Money and Money Market

BY CA. SAYANTAN BASU

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.
 Moneys Function

There are the three basic moneys 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 near money
Other liquid assets
 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 Currency in circulation

banks

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 Deposit
Investment Bank I
9 000,- Reserves Deposits
10 000
+ 1 000 + 10 000

Loans and
Investment Bank II
8 100,- Reserves Deposits Deposit
+ 900 + 9 000 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 10 000

and firms
Other assets Other liabilities

Total 10 000 Total 10

000
Balance sheet of the Commercial bank II.

Assets Liabilities

Bank reserves 900 Liabilities to central bank

Bank credits 8 100 Deposits of households 9 000

and firms
Other assets Other liabilities

Total 9 000 Total 9 000

 The Deposit Multiplier

Deposits: Loans:
Bank I: 10 000 9 000
Bank II: 9 000 8 100
Bank III: 8 100 7 290
:
Total 100 000 90 000
Total reserves: 10 000
 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
MDMD1 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 nations 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 The money market is affected by

MS a combination of :
The publics desires to hold
money (MD)
The CB monetary policy (MS)
The intersection of the supply and
demand curves determines the
E market interest rate
iE

MD

0 ME M
 Tight Money

i MS1
MS 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.
E1
i1
iE E
A
MD

0 M1 ME M
 Money-Demand Shift

i The demand for money has

increased because of higher
MS price level.
The higher demand for money
forces market interest rates
i1 E1 upward.

E
iE
MD1
MD

0 ME M