Money Money

“money, money, money, must be funny -- in a rich man’s

world” Abba

What does money do?1. Medium of Exchange

- it is used to transfer wealth from one person to another

- removes the need for bartering

- money can be anything that is readily and widely accepted by the people of society.2. Measure of Value

- prices of all goods and services are presented in units of dollars.

- it can also be compared to other currencies around the world through exchange rates.

What does money do?3. Store of Value

- Can save money for future purchases

- must take into consideration inflation which makes stored money less valuable

4. Stadard of Debts

- debts over a period of time can be paid with money -- value will continue over a long period of time.

Characteristics of Money

1. Identical - in units of specific value (cents $)

2. Divisible - pennies, nickels, dimes, quarters, etc.

3. Portable - easily carried and transferred

4. Durable - made of metal or strong paper

5. Acceptable - everyone agrees that it be a medium of exchange

Demand for MoneyIt is like any other commodity; it is

affected by supply and demandthere are 3 main reasons people

demand or want to hold money, apart from having it on hand to buy the goods and services needed immediately:

Transactions Motive - money held to finance immediate purchases (example - bills and coins in your wallet; mortgage, groceries,etc.)• the greater the incomes, the greater the

transactions desired. If total national income rises, then transaction demand increases as well

Precautionary Motive - money is held in case of emergenceis or unexpected situations. As the level of income increases, a person’s ability to hold money for emergencies increases as well.

Speculation Motive - interest rates affect the opportunity cost of holding money. As interest rates increase, people are unwilling to borrow money to spend and will place any extra money in intrest bearing assets (bonds). As interest rates decrease, the opportunity cost of holding the money decreases and people are more willing to spend their money or borrow (demand for money increases).

Transactions Demand

+

Precautionary Demand

+

Speculative Demand

=

Total Demand For Money

Demand for MoneyThe demand for money is known

as liquidity preference -- a willingness to make assets liquid or to convert to cash.

Interest rates represent the price or cost of cash -- as interest rates fall, the demand for cash increases -- as interest rates increase, the demand for cash decreases.

I1

Q1

Quantity of Money (dollars)

Inte

rest

Rate

%

I2

Q2

As interest rates decrease, the opportunity cost of holding money increases, and the quantity of money demanded increases.

Demand for MoneyChanges in Real GDP affect the demand

for money -- as real GDP varies, real income varies. The higher our incomes, the more people will spend and thus the greater the demand for money

Price level affects the demand for money -- as price increases, you will need more money to finance your expenditures, therefore causing an increase in the quantity of money demanded.

Definitions of Money in Canada

Money supply in Canada is represented by the total value of coins and paper currency in circulation outside of the banks:

M1

Currency outside the banks + demand deposits at the chartered banks - government deposits

M2

M1 + personal savings accounts + non-personal notice deposits (chartered banks)

M3

M2 + all other deposits (long-term, foreign) at chartered banks

M2+

M2 + all deposits at trust and mortgage loan companies, credit unions.

Near Money

assets which could be easily converted into bank deposits or cash (eg. Canada Savings Bonds)

Equilibrium in the Money Market

Equilibrium in the money market occurs at the intersection of the money demand and money supply curves

The money supply • is a set amount determined by

government decision- makers• is represented by a schedule or vertical

curve

The equilibrium interest rate is inversely related to the money supply

Ie

Sm

Quantity of Money (billions)

Nom

inal In

tere

st R

ate

%

When the nominal interest rate exceeds its equilibrium value, the quantity of money supplied exceeds quantity demanded. This surplus leads to more buying of bonds, forcing bond prices up and the nominal interest rate down, until the quantity of money demanded and supplied are the same. When the nominal interest rate is below its equilibirum value, the opposite occurs. A shortage of money pushes the interest rate up until the equilibrium point is reached.

Equilibrium in the money market

Dm

5

4

3

2

1

0 10 20 30 40 50 60 70 80

Surplus

Shortage

Money Creation

Until 1994, banks had to keep back reserves of cash that could not be used for loans

Now, only desired reserves are kept -- enough to satisfy anticipated withdrawals

Banks hold a certain portion of deposits in the form of cash reserves -- reserve ratio.

Reserve Ratio = Desired reserves

Deposits

Money Creation

Money Creation

Banks sometimes exceed desired levels -- this is called excess reserves.

Excess Reserves = cash reserves - desired levels

Money Creation Process

Suppose a person was given $1000. They put this in their bank account for future use. The bank has a reserve of 10%.

• Deposit $1000• Reserve $ 100• Loan #1 $ 900 Paid to someone who

deposits it into their bank

Money Creation Process

Deposit $900Reserve $ 90Loan #2 $810

Deposit $810Reserve $ 81Loan #3 $729

Paid to someone who will deposit it into their bank

This process will continue until all of the money is used

The Money Multiplier

The money multiplier is the value by which the amount of excess reserves is multiplied to give the maximum total change in money supply.

• For example, if the initial change in excess reserves is $900 and the final change in the money supply is $4500, the money multiplier has a value of 5: IN MONEY SUPPLY = IN EXCESS RESERVES x MONEY MULTIPLIER

$4500 = $900 x 5

The Money Multiplier

The multiplier is the reciprocal of the reserve ratio. If banks reserve 10% of deposits, the money multiplier is 10.

The initial change in excess reserves eventually causes an increase in the money supply

Money multiplier = 1

reserve ratio

10 = 1

.10

10% reserve rate causes an increase in the money supply of $10,000 ($1000 x 10); If the rate decreased to 5%, the money multiplier would be 20 (1/.05), causing an increase in the money supply of $20,000 ($1000 x 20).