.
Taking into account the costs of inflation in an economy, it should be noted that the costs of unexpected inflation are greater than the costs of expected inflation.
The costs of inflation are as follows:
- Costs of holding money in cash instead of investing it in instruments that bear interest. With inflation, cash reduces its value.
- Mainly lenders bear the costs of inflation that is higher than expected because loan payments are worth less and less. Similarly, the cost of lower-than-expected inflation is borne by the borrowers.
- In an economy with high inflation volatility, lenders require higher interest rates to compensate for unexpected changes in the inflation rates. This translates into a lower level of economic activity and a lower level of investment.
- Unexpected inflation reduces the information value of price changes.
- Monetary policy is a central bank activity aimed at influencing the quantity of money in an economy.
- Fiscal policy refers to changes in the level of government spending and taxes.
- Functions of money: money is a medium of exchange, money serves as a store of value, and money is a measure of value.
- In the Eurozone we distinguish 3 money measures: M1, M2, and M3 and in the USA we have 2 measures of money: M1 and M2.
- The money multiplier tells us how much money is created from 1 USD of bank deposit.
- According to the quantity theory of money if the amount of money increases, the price level will also increase.
- Money demand is something that depends on 3 main motives: transactions-related, precautionary, and speculative motives.
- The Fisher effect refers to the fact that the real interest rate in the economy is constant over time, so changes in the nominal interest rate are due to changes in expected inflation.
- The costs of unexpected inflation are greater than the costs of expected inflation.