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INTRODUCTION OF

MONETARY ECONOMICS

MONEY
Definition: An item
that is widely
acceptable as a
medium of
exchange (in order to
get something you
must give something
as a return)

Barter System

CHARACTERISTICS OF
MONEY
Recognizable must be acknowledged
by everyone in the economic system.
Scarcity limited in supply but not too
scarce. If it is too easy to obtain money, it
will not be acceptable to be exchanged with
goods and services. If it is too hard to find it
will limited the economic activities.
Durable last long and does not easily
deteriorate

CHARACTERISTICS OF
MONEY, cont..
Stable in value it will be difficult for
people to use money as a mean of payment if
its value changes or fluctuates frequently; too
much supply of money will reduce its value
Portable easy to carry
Divisible and standardized money
must be able to be divided into smaller units
to the extend of countable and standardized

FUNCTIONS OF MONEY
medium of exchange demanded for
transaction purposes.
store of value money does not suffer
from any physical deterioration; it can be
stored and can be turned into other forms of
wealth quickly.

FUNCTIONS OF MONEY,
cont..
a unit of account the value of goods
and services are expressed in terms of a
common measurement; which is money
a standard for deferred payment
money can be used as a payment at later
date and not necessarily when the goods
and services are purchased.

TYPES OF MONEY
1. Coins

1. Coins,cont..
also known as token money; the face
value is GREATER than the metallic
content of the coins fiat money
Standardized in weight, and produced
in large quantities to facilitate the trade.

Cont..
pieces of hard material used as a medium
of exchange or limited legal tender.
Legal tender; made legally by government
which must be accepted as a medium of
exchange and in settlements of debt.
Limited legal tender; certain values of
coins can only be used in a limited amount.

2. Notes

Unlimited legal tender where it can be


used without any limit.
Face value is greater than their own
values fiat money

3. Current Deposits
also known as demand deposit, sight
deposit, bank deposit or cheque deposit
transferable from person to person
through the use of cheques
considered as money because it
possesses the functions of medium of
exchange and a store of value.
not legal tender like coins and notes.

4. Near Money
consists of saving deposits and fixed
deposits at commercial banks, Bank
Negara Malaysia and other financial
institutions and other short-term bills.
why near money? insufficiently liquid
to be a medium of exchange but it serves
the function of a store of value
how to use it? convert it into cash
(coins and notes) first.

SUPPLY OF MONEY
Total supply of money refers to the total
money in economic circulation; not the same as
the amount of money that the gov print.
How we measure total money supply in the
economy? using a narrow or broad definition
of money
So, in measuring the total money supply, we
classify them according to the definitions as given
by Bank Negara Malaysia (BNM), namely M1, M2
and M3.

M1 Supply of Money
Comprises of the most liquid assets only
coins, notes and demand deposit/current
deposit (current accounts) at commercial
banks.
The most liquid assets since they can be
used as payments and settlements of debts
directly, without having to convert.
M1 = (coins + notes) + demand deposit
M1 = fiat money + demand deposit

M2 Supply of Money
also called as narrow near money
Includes some less liquid assets because
they need to be turned into cash first before can be
used as a medium of exchange
Can be converted easily
Comprises of M1 and savings and fixed
accounts at commercial banks and Bank Negara
Malaysia (BNM), negotiable bills and Bank Negara
Malaysias certificates.

M2 Supply of Money, cont..


M2 = M1 + (savings and fixed accounts with
commercial banks and BNM) + negotiable bills +
BNMs certificates)
M2 = M1 + narrow near money

M3 Supply of Demand
Includes all the M2 money supply PLUS
saving and fixed deposits at other financial
institutions, merchant banks and discount
houses.
The savings and fixed deposits at other
institutions are part of near money because
they need to be converted into cash too
before using it to make payments or settling
the debts.

M3 Supply of Money
M3 = M2 + (savings and fixed deposits with
other financial institutions, merchant banks
and discount houses)
Broad near money = M3 M1

M1, M2 and M3 Supply of


Money
Coins

Fiat Money
M1
Notes
Demand deposits at commercial banks
Narrow
Savings and fixed deposits at com. Banks
near
money
Negotiable bills and BNMs certificates
Savings & fixed deposits with other fin. Institutions,
merchant banks & discount house

M2
M3

Broad near
money

Money Supply and Price Level


(Fishers Equation)
Irving Fisher (one of the classical
economists) had developed a study on
the relationship between money supply
and the general price level
Through Quantity Theory of Money, he
produces a famous Fishers Equation.

Fishers Equation
Any changes in the total

money supply in economy


will produce the same rate
of changes in the general
price level
Change in money
supply and rate of inflation
is positively related.

Assumptions of Fishers Equation


Money is demanded for transaction
purposes only
The economy is always at the full
employment level
Since the economy is always at the fullemployment level, the volume of goods
and services produced/exchanged and
the velocity of circulation of money are
constant.

Fishers Equation, cont..


MV = PT
Where, M = total money supply in the economy
V = velocity of circulation of each
money in the economy
P = general price level (reflects rate of
inflation in economy)
T = volume of goods and services
produced / exchanged / purchased @
GDP @ the number of transactions in the
economy

Fishers Equation, cont..


M = total money supply
- Central Bank controls the money supply in
the economy
- So, Central Bank will determine the
amount of money supply and whether they
want to increase or reduce its amount.

