A central bank is an institution entrusted with the management of the supply of money. This involves the issue of fiat money as well as the control of commercial banks.
(a) Fiat Money Creation
Ordinarily, the central bank stands ready to issue money against interest-bearing claims on the government. The central bank creates money in two cases: firstly, when the government borrows directly from it, and secondly, when it (the central bank) decides to carry out an expansionary “open-market operation.”
In the first case, government borrows to finance a deficit in the budget, which is politically determined. In the second case the central bank attempts to stabilize the economy through open-market operations. The decision to borrow from the central bank is politically easier than raising taxes and less costly than borrowing from the public. This would make it relatively more attractive for governments to extend their hands to the central bank which is always there to oblige. Financing politically unpopular undertakings as well as an important fraction of the activities of politically weak governments, or governments with inefficient tax structure is always done through this method. While both bring forth to the government the resources it desires, borrowing from the public and borrowing from the central bank are not similar in economic effects.
Borrowing from the public keeps the current (nominal) money supply at the same level. However, to the extent it raises future tax liabilities, it redistributes wealth from future to present generations. Borrowing from the central bank, however, changes the nominal supply of money. This has ramifications on price and, consequently, on the distribution of wealth. It could, therefore, influence both efficiency and equity. Further effects of changes in the money supply on the real sector cannot be ruled out prima facie, and can, under certain conditions, be significant.
To be a lender of last resort to the government is not critical to the central bank. Besides, there is an alternative which is economically, if not politically, superior, i.e. to borrow from the public. However, if the central bank does not issue fiat money against interest-bearing assets, it may be thought of as not exercising its authority to control the money supply and, consequently, the price level. We will show below that there are alternative means for doing so.
(b) The Determination of the Money Supply
The function of the management of the money supply involves providing for the transaction needs of the community, especially in a growing economy. While the central bank must, therefore, set the money supply at the level which provides the “maximum” amount of transactions services, it must keep the level of prices stable.
It is important to note that it is the real and not the nominal unit of money that produces transactions services. This implies that an increase in the supply of (nominal) money will afford greater transactions services for the community only to the extent that the price level stays stable; or increases less proportionately than the money supply.
(c) Money, Growth and Prices
An increase in the rate of growth of money creates excess demand for goods (excess supply of money) at faster rates. Assuming markets to be stable, equilibria will be regained. However, the new rates of growth of prices will differ from the old ones depending on the price speed of adjustment as compared to the quantity speed of adjustments in all markets.
Speeds of adjustment can be related to three factors: the institutional framework of the economy, the degree of complementarity and substitution between goods, and the rate of growth of the economy.
To illustrate the first point, the rate of growth of prices can be written as:
p=pay,i = i,...,n) (i)
where P} is the rate of growth of the price of the ith good, which is equal to:
where Sj is the excess demand for the ith good.
Equation (3) shows that the rate of growth of the ith price can be decomposed into two factors. The first is the responsiveness of the price of the good in question to changes in its excess demand. The second is the extent to which that excess demand is increasing or decreasing over time. While the first term refers to the price speed of adjustment, the second refers to the quantity speed of adjustment.
Speeds of adjustment can be hindered by non-competitive elements on the institutional side of the market, e.g. government regulations, monopolies, etc. They also depend on substitutability and complementarity between goods.
Given the institutional arrangements as well as the degree of substitutability between goods, speeds of adjustment depend on the rate of economic growth. This is so because the quantity speed of adjustment is faster with higher rates of growth, as it becomes easier to satisfy excess demands in this case. Therefore, we can say that, ceteris paribus, the higher the rate of growth, the lower the rate of inflation resulting from a certain increase in (M).
The optimal supply of money is the rate of monetary growth which maximizes the transactions services for the community; and the optimal monetary policy is that which equates monetary growth to this rate. Since we are concerned with the services of real money units, a comparison between monetary growth and rate of inflation is necessary.
The comparison between the rate of growth of the money supply (M) and the rate of growth of prices (P) could be based on a postulated relationship between the two variables like the one depicted in Figure I. The faster the growth of money, the stronger is its effect on the real sector in terms of rising demand schedules and, consequently, the faster rise in prices.
We can, therefore, perceive rates of monetary expansion low enough not to produce any inflation, given the real growth of the economy and the state of expectations. As M rises, P will increase in response, but less proportionately in the beginning. Sooner or later, increase in M produces equiproportional changes in P. This is depicted by the portion of the curve in Figure I beyond Oa.
It is possible that increase in M produces more than a proportional change in P, when higher monetary growth gives reason to expect more of the same in the future. However we rule this case out for simplicity.
We can consider the proposition that economic growth attenuates the effects of monetary expansion on prices. Figure II shows the monetary expansion lines Ll, through L4 which are associated with the rates of growth gj through g4, respectively; where gx > g2 > g3 >g4- The proportion of the expansion curve within which prices respond less proportionately to monetary expansion is larger with higher rates of economic growth. Along L4 (g4) the rate of growth is so low that any monetary expansion produces equiproportional change in prices.3
The portions of the expansion lines which coincide with the horizontal axis show that monetary expansion is being fully reflected in growing real balances. As indicated by Figure II, such a non-inflation- ary monetary expansion would be equal to 0e1 when the economy grows at gj, and 0e2 when it grows at g2. Higher rates of monetary expansion would lead to positive rates of inflation.
An economy which prefers strict price stability, viz, P = 0, should choose M = Oep or 0e2 when real growth is equal to gj or g2, respectively. Otherwise, M should equal zero. Rates of monetary expansion higher than Oap 0a2, or 0a3, with gp g2, or g3, respectively would cause correspondingly equal rates of inflation. However, if the central bank cannot issue money against interest-bearing securities, the mechanism for monetary expansion, or contraction must be outlined.
(d) Variation in the Supply of Money
Variations in the supply of money can be effected through opening investment accounts by the central bank in the member banks to which the central bank deposits whatever money it creates and from which it withdraws whatever money it retires. Member banks, as will be seen below, will invest those deposits in the real sector in accordance with their investment policies. Profits earned on such deposits could be used to cover the cost of central bank operations. Such deposits will be termed central deposits, or CDs.
While CDs can be used as a tool of monetary policy, they can also be used as a means of financial intermediation, which would amount to additional monetary services. The central bank can create an instrument which could be termed as “central deposit certificate”. These certificates can be sold to the public and their proceeds be invested in CDs throughout the banking system. Obviously, the central deposit certificates provide a lower degree of financial risk, since each carries with it a title to a more diversified investment portfolio than any member bank by itself can provide. The rate of return on the CDCs will approach the average rate of profit on investment for the whole economy.
Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.