Transcript Money and Money Market

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 exchange
 Unit of account
 Store 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/Q
If 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 . Q
k 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 deposits
 Assets 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 deposits
 Other 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 securities
 Commercial papers
 Other liquid assets

near money
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
Required reserves r = 10 %
Loans and
Investment
9 000,-
Loans and
Investment
8 100,-
Bank I
Reserves
Deposits
+ 1 000
+ 10 000
Deposit
10 000 €
Bank II
Reserves
+ 900
Deposits
+ 9 000
..............
Deposit
9 000,-
Deposit
8 100,-
Balance sheet of the
Commercial bank I.
Assets
Liabilities
Bank reserves
1 000
Liabilities to central bank
Bank credits
9 000
Deposits of households
and firms
Other assets
Total
10 000
Other liabilities
10 000
Total
10 000
Balance sheet of the
Commercial bank II.
Assets
Bank reserves
Bank credits
Liabilities
900
Liabilities to central bank
8 100
Deposits of households
and firms
Other assets
Total
9 000
Other liabilities
9 000
Total
9 000
The Deposit Multiplier
Deposits:
Bank I:
 Bank II:
 Bank III:
10 000
9 000
8 100
:
Total
100 000
 Total reserves: 10 000

Loans:
9 000
8 100
7 290
90 000
The Deposit Multiplier
The banking system transforms deposits into a
much larger amount of bank money:
1
M   D
r
1
M 
 10000  10  10000  100000
0,1
The Money Multiplier
The money multiplier (m) is the number
you multiply the monetary base by to
get the money supply:
M
m.MB  M  m 
MB
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 Multiplier
The 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)

M Dk  1 k  1
m


MB Dk  r  k  r
The Demand for Money
The 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 Money
The 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 interest
 Expectations of changes in the prices of
securities and other assets
 The 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 Money
i
MDMD1 the demand for
money increases because of:
•Rising prices
•Rising incomes
MD1
MD
0
M
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
i
MS
E
iE
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
MD
0
ME
M
Tight Money
i
MS1
MS
E1
i1
iE
The lower MS produces an excess
demand for money shown by the gap
AE. As people attempt to attain
the desired money stock, interest rates
rise (i1) to the new equilibrium at E1.
E
A
0
M1 ME
MD
M
Money-Demand Shift
i
The demand for money has
increased because of higher
price level.
The higher demand for money
forces market interest rates
upward.
MS
i1
E1
iE
E
MD1
MD
0
ME
M