Fishers Equation, cont..


V = velocity of circulation
- The average number of times that every
single money is being used to purchase
goods and services in a year or the
frequency that money is used in doing
transactions.
- If V = 5, it means that, in average every
money is used for 5 times or 5 transactions
during that year.

Fishers Equation, cont..


As Classical economists always believed
that economy achieved full-employment
level, the amount of labors being
employed will remain constant thus,
there would not be any changes in the
total volume of GDP or the number of
goods and services produced every year it
makes T constant.

Fishers Equation, cont..


when the level of economic activities
is constant, the average of using every
money in doing transactions will also be
constant. (

Fishers Equation, cont..


The Fishers equation explains that when:
MV = total money supply in economy X
velocity of circulation
Thus, MV = total expenditure in economy
Whereas, PT = general price level X total
volume of goods and services
Thus, PT = total value of national output

Cont..
Therefore, MV = PT means,
Total expenditure in economy = total value of
national output
Since V and T are constant, therefore,
M = P.
It means that, change in money supply, M will lead
to change in the general price level, P with the
same rate. (CB increase money supply by 5%, the
general price level will also increase by 5%, with
assumption, V and T are constant.

Example
Suppose:

Money supply = $80 million


Price level
= $5.00
Velocity of circulation = 4 times

a. Determine the quantity of output, T


b. If there is an increase in the money supply by 6%,
determine the new amount of money supply.
c. What happen to the price level? Determine the
new price level (Assuming others remain unchanged)
d. Determine the rate of changes in the price level
above.

Demand for Money (Keynes


Liquidity Preference Theory)
According to Keynes,
-money is not demanded for the
purpose of purchasing output only.
-money is also demanded for other
reasons like saving and speculation
Thus, Keynes developed a theory of
demand for money liquidity preference
theory

Demand for Money (Keynes


Liquidity Preference Theory)
He incorporate the significance of
interest rate in this theory.
Keynes stated that people want to hold
money
for
3
purposes
only

1)transactions,
2)Precautionary
and
3)speculative

1) Transaction Purpose, Lt
people hold money to buy goods and
services which depends on the level of
income and has no relation to interest
rate at all.
the higher the income of individuals, the
greater the amount of money that they want
to hold to do transaction.
positively related with income level

Transaction Purpose, cont..


Income, Y
Lt

Quantity of Lt

2) Precautionary Purpose, Lp
Individuals demand money for the
emergency or unexpected circumstances
accidents, sickness, fire and others.
total money demanded for precautionary
is influenced by the level of income and not
related to interest rate.

Precautionary Purpose, cont..


Income, Y
Lp

Quantity of Lp

3) Speculative Purpose, Ls
Individuals hold money to speculate on
securities (bonds and shares)
The quantity of money depends on the
rate of interest and not influenced by income
level anymore.
they hold money for the purpose of getting
profit from the speculation activities.
Speculators will buy more securities when
the prices are low and sell the securities
when the prices are expensive

Speculative Purpose, Ls
Interest rate, r
Bonds and shares prices
are negatively related with
rate of interest

r1
r0
r*

Ls

Q1 Q0
Low r (r0) and high Psec
expect r to and Psec to
Security now
quantity of money balances (Q0)

Quantity of Ls
sell

Conclusion of Money Demand


The total demand for money is given as:
Mdd = Lt + Lp + Ls

Monetary Policy
One of the major stabilization policies adopted by
the government to overcome two major
macroeconomic problems inflation and
deflation.
this policy is designed to influence the supply of
money and/or interest rate through Central Bank.
Tools (methods) of monetary policy are all
related to the financial and banking system raise
or reduce the amount of money supply in the
economy

Contractionary Monetary Policy


the government will restrict the credit and
reduce the money supply in the economy.
adopted by gov to control inflation.
purpose: to reduce peoples spending by
reducing the amount of money supply
available
Mss

- adopt during inflation

Expansionary Monetary Policy


Gov encourage the availability of credit and
increase the money supply
Adopted when the gov wants to deal with
deflation problem where the level of economic
activity is slow.
It is expected to boost the spending activities in
the economy as people hold more money.
Mss - adopt during deflation

Tools of Monetary Policy


Open Market Operation
- the activities of selling and buying of
government securities by the Central
Bank in the open market
To Mss
reserves
To Mss
reserves

BNM buy securities


credit
BNM sells securities
credit

banks
banks

Tools of Monetary Policy, cont..


Reserves Ratio
- the proportion of commercial banks
deposits that must be kept with Central Bank.
- the ratio is set by CB.
To Mss
credit
To Mss
give credit

ratio
ratio

reserves
reserves

ability to give
ability to

Cont..
Discount Policy (Bank rate)
- the rate charged by the Central Bank on banks and
discount houses loan.
- any loan made by the banks from the CB will be
discounted by certain rate called as bank rate which
influence the interest rate charged by the banks on the
loans made to the public.
To
To

Mss: bank rate


credit
Mss: bank rate
credit

interest rate

reserves

interest rate

reserves

Cont..
Selective Credit Control
- the gov control ways of giving loans by
the commercial banks and other financial
institutions.
- the gov (through CB) can either tighten
or loosen the provisions of giving loan to
the public.
To
To

Mss: less strict provision


Mss: stricter provision

credit
credit

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