Macroeconomics II

Chapter three
Money demand and money supply
 3.1. INTRODUCTION
What is Money?
What economists mean by money?
Economists use the term “money”
“money” to mean stock of
assets that can be readily used /the most liquid part
of a person's assets/ to make transactions.
• To an economist, money does not refer to all
wealth but only to one type of it:
Money is the stock of assets that can be readily
used to make transactions.
• Alternatively, economists define money as
anything that is generally accepted in payment for
goods or services or in the repayment of debts.
• money is anything that is widely accepted in payment for
goods or in discharging other kinds of business obligations.
Robertson
• Corther is the most suitable. He defined it as -anything
-anything that is
generally acceptable as a means of exchange (i.e. as a
means to settle debt) and that at the same time acts as a
measure and as a store of value.
value.
• This definition covers the important functions of money and
also stresses its basic characteristic, namely general
acceptability.
• Money is the most liquid asset because it does not have to
be converted into anything else in order to make purchases.
• Liquidity refers to the relative ease and speed with which an
asset can be converted into a medium of exchange.
• Before the introduction of money there has been other
mechanism on which the former society used to have, the
first and for most was barter system.
• Barter system (Commodity Money) this is an exchange of
goods for other goods.
• The barter mechanism has its own weakness that makes
the people to shift from barter to some other mechanism.
• Some of the weaknesses are as follows.
 Difficulty fulfilling double-coincidence of wants
 difficulty in measuring value
 problem of indivisibility
 High transportation costs
 storage problem and
 Problem of portability
 Functions of money
• Money has three basic functions:
• Money as a Medium of Exchange, a unit of account,
and a store of Value.
a) Money as a Medium of Exchange
• Money is used to buy goods and services. This is the
most basic function of Money.
• Money in the form of currency or checks is a medium
of exchange is used in almost all market transactions
in our economy to pay for goods and services.
• Money has a power to command and purchase goods
and services that will satisfy human wants.
b)Money serves as a unit of account: - money
provides the terms in which prices are quoted and
debts are recorded.
• How does one know the GDP value of a county?
• It is simply the money value of the goods and
services produced in a country in a given year.
• In this case, money is used as a unit of account that
is as base for measure of values of goods and
services.
• Without money, we would face difficulty in
comparing various goods used in exchanges.
• With this function, we can easily compare one kg of
teff with three loaves of bread if their money values
are the same.
• Money serves as a store of value: -
money is a way to transfer purchasing power from the
present to the future.
 Values of goods and services produced can be
changed to money and stored in the form of money
for future purpose.
• This is because keeping the products for future sale
may not be possible or may be wasteful or costly.
• The other importance of money as a store of value
depends on the inflation rate.
• Hence, money is an imperfect store of value.
• The reason is that, for instance, if prices are rising
(inflation), the amount you can buy with any given
quantity of money is falling.
Money permits the society to achieve a more
efficient allocation of resources.
Money promotes economic efficiency by:
Eliminating transaction cost
Avoiding the problem of double coincidence
Allowing people to specialize in what they do
best
Allowing freedom of choice
• The acceptance of money as a medium of
exchange is a matter of social convention.
• A Commodity to be used as money, if it should
meet the following criteria :
 Widely accepted
 Standardization
Standardization:: it must be easily standardized
 Divisibility –it is easy to make a change
 Portability – it must be easy to carry
 Durability
Durability–– it must not deteriorate quickly
 The Supply of Money
• Money supply is the amount of money in circulation in
an economy.
• The quantity of money available in an economy is
called the money supply.
• Any fluctuation in brings changes in the aggregate
macroeconomic variables.
• Relatively a larger amount of Money supply may lead to
both negative and positive impacts in other
macroeconomic variables.
• For example, larger inflation rate, lower interest rate,
and lower cost of borrowing or cheaper loan, lower
saving and better investment.
This makes Money supply one of the major policy
instruments in the hands of governments.
• The policy packages prescribed related to money supply is
known as monetary policy and the variables changed in
achieving the objectives are known as monetary policy
instruments.
 The most obvious asset to include in the quantity of money is
currency, which is the sum of outstanding paper money and
currency,
coins.
 A second type of asset used for transactions is demand
deposits, which is the funds people hold in their checking
deposits,
accounts.
• Demand deposits are, therefore, added to currency when
measuring the quantity of money.
Money = currency + Demand deposits

