Money Supply and Money Demand 09 52 Frederick

Money Supply and Money Demand 09: 52 Frederick University 2014 1

Money & the Payments System n n meaning of money functions of money forms of money measuring money

without money n barter for stuff -- need “double coincidence of wants” -- inefficient: more time shopping, less time producing 09: 52 3

example n I have exam 2, want to trade it for soda 09: 52 4

You have to want the exam & be willing to give up soda AND I have to want the soda & be willing to give up exam 09: 52 5

double coincidence of wants 09: 52 6

The Meaning of Money n n anything commonly accepted in exchange for goods/services many objects throughout history 09: 52 7

examples livestock n shells n metals n cigarettes n 09: 52 8

to act as money, must be n n measurable divisible widely accepted durable 09: 52 9

Forms of Money n commodity money has its own value as a good -- gold & silver coins 09: 52 10

Paper money - a substitute for the commodity money - freely convertible n 09: 52 11

n credit money (fiat money) -- no value other than fact that it’s accepted in exchange for goods and services 09: 52 12

Our money is fiat money! NOT backed by gold n coins do not contain silver or gold n 09: 52 13

fiat money is more efficient n 09: 52 commodity money has opportunity cost: you could use it for something else 14

debit or credit cards? n n NOT money payment mechanisms 09: 52 15

money, income, & wealth n money n n income n n what is accepted as payment earnings during time period (year) wealth n 09: 52 accumulated assets at a point in time 16

n money, wealth are STOCKS n n amount at a point in time income is a FLOW n 09: 52 amount during a time period 17

examples n I own € 2 million in diamonds. n n 09: 52 I am wealthy I have no money 18

n n n I win € 25 million in lottery I put it under my bed I quit my job n n n 09: 52 I am wealthy I have a lot of money my income is zero 19

n n n software engineer earnings € 100, 000/yr blows it all, every paycheck n n high income no wealth 09: 52 20

Functions of Money money is a means of payments n (medium of exchange) -- accepted as payment for goods and services -- main function of money n 09: 52 21

n money is a unit of account -- money is used to measure value 09: 52 22

if something costs € 5, not that valuable n if something costs € 500, that’s valuable n 09: 52 23

n money is a store of value -- use money to save, accumulate wealth, buy stuff later -- money is liquid asset 09: 52 24

n money is NOT always a good store of value -- political instability -- poor economy -- high inflation 09: 52 25

example Historically, the U. S. dollar has been a good store of value n but when the $ started falling in value, this changed… 09: 52 26

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 … =Px. Q 09: 52 27

Measuring Money and on the velocity of money circulation = the number of transactions, served by the same money asset (V) 09: 52 28

example n n n n 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. 09: 52 29

The quantity of money M = (P x Q) : V or MV = PQ 09: 52 30

Measuring Money n Money aggregates amount of cash (coins and banknotes) BUT n other forms of money too (quasi money n 09: 52 31

M 1 (high power money) = currency in circulation (cash) + demand deposits + checkable deposits + traveler’s checks 09: 52 32

M 2 = M 1 + savings deposits + small time deposits 09: 52 33

Comparing measures n get larger n n M 1 < M 2 add less liquid assets to larger measures 09: 52 34

Which measure is best? n n n move together in general BUT behavior can vary in short-term M 2 most watched 09: 52 35

Money Demand n Money demand – the quantity of liquidity that the public would like to hold at every level of the interest rate, ceteris paribus 09: 52 36

Motives for money demand Ø Transactionary to pay purchases 09: 52 37

Ø Precautionary because of the possible lack of synchronization of payments 09: 52 38

Ø ü ü ü 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. 09: 52 39

Equilibrium on the Money Market i MS MD M/P 09: 52 40

Factors, Determining Money Demand n n n Nominal GDP Current transactions Expectations Frequency of payments Synchronization of payments Wealth 09: 52 41

Financial Institutions n Ø Ø Ø Ø Banking institutions: The Central bank Commercial Banks Nonbanking: Insurance funds Pension funds Investment funds Mortgage funds Brokering houses Mutual funds 09: 52 42

Commercial Banks The Balance sheet of a commercial bank assets loans liabilities deposits reserves 09: 52 43

The Money Tree Deposit Multiplier – Maximum increase in money supply as a result of the increase in the reserves of the banking system 09: 52 44

The Deposit Multiplier € 1000 new reserves enter Commercial Bank “А” Reserves (safety) 1000 + 800 + 640 + 512 + … 200 800 Loans (income) DM = ΔD/ ΔR 160 640 128 09: 52 512 45

The Central Bank Functions: n Control on money supply n Supervision of Commercial Banks n Banker of the government n Providing cash n Lender of last resort n Monetary policy n Control on reserves n Foreign currency policies and external payments 09: 52 46

The Central Bank Liabilities: n Coins and notes n Deposits of the CBs Assets: n Foreign currency n Government bonds n Loans to the Treasury and to CBs 09: 52 47