LECTURE 6
Money and
the Financial
Sector
How do we define money?
 Trying to define ‘money’ from the viewpoint of
materials or forms is a complete failure.

This is because money changed its materials and its
forms in the course of the development of economic
society.
 Some times, money is considered to be some
commodity


Historically, money things have been used as money




Soap
Salt
Several precious metals: gold,…
But, what kind of commodity is likely to become
commodity money?

“The commodity with the highest salability or marketability
will be accepted as money by the society.”

Some times it is considered to be the paper on
which some numbers and figures are printed.

Some times it is often considered to be the only
abstract number recorded in the computers
used by the banks.

As Hicks (1967) pointed out correctly, therefore,
we must define ‘money’ from the viewpoint of its
function.


Usually, the economists define ‘money’ as the
‘generally accepted means of payments’,
As a result it is said that ‘money’ must have the
following three functions.
Means of payments (or means of exchange)
 Measure of value (or unit of calculation)
 Means of store of value
Page 198 spe Page 200


As Hicks (1967) noted, this definition has
somewhat paradoxical nature, because it means
that


‘money’ is what is considered to be money by a lot of
people in a society.
It may be worth noting that the first function is
primary, and other two functions are derived
from the first function.

Attributes/characteristics of money





divisibility
Homogeneity
Durability
Acceptability
portability

Though commodity moneys may satisfy most of
these attributes of ideal money, in modern society
money is not commodity money but paper money
and/or credit money.

This is because commodity many has one serious
limitation: divisibility!

How do we measure (or define) money in
macroeconomics?

Narrow money (M1): is the sum total of
Currency outside banks
 Demand deposits (checking accounts)
 These are very liquid and they don’t pay interest


"Intermediate" money (M2) is slightly broader
than M1and comprises
narrow money (M1) and,
 Saving deposits.

Now a days the difference between saving and
checking accounts are diminishing because modern
banks are paying interest for checking account.
 The distinction of M1 and M2 depends on the degree
of liquidity.


The more liquid the elements, the more to be a component
of M1, and vice versa

M3: the broadest form of many and includes all
things to be considered as money

This consists of M2 plus longer term deposits such as time
deposits and repos, foreign currency deposits.


M1, M2, M3 are all measures of money supply, that is the
amount of money in circulation at a given time.
But the exact classifications depend on the country.
Definitions of euro area monetary aggregates
M1
M2
M3
Currency in circulation
X
X
X
Overnight deposits
Deposits with an agreed maturity up to
2 years
X
X
X
X
X
X
X
Deposits redeemable at a period of notice
up to 3 months
Repurchase agreements
X
Money market fund (MMF) shares/units
X
Debt securities up to 2 years
X
B. DEMAND FOR MONEY

The demand for money is how much money
people wish to hold as cash.
 Two

types of theories
Portfolio theories
emphasize “store of value” function
 relevant for M2, M3



(As a store of value,
M1 is dominated by other assets.)
not relevant for M1.
Transactions theories
emphasize “medium of exchange” function
 also relevant for M1


Quantity Theory Of Money Demand
This is the classical quantity theory and first
developed by the American economist Irving Fisher
 Fisher wanted to examine the link between the total
quantity of money (M) and the total amount of
spending on final goods and services produced in the
economy (P×Y).


He established this relationship as
M=PY/V
where P is the price level and Y is aggregate output,
V is he velocity of money.

The transaction velocity of money (V) is the average
number of times that a dollar is exchanged between a
buyer and a seller in one year.

Fisher believed that velocity is determined by the
institution in an economy that affect the way
individuals conduct transactions.
He thought the institutional and technological
features of the economy would affect velocity only
slowly over time, so velocity would normally be
reasonably constant in the short run.
 This view transforms the equation of exchange into
the quantity theory money, which is in fact the
theory of the demand for money.

When the money market is in equilibrium, the
quantity of money M that people hold equals the
quantity of money demand Md, so we can replace M
in the equation by Md.
 using k to represent the quantity 1/V, we can rewrite
the equation as


Because k is a constant, the level of transaction generated
by a fixed level of nominal income PY determines the
quantity of money Md that people demand.
Therefore, Fisher’s quantity theory of money
suggests that the demand for money is purely a
function of income, and interest rates have no
effect on the demand for money.
 Thus, the demand for money is determined

1.
2.
by the level of transactions generated by the level
of nominal income PY and
by the institutions in the economy that affect the
way people conduct transactions that determine
velocity and hence k.