Where, M- the money supply,

C - is currency/cash and
 The Money Supply Process
• There are three Players in the Money Supply
Process
• Central banks (National Bank of Ethiopia in our
case)- in charge of money supply management
• Banks (depository institutions; financial
intermediaries)
• Depositors (individuals and institutions)
The interaction between these three sets of
people determines the money supply.
100 Percent- Reserve Banking
• The deposits that banks have received but have
not lent out are called reserves.
• Some reserves are held at the Central bank.
• If all deposits are held as reserves,
reserves, such a
system is called ‘100
‘100 Percent Reserve Banking’.
Banking’.
• If banks hold 100 percent of deposits in
reserve, the banking system does not affect the
supply of money.
 Fractional-Reserve Banking
• Now imagine that banks start to use some of
their deposits to make loans then banks earn
interest from loans.
• The banks must keep some reserves on hand
so that reserves are available whenever
depositors want to make withdrawals.
• This kind of system is called ‘fractional reserve
banking,’ a system under which banks keep
only a fraction of their deposits in reserve.
• Thus, in a system of fractional reserve banking,
banks create money.
money.
• Note that although the system of fractional–
reserve banking creates money,
money, it does not
create wealth.
• When a bank loans out some of its reserves,
reserves, it
gives borrowers the ability to make
transactions and therefore increases the supply
of money.
money.
• The borrowers are also undertaking a debt
obligation to the bank, however, so the loan
does not make them wealthier.
• In other words, the creation of money by the
banking system increases the economy’s
liquidity,, not its wealth.
liquidity wealth.
 A Model of the Money Supply
• What determines the money supply?
• This model of the money supply is based on
fractional-reserve banking.
• This model involves three exogenous variables:
1. Monetary Base
2. Reserve requirement
3. Currency–deposit ratio
• 1. Monetary Base (B)
• This is a total amount of money held by the public as
currency (C) under control of the public; and the
amount kept by banks as reserves (R).
B=C+R
• Its size and use is determined or controlled by central
bank.
2. Reserve requirement
• This is the proportion of deposits that commercial
banks keep with central bank.
• Reserve – deposit ratio (R/D) = is the ratio of
reserves to the deposit kept with banks.
• Its size and use is determined or controlled by the Fed
(central bank).
3. Currency-Deposit Ratio (cr): It expresses the
preferences of the public about how much
money to hold in the form of currency (C) and
how much to hold in the form of demand
deposits (D).
• This model shows how the money supply
depends on the monetary base,
base, the reserve-
deposit ratio, and the currency-deposit ratio’
ratio’
• The model begins with the definition of money
supply and monetary base.
Instruments of Monetary
Policy
• Central Banks have three instruments of
monetary policy:
i. open market operations,
ii. reserve requirements, and
iii. the discount rate.
 Open market operations
• These are the purchases and sales of government
bonds by the Central bank.
• A purchase of bonds by the Central bank is called
an open market purchase,
purchase, and a sale of bonds by
the Central bank is called an open market sale.
When the Central bank buys bonds from the public,
the dollars it pays for the bonds increase the
monetary base and thereby increase the money
supply.
When the Central bank sells bonds to the public,
the dollars it receives reduce the monetary base
and thus decrease the money supply.
• Reserve Requirements – is ratio of cash reserves to
deposits that banks are required to maintain.
• These are Central bank regulations that impose on
banks a minimum reserve-deposit ratio.
• An increase in reserve requirements raises the reserve-
deposit ratio and thus lowers the money multiplier and
the money supply
supply..
• Discount Rate: It is the interest rate that the Central
bank charges when it makes loan to banks.
• The reductions in the discount rate raise the monetary
base and the money supply.
• When the CB increase the discount rate, it discourage
the commercial banks from borrowing much money
from the CB.
CB. This will decreases commercial’s reserve
and thus the money base and then money supply.
supply.
 Demand for Money
What determines money demand?
Why we demand money?
• In our economy almost everyone including firms sells
goods and services for money and in turn uses money to
buy the goods and services.
– This refers to money as a medium of exchange.
exchange.
• The demand for money arises from the important
functions money performs, such as units of account,
store of value and medium of exchange.
• Money as a unit of account does not by itself generate
any demand for money, because one can quote prices in
dollars without holding any.
• The theories of money demand emphasize the role of
money either as a store of value or as a medium of
exchange.
 Quantity Theory of Money
Demand
• American economist Irving Fisher in the 19th c and
early 20th wrote book “the Purchasing Power of
Money”, published in 1911.
• The most important feature of this theory is that
interest rates have no effect on the demand for
money.
• Fisher examine the link between the total quantity
of money (M=the money supply) and nominal value
of aggregate income or total amount of spending
on final goods and services produced in the
economy (nominal GDP (PxY))
• His model is based on the concept of velocity of
money (the rate of turnover of money).
Keynes’s Liquidity Preference Theory:
• Why do people hold money?
• In his famous 1936 book “The
“The General
Theory of Employment, Interest, and
Money”,, Keynes developed a theory of
Money”
money demand which he called liquidity
preference theory.
• He postulated that there are three motives
behind the demand for money:
Transactions motive,
Precautionary motive, and
Speculative motive.
motive.
i. Transactions Motive: - Keynes emphasized that this
component of the demand for money is determined
primarily by the level of people’s transactions.
• The motive of holding money to carryout regular and
planned/expected transactions.
• It is purely a function of income and interest rate does not
affect it.
• Keynes believed that transactions demand for money to be
proportional to income.
ii. Precautionary motive: the motive of holding money to
ii.
carryout unplanned/ unexpected transactions.
People for example, may not be sure about their future
health expense and may hold some money for fear they may
face some health problem.
Here money is not demanded for current transactions and it
is rather demanded a cushion against unexpected
transactions in the future.
iii. Speculative Motive: - The transactions motive
and the precautionary motive for money
emphasized medium of exchange function of
money, for each refers to the need to have money on
hand to make payments
People hold their wealth in different assets and
money is one alternative of holding wealth.
Keynes considered people can hold their wealth
either in the form of money or bond and since
money does not earn interest people will choose to
hold bond if they expect a positive return from
holding bond.
Therefore, the speculative motive is inversely
affected by interest rate, i.e., as interest rate from
bonds increases the return from bonds will increase
and people will shift from money to bonds (they will
hold less money and more bond).
 Generally according to Keynesian demand for
money , income is the most determinant factor
that influence both transaction demand and
precautionary demand.
But decisions regarding how much money to hold
as a store of wealth, especially affected by interest
rates.
Therefore, according to Keynesian demand for
money interest rate is the most determinant factor
that influence speculative demand.
Keynes’ demand functions for money:

