Money and Money Market

Money

The Quantity Theory of Money

Monetary Aggregates

The Deposit and Money Multipliers

The Money Market

Money

Money is anything that serves as a commonly accepted medium of exchange or means of payment.

The earliest kind of money were commodities, but over time money evolved into paper currencies, bank money.

Money’s Function

There are the three basic money’s function:Medium of exchangeUnit of accountStore of value

The Quantity Theory of Money

Economists use to express the quantity theory of money as the equation:

M . V = P . Q

M: money supply

V: velocity of circulation of money

P: the average price level

Q: the total output

The Quantity Theory of Money

The key assumption is that the velocity of money is relatively stable and predictable.The original equation can be rewritten:P = M . V/QIf transaction patterns are stable and real

output grows smoothly (at potential output level) then the prices move proportionally with the supply of money.

The Quantity Theory of Money

Cambridge version of the quantity theory of money: M = k . P . Qk is the the fraction of income that people

seek to hold in the form of cash and demand deposits.

M is money demand

J.M.Keynes and The Quantity Theory of Money

There a two major differences between Keynesian and classical view of the role of money in the economy:Economy is not operating at potential level

of output.Velocity of circulation of money is not

stable.

Liquidity Preference

According to Keynes, demand for liquidity is determined by three motives. One of them is speculative motive: speculative motive: people retain liquidity to

speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

Monetarism and The Quantity Theory of Money

According to monetary economists, the reason for stability of the velocity of money is that velocity mainly reflects underlying patterns in timing of income and spending. The velocity of money is closely related to the demand for money.

Monetarism and The Quantity Theory of Money

The monetary rule: Optimal monetary policy sets the growth of the money supply at a fixed rate (e.g. at 3 % annually in case of 3 % GDP growth).Monetarists believe that a fixed growth rate of money would eliminate the source of instability in a modern economy.

Monetary Aggregates

Monetary aggregates are the quantitative measures of the supply of money.

The money supply in an economy encompasses all the assets that serve the functions of money.

The Liquidity of Assets

Liquidity is an ability to quickly and easily convert an asset into spendable money at a price near its maximum market value.

Monetary Aggregates

Narrow definitions of money include items that can be spend directly (cash, current accounts).

Broad definitions of money include items that cannot be spent directly but can be readily converted into cash.

Monetary Aggregates

The M1 money supply includes:Assets that serve as media of exchange –

currency, checking accounts (deposits regarded as money, you can write checks on it).

M 2 includes all M1 +Saving deposits and small time depositsAssets that act as media of exchange and

other very liquid assets that can be converted into media of exchange very easily at little cost.

Monetary Aggregates

M 3 includes all of M 2 +Large –denomination time depositsOther less liquid savings instruments (money

market funds, shares, debt securities)

L is a broad measure of liquid assets, which includes M 3 +:Short-term treasury securitiesCommercial papers near moneyOther liquid assets

Monetary Aggregates

D includes all forms of credit money:Any future monetary claim that can be used to

buy goods and services. There are many forms of credit money, such as mortgage loans, bonds and money market accounts.

Balance sheet of the central bank

Assets Liabilities

Loans granted to commercial banks

Currency in circulation

Securities Commercial banks reserves

Reserves Deposits

Other assets Securities issued

Other liabilities

Balance sheet of the commercial bank

Assets Liabilities

Bank reserves Liabilities to central bank

Bank credits Deposits of households and firms

Other assets Other liabilities

The Deposit Multiplier

All commercial banks are required by law and the CB regulations to keep a fraction of their deposits as reserve.

The ratio of new deposits to the increase in reserves is called the money supply multiplier: 1/r

Reserves

+ 1 000 + 10 000

Bank I

Reserves

+ 900 + 9 000

Bank II

10 000 €

..............

Deposit9 000,-

Loans and Investment 9 000,-

Loans and Investment 8 100,-

Deposit 8 100,-

Required reserves r = 10 %

Deposit

Deposits

Deposits

Balance sheet of the Commercial bank I.