Cambridge Approach To Money Demand
While fisher was developing his quantity theory
approach to the demand for money, a group of
classical economists in Cambridge, England, which
included Alfred Marshall and A.C. Pigou. Were
studying the same topic.
 Although their analysis led them to an equation
identical to Fisher’s money demand equation, their
approach differed significantly.

In Cambridge model, individuals are allowed
some flexible in their decisions to hold money and
are not completely bound by institutional
constraints such as whether they can use credit
cards to make purchases.
 Accordingly, the Cambridge approach did not
rule out the effects of interest rates on the
demand for money.
 The classical Cambridge economists thought that
two properties of money make people want to
hold it:

(1) its utility as a medium of exchange ;
 (2) its utility as store of wealth.

Cambridge economists agreed with Fisher that
demand for money would be related to the level of
transactions and there would be a transactions
component of money demand proportional to
nominal income.
 As far as money functions as a store of wealth,
the Cambridge economists suggest that the level
of people’s wealth also affects the demand for
money.


Cambridge economist also expressed the demand
for money function as:
the Cambridge approach allowed individuals to
choose how much money they wished to hold.
 This approach allowed for the possibility that k
could fluctuate in the short run because the
decisions about using money to store wealth
would depend on the yields and expected returns
on other assets that also function as stores of
wealth.

KEYNESIAN’S LIQUIDITY PREFERENCE
THEORY PAGE 234
In his famous 1936 book The General Theory of
Employment, Interest, and Money, Keynes
developed a theory of money demand which he
called liquidity preference theory.
 Keynes abandoned the classical view that
velocity was a constant, emphasized the
importance of interest rates.
 He postulated that there are three motives
behind the demand for money:

the transactions motive,
 the precautionary motive, and
 the speculative motive.


The transactions demand for money is money
that is needed to undertake purchases of goods
and services.

Keynes believed that these transactions were
proportional to income, and thus, like the classical
economists, he considered the transactions
component of the demand for money to be
proportional to income.

The precautionary demand for money is money
that is needed to meet unforeseen expenses (as
caution against an unexpected need)
People hold an amount of money over and above what is
necessary to meet normal expenses.
 the amount of precautionary money balances people want
to hold is determined primarily by the level of transactions
that they expected to make in the future and that these
transactions are proportional to income. So he considered
the demand for precautionary money balances to be
proportional to income.
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.

•

The speculative demand for money is money
that forms part of an individual’s portfolio of
assets.
Keynes agreed with the classical Cambridge
economists that money is a store of wealth and called
this reason for holding money the speculative motive.
 Keynes believed that interest rates have an
important role to play in influencing the decisions
regarding how munch money to hold as a store of
wealth.

Speculative demand for money is
negatively related to the level of
interest rates.


Keynes developed the following demand for money
equation, known as the liquidity preference function,
which says that the demand for real money balances
Md/P is a function of i and Y:
Where
the minus sign below i means that the demand for real
money balances is negatively related to the interest rate,
and
 The plus sign below Y means that the demand for real
money balances and real income Y are positively related.


Thus, Keynes thought that the demand for
money is related not only to income, but also to
interest rates.

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 Md/P can be rewritten as
where L1 means the transactions demand for money; L2
means the speculative demand for money.

But such disaggregation is not popular in academic
literature

What is liquidity trap? page 237
FURTHER DEVELOPMENTS IN THE
KEYNESIAN APPROACH PAGE 249
 The
Baumol- Tobin Model
 It
is the Transactions theory of demand
for Money
William Baumol and James Tobin independently
developed similar demand for money models, which
demonstrated that even money balances held for
transactions purposes are sensitive to the level of
interest rates.
 In developing their models, they considered a
hypothetical individual who receives a payment once
a period and spends it over the course of this period.


The conclusion of the Baumol-Tobin analysis is
as follows:
as interest rates increase, the amount of cash held for
transaction purposes will decline, which in turn
means that velocity will increase as interest rates.
 thus, the transactions component of the demand for
money is negatively related to the level of interest
rates.