Keynes’s demand for money equation, known as the liquidity

preference function, which says that the demand for real money
balances is a function to real income Y and to interest rates i
and given as:

The (+) sign means that the demand for real money balances
and real income Y are positively related and,

The (-) sign shows that the demand for real money balances is
negatively related to the interest rate i

Keynes’s conclusion that the demand for money is related not

only to income but also to interest rates is a major departure
from Fisher’s view of money demand, in which interest rates
can have no effect on the demand for money.
• Because the transactions motive and
precautionary motive demand for money is
positively related to real income Y, speculative
motive demand for money is negatively related
to interest rate i, the demand for real money
balances can be rewritten as:

Where,
• L1 means the transactions demand for
money;
• L2 means the speculative demand for
money.
Transaction Theories of Money Demand
• Theories of money demand that emphasizes the role of
money as a medium of exchange are called
‘transactions theories.’
• These theories acknowledge that money, unlike other
assets, is held to make purchases.
Almost everyone needs to hold some amount of money
to carry out ordinary day-to-day transactions.
– The amount of money to be kept for transaction
depends on the timing of receipts and the timing of
payments.
• For example, if a person gets daily wage, the amount he
wants to keep with him for transaction is different from
a person who gets monthly salary.
• In this case, on an average level a daily labor would
keep fewer amounts for transaction.
• Note that if people save their money to receive
interest income until they consume or use for
transaction purpose, higher interest rate
reduces money holding or demand.
– Moreover, transaction demand (M ) depends
on the income (Y).
• According to this theory, these factors are
linearly related.
M= (Y)
– Boumol theory of cash management is a more
detail related theory.
 The Baumol-Tobin Model of Cash
Management
• The Baumol-Tobin model analyses the costs and benefits
of holding money.
• This theory is concerned with the calculation of the
optimal number of time of cash withdrawal from banks
and optimal amount of cash to hold during any given
period.
• This depends on the benefit and cost of holding money.
• Benefit of holding money: This is convenience of making
transactions i.e. avoiding making trips to banks every time
they wish to buy something.
• Cost of holding money: This is the foregone interest
income that they would have received had they left their
money in the saving account.