Money. Money Supply and Money Demand

Frederick University2014

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Money & the Payments System Money & the Payments System

meaning of money functions of money forms of money measuring money

meaning of money functions of money forms of money measuring money

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without money

barter for stuff-- need “double coincidence

of wants”-- inefficient:

more time shopping,less time producing

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example

I have exam 2,want to trade it for soda

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You have to want the exam &be willing to give up soda

ANDI have to want the soda& be willing to give up exam

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double coincidence of wants

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The Meaning of Money

anything commonly acceptedin exchange for goods/services

many objects throughout history

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examples

livestock shells metals cigarettes

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to act as money, must be

measurable divisible widely accepted durable

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Forms of Money

commodity moneyhas its own value as a

good-- gold & silver coins

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Paper money - a substitute for the commodity

money - freely convertible

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credit money (fiat money)-- no value other thanfact that it’s acceptedin exchange forgoods and services

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Our money is fiat money!

NOT backed by gold coins do not contain silver or

gold

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fiat money is more efficient

commodity money hasopportunity cost:

you could use it for something else

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debit or credit cards?

NOT money payment mechanisms

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money, income, & wealth

money what is accepted as payment

income earnings during time period (year)

wealth accumulated assets at a point in time

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money, wealth are STOCKS amount at a point in time

income is a FLOW amount during a time period

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examples

I own € 2 million in diamonds. I am wealthy I have no money

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I win € 25 million in lottery

I put it under my bed

I quit my job I am wealthy I have a lot of

money my income is zero

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software engineer earnings € 100,000/yr blows it all, every paycheck

high income no wealth

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Functions of Money money is a means of payments (medium of exchange)

-- accepted as payment forgoods and services

-- main function of money

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money is a unit of account-- money is used to

measure value

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if something costs €5,not that valuable

if something costs € 500,that’s valuable

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money is a store of value-- use money to save,

accumulate wealth,buy stuff later

-- money is liquid asset

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money is NOT alwaysa good store of value-- political instability-- poor economy

-- high inflation

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example

Historically, the U.S. dollar has been a good store of value

but when the $ started falling in value, this changed…

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Measuring Money

How much money do we need?

The quantity of money (money supply) depends on the value of goods and services that will be bought …

= P x Q

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Measuring Money

and on the velocity of money circulation = the number of transactions, served by the same money asset (V)

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example I buy from George coffee with a €2 coin George buys from Maria a newspaper with the

same €2 coin Maria buys from Sofia a sandwich with the

same €2 euro coin One and the same €2 coin serves 3

transactions Therefore, for these transactions we do not

need €6 but only €2 The velocity of circulation (V) is 3 The greater the velocity, the smaller the

quantity of money needed.

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The quantity of money

M = (P x Q) : Vor

MV = PQ

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Measuring Money

Money aggregates amount of cash (coins and

banknotes)BUT other forms of money too (quasi

- money

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M1 (high power money)

= currency in circulation (cash)+ demand deposits + checkable deposits+ traveler’s checks

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M2

= M1+ savings deposits+ small time deposits

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Comparing measures

get larger M1 < M2

add less liquid assets to larger measures

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Which measure is best?

move together in general BUT behavior can vary in short-

term M2 most watched

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Money Demand

Money demand – the quantity of liquidity that the public would like to hold at every level of the interest rate, ceteris paribus

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Motives for money demand

Transactionaryto pay purchases

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Precautionarybecause of the possible lack of synchronization of payments

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Speculative (liquidity preference) because holding money has an opportunity

cost money has time value – it may bring interest on the one hand, people are motivated to have

liquidity, on the other hand, they want extra income

(interest) … when the interest rates fall, people will be

willing to convert part of their interest bearing assets into liquidity

… when the interest rates increase, the liquidity preference diminishes.

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Equilibrium on the Money Market

i

M/P

MS

MD

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Factors, Determining Money Demand

Nominal GDP Current transactions Expectations Frequency of payments Synchronization of payments Wealth

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Financial Institutions Banking institutions: The Central bank Commercial Banks Nonbanking: Insurance funds Pension funds Investment funds Mortgage funds Brokering houses Mutual funds

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Commercial Banks

The Balance sheet of a commercial bank liabilitiesassets

depositsloans

reserves

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The Money Tree

Deposit Multiplier – Maximum increase in money supply as a result of the increase in the reserves of the banking system

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The Deposit Multiplier€ 1000 new reserves enter Commercial Bank “А”

Reserves(safety)

Loans (income)

200

800

160

640

128

512

1000 + 800 + 640 + 512 + …

DM = ΔD/ ΔR

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The Central BankFunctions: Control on money supply Supervision of Commercial Banks Banker of the government Providing cash Lender of last resort Monetary policy Control on reserves Foreign currency policies and external

payments

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The Central Bank

Central BankLiabilities: Coins and notes Deposits of the CBsAssets: Foreign currency Government bonds Loans to the

Treasury and to CBs