 Assumptions

Household expenditure at time t is Y (=C.P)







and notations:
C is quantity of goods and services consumed and P is
their price
All purchases are evenly spread over the period
All purchases are paid in cash
Income is earned at the start of each period
Deposits in saving account earns interest (Rt)
N = number of trips consumer makes to the bank
to withdraw money from savings account
F= cost of a trip to the bank (F=P𝜹)
(e.g., if a trip takes 15 minutes and
consumer’s wage = $12/hour, then F = $3)

Since expenditure is a constant flow, the number
of times you decide to go bank determines the
amount of money you hold in your pocket.
Money
holding
s
Y
N=1
Average
= Y/ 2
1
Time
Money
holdings
N=2
Y
Average = Y/ 4
Y/ 2
1/2
1
Time
Money
holdings
N=3
Y
Average
= Y/ 6
Y/ 3
1/3
2/3
1
Time

In general, households’ average money holdings =
Y/2N
M= Y/ 2N
Foregone interest = Rt (Y/2N )
 Cost of N trips to bank = FN


Thus,
Y
Total Cost  Rt x
 ( FxN )
2N

Given Y, i, and F, consumer chooses N to minimize
total cost

Finding the cost-minimizing N
Cost
Foregone
interest =
iY/2N
Cost of trips
= FN
Total cost
N
Y
Total Cost  Rt x
 ( FxN )
2N

Take the derivative of total cost with respect to N, set
it equal to zero:
Rt Y

F 0
2
2N

Solve for the cost-minimizing N*
N 

Rt Y
2F
This is the cost minimizing value of N

To obtain the money demand function,
plug N* into the expression for average money
holdings:
YF
Average Money Holding 
2R

Money demand depends positively on Y and F,
and negatively on R.

The Baumol-Tobin money demand function:
YF
M 
 L( R, Y , F )
2R
d
How this money demand function differs from
the others:
 B-T shows how F affects money demand.
 B-T implies:
 income elasticity of money demand = 0.5,
interest rate elasticity of money demand = 0.5
Then this function in such away that money
demand is positively related to Ct and negatively
related to Rt
 Empirical results for developing countries:

although the sign of Rt is negative, it is not
significant because people is not sensitive interest
rate.
 Currency substitution (holding money in foreign
currency) is more significant



When people expect domestic currency to depreciate, they
prefer to hold their money in foreign currency
In subsistence economy, no money left for saving

EXERCISE:


This days, automatic teller machines are becoming
widely available. How do you think this affected N*
and money demand? Explain.
Reading assignment:
3. THE SUPPLY OF MONEY

3.1. Introduction
Hitherto, we have intrinsically and explicitly
assumed that the money supply is exogenous.
 But money supply is not completely exogenous
 There are three agents which play a role in MS:

Private hhs: if M=C+deposit, it is the household who
decides how much money to hold as cash and how much to
deposit
 Private banks: decides on how much deposits to lend to
investors and how much to hold as excess reserve (ER)
 Central bank: decides only on the minimum amount of
money (deposits) banks should hold

•
•
Thus, the assumption that monetary authorities (MA)
have full control is not true.
The MA controls MS iff money is commodity money, not
fiat money, because in the latter case banks have no
ability to create.

When the required reserve ratio is 100%, only then do the
MA has full control on fiat MS.
But there are economists who argued that MS is
not defined (measured) accurately. This is
because over time money is continuously
changing its form
 So, we shall focus on two things:

What is the definition or measurement of MS?
 How do monetary authorities try to control the MS


the tool to gauge (supply) the amount of money the economy
need
A MODEL OF THE MONEY SUPPLY

The money supply equals currency plus demand (checking account) deposits:
M = C + D

Since the money supply includes demand deposits, the banking system plays an
important role.
Exogenous variables

Monetary base, B = C + R
controlled by the central bank
-
R is total that private banks puts with the NB
-
-

R=RR (by law)+ER(reserves above RR)
B is also called high powered money
Reserve-deposit ratio, rr = R/D
depends on regulations & bank policies

Currency-deposit ratio, cr = C/D
depends on households’ preferences
SOLVING FOR THE MONEY SUPPLY:
M  C D
C D

B
B
where
C D
m 
B
C D 

C R
C
C
 m B
D   D D   cr  1
cr  rr
D   R D 
cr  1
Thus, m 
cr  rr
m is called the money multiplier
Note: If rr < 1, then m > 1
THE MONEY MULTIPLIER


the money multiplier (m), is the increase
in the money supply resulting from a onedollar increase
in the monetary base.
Note that M = m x B

Thus, if monetary base changes by B,
then M = m  B

Ms = mB
= f(rr, Cr). B
 But rr has two component
Required reserve to deposit (k)
 Excess reserve to deposit(r)


so,
Ms=f(r, k,cr)B

Hence, Ms is determined by the completely
different agents such as:
Behavior of NB …………. via cr and B
 Behavior of private banks ……..via R (reserve)
 Behavior of hhs ………………….via cr


So, the reason why the MA can’t precisely
control Ms is that

Households can change cr, causing m and M to
change.

