Once again, welcome back my friends. As we discussed, let's see now something about monetary policy. We know already how the real economy tends to behave, or how GDP could go up or down based on those variable we discussed previously. Again, consumption, investment, government expenditure, and trade imbalance. But how a monetary authority or central bank can really influence the interest rates? Why do I want to know? Eventually you might say. Well, remember, you never forget, remember that interest rate is the cost of money. If the Central Bank or the monetary authority decides to raise interest rates, he wishes to cool down the economy to tap in inflationary pressure. In the short-term, your income, GDP, remember, could be affected in a negative way. Always keep an eye on central bank decision, because that could affect GDP, income, and your investment and your business plan. Can you see how we're going to put all things together now? Everything is important and the world is full of information and we need to put everything together. But let's go on. Let's begin with the concept of a monetary authority, such as Federal Reserve, European Central Bank, Bank of Japan, Bank of England, People's Bank of China, etc. The main question is, what are the main role of a Central Bank? Why do exist, a Central Bank? First, to control inflation. Why control inflation? To control the purchasing power of your money? Because if inflation increase, the general price increase, so the purchasing power of your money is getting lower, lower and lower. That's why the Central Bank needs to control inflation. Two, Central Bank sometimes act as a banker of the banks, because sometimes banks need money. They can get money within the financial system, but sometimes they need to get money from the Central Bank because the financial market could be shut down and they need to get money from the Central Bank. Central Bank can act as the banker of the government. When I say government, understand as Treasury, Treasury Department. Fourth, Central Bank are also responsible for financial system regulation. One of them, for example, the fifth, it has the monopoly of currency printing, legal tender. You know that currency, that paper that you have in your pocket? That's the Central Bank, they could print. Six, it manages the international reserves. Because all central banks, they have assets, and part of those assets are considered to be international reserves. What I mean international reserves? For example, in England, international reserves could be part of US dollar, in Japanese Yen, in Chinese, RMB, Yuan, whatever it is, but sterling pound. You have international reserves. But the first thing I would like to ask you, and I love that question. I know there's going to be absolutely different answer, unfortunately I cannot see you guys. But the question is, a commercial bank can create money? I would love to hear you guys, but I know that. Yes, no, maybe. What do I mean by money? What do you think? Stop the video for a moment, discuss, think. Are you curious? Let's see. Let's suppose we have a commercial bank if they can create money. Let's assume that all deposits a bank receive from, let's say a client, the Central Bank requires that 30 percent of that deposit should be blocked in and deposit in the Central Bank, as what we call reserve requirement. For example, you get in a bank and deposit $100, 30 percent or $30 is considered to be reserve requirement. That's the only thing you have to do. Let's think about the first bank, you are one of those guys. In the first bank, what do you do? You get in a first bank and deposit $1,000. As assets should be equal to liabilities. Let's see what's going to happen with assets. Given the fact that reserve requirement or 30 percent of reserve requirement should be deposited at the Central Bank, so $300 is going to be back to the Central Bank and several hundred dollars, what the bank is going to do, they're going to lend this money to someone else. Either could be a client or to other bank, so you see $1,000, $1,000, $1,000 deposit as liability, $300,000 as asset reserved requirement, and 700 as loan. Second bank, let's suppose you deposed to another bank or another client took this loan and they deposited in a second bank. The second bank, what they have, liability 700, remember, 30 percent of all deposit, 30 percent of 700 is 210, 210 as a reserve requirement. The remaining 490, the second bank can lend to other clients or to other banks. Do you realize that banks now in this example are creating money? Let's see the first bank, 1,000, second bank, 409, third bank, keep moving, 343 and keep moving, keep moving. Until the end, you'll figure out that $1,000 could transform into $3,333. Why? Because yes, bank can create money. But I thought it was currency. Who said that currency is the only money? Site deposit is money as well. You deposit a $100 here, what this bank is going to do, is going to lend to another one. This bank is going to lean to another one. In order to avoid or to limit this, the capacity of banks in creating money because this could generate inflation. The Central Bank has what we call instrument of monetary policy, that's what we call reserve requirement so let's understand. The higher the reserve requirement, for example, instead of 30 percent, let's say 50 percent, the higher or the lower, the capacity of banking to create money. Again, the higher the reserve requirement, the lower the capacity of commercial banks can create