Money and Money Market Money The Quantity Theory

Money and Money Market Money The Quantity Theory of Money Monetary Aggregates The Deposit and Money Multipliers The Money Market

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 three basic money’s function: Medium of exchange l Unit of account l Store of value l

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 fraction of income that people seek to hold in the form of cash and demand deposits. l M is money demand l

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. l Velocity of circulation of money is not stable. l

Liquidity Preference According to Keynes, demand for liquidity is determined by three motives. One of them is speculative motive: l 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 M 1 money supply includes: l Assets that serve as media of exchange – currency, checking accounts (deposits regarded as money, you can write checks on it). M 2 includes all M 1 + l Saving deposits and small time deposits l 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 l Other less liquid savings instruments (money market funds, shares, debt securities) l L is a broad measure of liquid assets, which includes M 3 +: Short-term treasury securities l Commercial papers l Other liquid assets l 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, - Bank I Deposits + 1 000 Loans and Investment 8 100, - Reserves + 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 000 10

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: l Bank III: 10 000 9 000 8 100 : Total 100 000 l Total reserves: 10 000 l 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:

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

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 l 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) l MB = D (k + r) l

The Demand for Money The demand for money refers to the desire to hold money: l l l 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 l Expectations of changes in the prices of securities and other assets l The expectation about changes in the exchange rate. l

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 MD 1 the demand for money increases because of: • Rising prices • Rising incomes MD 1 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. l Commercial banks create deposits out of the central bank reserves. l By manipulating reserves, the central bank can determine the money supply.

The Money Market i MS E i. E 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 MS 1 MS E 1 i. E A 0 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 (i 1) to the new equilibrium at E 1. E M 1 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 i 1 E 1 i. E E MD 1 MD 0 ME M