Banks often hold excess reserves (reserves above
the reserve requirement). if banks change their
excess reserves, then rr, m, and M change.
3.3. MONEY CONTROL
What instruments do MA use to control money?
 There are three common instruments of
monetary policy

1.
2.
3.
Open-market operations
Reserve requirements
The discount rate

Open-market operations
definition: The purchase or sale of government bonds by the NB
or MA.
 how it works: If MA buys bonds from the public,
it pays with new dollars, increasing B and therefore M.


Reserve requirements
definition: MA regulations that require banks to hold a minimum
reserve-deposit ratio.
 how it works: Reserve requirements affect rr and m:
If MA reduces reserve requirements, then banks can make more
loans and “create” more money from each deposit.


The discount rate
definition: The interest rate that the MA charges on loans it
makes to banks.
 how it works: When banks borrow from the MA, their reserves
increase, allowing them to make more loans and “create” more
money.
The MA can increase B by lowering the discount rate to induce
banks to borrow more reserves from the MA.

WHICH INSTRUMENT IS USED MOST
OFTEN?

Open-market operations:


Changes in reserve requirements:


most frequently used.
least frequently used.
Changes in the discount rate: largely symbolic.

The MA is a “lender of last resort,” does not usually make
loans to banks on demand.
Is MA often effective in attempting to control the
money supply?
 Lets see the effectiveness of MA that attempted
to control the money supply via different targets.

Money targeting
 Interest targeting


Money targeting:
MA can identify the monetary target Mt that the
economy need and supply that amount
 Recall that

Mt
 f (cr , kt , rt )
B
kt and cr can be assumed exogenous to the MA
Mt
 Thus,
 f (c , k , r )

B
r
 f (rt )
t
t

Money demand on the other hand is
Mt
 L (Yt , Rt )
pt

Mt
Mt 
 L Yt , f (
)
pt
Bt 

 e
M t*
Mt 

L
Y
,
f
(
)
 t
e
pt
Bt 


In practice, however, the expected value may not
be the correct figure. So, there is always a
problem in using expected values.

Hence, the MA has two problems:

Their expectation of Md may not be exact


The targets can not be achieved even when the
government try to supply Mt*


Because it depends on Ye and Pe
Because private banks and hhs may disturb the Ms (the real
money may be above or below Mt*)
To avoid this, they set their target to a range of
values, not a specific value.

How?
 They estimate (predict) the max and min of both Md and
Ms
This means, if MA set the maximum and
minimum of both Ms and Md, the probability of
making a wrong target is low.
 In such cases, the actual Ms is likely to be
between Mt1 and Mt2


Interest Targeting:

This is fixing the interest rate and supplying the
amount of money that equates R* and M*

Which targeting is superior?


Note that:


Which of the instrument is superior depends on the
nature of error made by MA
The larger the range of Mmax and Mmin is, the larger
the error of MA
To evaluate which one superior, lets consider two
cases:

Case 1- Ma makes large error in predicting Ms


i.e, the gap between max and min of MS is larger than the
gap between the max and min of Md
Case 2- Ma makes large error in predicting Md

i.e., variation in Ms is small and the variation in Md is large
Case-1: MA makes a larger mistake in predicting Ms than Md
MSmax
Rt

If the MA use monetary
targeting, the range by which
the MA makes error is given by
M1-M4

If the MA use interest
targeting, the range by which
the MA makes error is given by
M2-M3

Hence in this case, interest
rate targeting is superior to
the money marketing!
MS
MSmin
Rt
MDmax
MD
MDmin
M1
M2 M*
M3 M4
Mt
Case 2-MA makes larger error in predicting Md than Ms
MSmin
Rt

If the MA use monetary
targeting, the range within
which Mt achieved varies is
given by M2-M3

If the MA use interest
targeting, the range within
which MS achieved varies is
given by M1-M4
MS
MSmax
Rt
MDmax
MD

MDmin
M1 M2
M*
M3 M4
Mt
Hence in this case,
money targeting is
superior!

Thus, it can be conclude that:
If Md variation is greater than Ms variation, the MA
better use the interest rate targeting.
 If Ms variation is greater than Md variation, the MA
better use the monetary targeting.

**************END****************