money. The lower the capacity of bank to create money, the higher the interest rates. What can I do with this information? For example, if you read in a newspaper and Federal Reserve, European Central Bank, Bank of Japan, Bank of the Brazil, whatever it is, say, well, I think that the Central Bank will raise reserve requirement in a month. Usually, they do not announce, they just implement. If you read that kind of news and your company needs to get a loan, would get a loan now or would you wait until the Central Bank increase the reserve requirement? What do you think? If you wait until the Central Bank increase the reserve requirement, remember, if the Central Bank increases the reserve requirement, the capacity of bank to create money, is lower and then the interest rate is going to be higher. If you read in the newspaper and the news, whatever it is, that the Central Bank is going to increase, the reserve requirement get a loan now, not later. But if you read the other way around, that the reserve requirement is going to be lower. Well, if the reserve requirement is going to be lower, the capability or the capacity of the bank to create money is going to be higher, so the interest rate is going to be lower. Don't take loan now, wait. Do you understand how macroeconomics is so important for your life? Eventually, you'll need a personal saving money or ordinary working capital, whatever it is. If you do not, all these news is in front of you, but you need to understand and comprehend how they could affect your personal life in your business plan. Enough talking. Let's move on. Well, I didn't know that we have all the money. Pause for a definition of money to be consider money actually it has to have the following features; measure of value, medium of exchange, and a store of value, sorry Dumas, I'm lost. For example, you know the currency is not only money that exist. I'm pre-matured and also site deposit is also not the only sort of money. For example, if you ask your grandmother, grandma, how much money you have in your purse? Nothing. Wow, you poor. Now how much money you have deposit in a bank? Nothing. Well, what happened with my grandma. How much money you have in a saving account? Nothing, so my grandma is poor. How much money you have deposited in a commercial bank, in a certificate of deposit. Fifty million dollars. Is this money or not? Yes, this is money, is not currency, is not side deposit, is not a saving account but it is certificate of deposit. It is money, is a store of value. Be careful, move from the old mind that money is just currency. Money, it has all these features that we discussed: measure of value, medium of exchange, and store of value. Actually, as a matter of fact, I know you knew that but you're blocking your mind that money is just currency. But if you've stopped for a moment all you knew that, most of you might have mistaken money with just currency, that's not only currency. All right, we understand, let's back to our central bank now that we've figured out that, yes, commercial bank can create money, how would be our central bank balance sheet, given those roles we mentioned previously? We know the central bank have monopoly of currency printing, they are banker of banks, banker of the government treasury department, it manages the international reserves and also use a reserve requirement. Remember, to control the capacity of commercial banks in creating money. Actually, that's exactly how it's going to be the central bank balance sheet. Again, assets and liabilities are pretty much the same, they have to be equal. What haven't assets based on the role of a central bank that I mentioned previously, one, credit to commercial bank, this the central bank's assets. That's the right of the central bank against commercial banks. Credit to the government or to the Treasury Department because I might lend money to the treasure, but how can I lend money to the government by government bonds? If the central bank buys government bonds, what happened? There's the credit to the government and international reserves, this is my assets. Liability currency because banks can create money, the central bank that's the currency and reserve requirement in this side of a liability but why reserve requirement is central bank's liability? Because this reserve requirement actually is on by those commercial banks, is their assets but is the central bank's liability. If you sum up currency plus reserve requirement, that's what we have monetary base, that's the main concept of money, monetary base. Then if it's not monetary base, you have no monetary liabilities, we don't need to get that detail. Then you figure out, let's figure out about how can I increase or decrease monetary base because if I increase the monetary base, the money supply in the market will increase. Remember, interest rate is the cost of money. If monetary base increase, money supply increase, the cost of money decrease, interest rate is going down. If monetary base goes down money supply goes down, and interest rate goes up. Why because interest rate, again is the cost of money. Demand and supply but again, we know that a central bank, assets equal to liabilities. If you use the central bank, is going to be assets is equal to monetary base plus non-monetary liabilities. Let's isolate the monetary base in this equation, we will see that monetary base is equal to assets minus non-monetary liabilities. What the conclusion I have, the only way to increase or decrease the monetary