Assets Liabilities

Bank reserves 1 000 Liabilities to central bank

Bank credits 9 000 Deposits of households 10 000and firms

Other assets Other liabilities

Total 10 000 Total 10 000

Balance sheet of the Commercial bank II.

Assets Liabilities

Bank reserves 900 Liabilities to central bank

Bank credits 8 100 Deposits of households 9 000and firms

Other assets Other liabilities

Total 9 000 Total 9 000

The Deposit Multiplier

Deposits: Loans:Bank I: 10 000 9 000Bank II: 9 000 8 100Bank III: 8 100 7 290

:

Total 100 000 90 000Total reserves: 10 000

The Deposit Multiplier

The banking system transforms deposits into a much larger amount of bank money:

Dr

M 1

1000001000010100001,0

1M

The Money Multiplier

The money multiplier (m) is the number you multiply the monetary base by to get the money supply:

MB

MmMMBm .

The Money Multiplier

The supply of money (M) is currency (CU) plus deposit (D): M = CU + D

Although currency and deposits are both part of money supply, they have different characteristics. In order to determine the amount of currency versus deposits in the economy as a whole, we assume that people want to hold currency equal to a certain fraction of their deposits: CU = k . D k is the currency to deposit ratio.

The Money Multiplier

The supply of money (M) is currency (CU) plus deposit (D):

M = CU + D

M = k.D + D

M = D(k + 1)

The Money Multiplier

The sum of currency and bank reserves (BR) is called the monetary base (MB):MB = CU + BR

Bank reserves (BR) represent the reserves that commercial banks hold at the central bank. Then the relationship between reserves and deposits can be written using symbols as: BR = r . D

The Money Multiplier

The sum of currency and bank reserves (BR) is called the monetary base (MB):MB = CU + BR

MB = k . D + r . D

MB = D (k +r)

The Money MultiplierThe link between the monetary base (MB) and the money supply (M) can be derived and used by the central bank to control the money supply:M = D (k+1)MB = D (k + r)

rk

k

rkD

kD

MB

Mm

11

The Demand for MoneyThe demand for money refers to the desire to hold money: The transaction motive: people and firms use

money as a medium of exchange. The transaction demand for money responds to changes in income and prices. If all prices and incomes increase then the transaction demand for money increases.

The precautionary motive: unforeseen circumstances can arise, thus individuals and firms often hold some additional money as a precaution.

The speculative or assets motive

The Demand for MoneyThe transaction and precautionary demand for money is determined by the national income, frequency of payments, and interest rate.There are three major determinants of the speculative demand for money:The rate of interestExpectations of changes in the prices of

securities and other assetsThe expectation about changes in the

exchange rate.

The Demand for Money

The demand for money is sensitive to the cost of holding money: other things equal, as interest rates rise, the quantity of money demanded declines.

The major impact of interest rates on the quantity demanded of money comes in the business sector.

The Demand for Moneyi

M0

MD

MD1

MDMD1 the demand for money increases because of:•Rising prices•Rising incomes

The Supply of Money The supply of money is determined by the private banking system and the nation’s central bank.The central bank through different

instruments provides reserves to the banking system.

Commercial banks create deposits out of the central bank reserves.

By manipulating reserves, the central bank can determine the money supply.

The Money Market

MD

MS

M

i

0

EiE

The money market is affected by a combination of :•The public’s desires to hold money (MD)•The CB monetary policy (MS)The intersection of the supply and demand curves determines the market interest rate

ME

Tight Money

MD

MS

M

i

0

EiE

MS1

i1

MEM1

The lower MS produces an excess demand for money shown by the gapAE. As people attempt to attain the desired money stock, interest ratesrise (i1) to the new equilibrium at E1.

A

E1

Money-Demand Shift

MD

MS

M

i

0

EiE MD1

i1

ME

E1

The demand for money has increased because of higher price level.The higher demand for money forces market interest ratesupward.