base, assuming non-monetary liabilities constant is increasing or decreasing the assets of the central bank. For example, you might see, central bank is printing money, yes, central bank can print money but to print money, to increase liabilities of the central bank needs to increase assets first, for example, buying government bonds, and then to buy government bond the central bank can print money and increase money supply. If the increase money supply interest rate goes down, if interest rate goes down, it affects my real economy GDP bingo, well, I love that, yes. Sorry, I got a little bit but put everything together. Central bank, GDP, inflation, anyway let's get back to reserve requirement. Now, formally speaking is considered to be a very important instrument of monetary policy as we discussed already, it impacts money supply and interest rates. If the central bank decides to pursue an expansionary monetary policy to increase money supply, the central bank will decrease the reserve requirement because it will increase the capacity of bank creates money. If the central bank wants to pursue a contractionary monetary policy, the central bank will increase the reserve requirement that will decrease the money supply and the capacity of bank in create money, interest rate's going to be higher. That's what you have to keep in mind. But the monetary authority or central banks have just the reserve requirement as an instrument of monetary policy to control interest rates? Not really. Why not? I mean, not really, because I'm not central bank, sorry. They also have what we call open market operations, which stands for the purchasing and/or selling of government bonds by the central bank. Where's the government bonds? On the asset side of the central bank. Remember, credit to the government, government bonds. One thing, please, sorry. Do not forget, do not mess up. Central Bank is something, treasury department is another one. They are not the same. Central bank and treasury department. Again, but a Central Bank in order to affect the monetary base, demand and supply, and the interest rate. But how that works? Let's get back. What's the balance sheet of a central bank? Assets, credit to commercial banks, credit to the government, international reserves. Liabilities; currency, reserve requirement, and non-monetary liabilities. We know that assets equal to liabilities. Yes, we know that. Assets equal to monetary base plus non-monetary liability. In order, for the sake of simplicity, let's think that non-monetary liability is equal to zero. We figure out that assets, so it's equal to monetary base. If I want to do something with my monetary base, as we discussed, I have to do something with my assets. Let's suppose now the central bank intervene in the market by buying government bonds. The central bank is buying government bonds. The asset side of the central bank will increase. If the asset increase, liability increase. How come? I call the banks and say, "Listen, I'm buying government bonds. How can I pay you back?" Printing money. If I print money, monetary base increase. If monetary base increase, money supply increase. If your money supply increase, interest rate decrease. But why do you want to change interest rates? Remember GDP? How interest rates affect my GDP? Remember GDP and inflation? That's the role of the central bank. The central bank does not exist just to change interest rates. The central bank exists, as we said, the main purpose is to control inflation. It's not just, "I want to change interest rate." No. They just want somehow to affect the real economy. If the economy is booming, interest rate should increase. How? For example, if you sell government bonds, as you see in the next one, instead of buying government bonds, what do we do? Let's suppose now the government wants to increase interest rate. It's just selling government bonds. The assets of the central bank will decrease. If the assets decrease, monetary base decrease. Yes, in terms of accounting, I understand. But if you sell government bonds, what's going to happen with your asset? Your asset will decrease. Why my monetary base decrease as well? What are they going to do with the money that are within the financial system? I mop up liquidity. Once I mop up liquidity, monetary base decrease, money supply decrease, interest rate increase. Why do you want interest rate to increase? Well, eventually, my economy's too overheated, so I want to increase interest rate to cool down the household consumption. Wow. Now you're liking it? Or no? No? Hate? No, I think it's nice. But anyway, we understand that assets, liabilities, that's something that we have, open market operation, for example. Purchasing and selling of government bonds impacts money supply and interest rates. It's just to clear up. Restrictive or contractionary monetary policy, the central bank will sell government bonds, and then monetary base decrease, money supply decrease, interest rate increase. Expansionary monetary policy. The central bank purchase government bonds. If it purchase government bonds, monetary assets increase, monetary base increase, money supply increase, interest rate decrease. Now you understand all of how the central bank and monetary authority affect the interest rate, which in turn affect the real economy, if the real economy is overheated or they need some boom, they can do that using monetary policy. That's what we saw. In the next lesson, we will discuss something about balance of payments.