Reflective Exercise: Money –just another good?
1
Scenario
What is meant by the money market? Can it be analysed in the same way as the
market for any other good? What happens in the money market if there is an
increase in income? Does this depend on whether a Monetarist or Keynesian view is
taken? This exercise examines these aspects.
Section 1: Setting the framework for investigating this question
A
Why do people need money?
Tick however many of the following you think appropriate
a
To buy things like food, beer and haircuts.
b
Because what we have in money determines our wealth.
c
So that we can replace important things that are broken or lost
quickly and easily.
feedback page 4
B
Tick however many of the following you think appropriate
As a student, when you graduate and get a job your income will
rise and you will demand more money in order to spend more.
For many students their money demand is their student loan.
Income is what we get paid over a certain period of time – over a
week, month or per term – whereas our money is what we have in
notes and coins or in a bank account at a particular time.
The quantity of money is the amount of notes and coins issued.
The quantity of money is the amount of notes and coins in
circulation and certain types of bank deposits.
What I have in notes and coins and in my bank account today is
my income.
What I have in notes and coins and in my bank account today is
my money balance.
feedback page 4
C
Tick however many of the following you think appropriate
In examining the money market we will start by considering
demand, supply and equilibrium as these are important in any
market.
In examining the money market we will start by considering
demand, supply and disequilibrium.
Whether we use demand and supply will depend on whether we
are taking a Monetarist or Keynesian view.
feedback page 4
a
b
c
d
e
f
g
a
b
c
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
2
D
Tick however many of the following you think appropriate
If there is inflation we will have to hold more money to purchase
the same amount of goods and services because of the higher
prices.
In considering the quantity of money we are concerned with the
quantity of goods, services and assets that the money will buy.
The quantity of money we are concerned with is the amount of
money held, adjusted for changes in the price level, which is
known as real money balances.
The quantity of money we are concerned with is the money held,
which is known as nominal money balances.
feedback page 4
E
Tick however many of the following you think appropriate
Since we measure the price of other goods in terms of money, it
cannot have a price itself.
The price of money is the opportunity cost of holding money.
If interest rates rise some people may shift money from their
current accounts into other forms of savings.
If inflation rises then some people will buy things like cars and
houses with their money before it loses more value.
feedback page 5
a
b
c
d
a
b
c
d
The money market
Now draw a demand and supply diagram with the normal demand and supply
slopes and label the axes for the money market. Use the diagram to show the effect
of an increase in income on the money market. Then answer the following:
F
a
b
c
d
Using your diagram, tick however many of the following are correct
The demand for money will increase and the interest rate will fall
and the real quantity of money will rise.
The demand for money will increase and the interest rate will rise
and the real quantity of money will rise.
The demand for money will decrease and the interest rate will fall
and the real quantity of money will fall.
The demand for money will decrease and the interest rate will rise
and the real quantity of money will fall.
feedback page 5
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
3
.
Section 2: Keynesian and Monetarist views
Distinguish which of the propositions below reflect Keynesian views and which
Monetarist views.
(a) `Money is not a close substitute for financial assets. Hence changes in the rate
of interest will have little effect upon money demand. The liquidity preference curve
(demand for money) is thus relatively inelastic.'
Monetarist
Yes / No
Keynesian
Yes / No
(b) `Money and financial assets are relatively close substitutes for each other. Thus,
as interest rates rise, so will the demand for financial assets. Consequently the
demand for money will fall significantly. The liquidity preference curve (demand of
money) therefore is relatively elastic.'
Monetarist
Yes / No
Keynesian
Yes / No
Redraw the diagram from section 1D in an appropriate way given first (a) and
then (b), and explain how the answer to 1D would be amended in each case.
Continue on anther sheet if needed…
feedback page 6
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
4
Feedback Section 1: Setting the framework
Now review your answers in the light of the economists’ approach below. Were your
answers the same? If not, why not?
A
We receive our income in money and use this to spend on goods and services, so
(a) is correct (the transactions motive). If we are sufficiently wealthy, most of us also
keep some money by in case we need to replace quickly things that break down or
get lost, so (c) is correct (the precautionary motive). However, how wealthy we are
depends on ownership of things like houses, cars, companies, shares etc. Money is
only a very minor way of holding wealth – indeed, if we keep too much in money it
will reduce our future wealth because money earns little or no interest and falls in
value with inflation. Therefore (b) is not true.
B
The most important function of money is as a medium of exchange. We receive
our wages (or student loans) in money and pay using money for goods and services.
If our incomes increase, so will our demand for money, so (a) is true.
However, this does not mean that money and income are the same thing. Income
is a flow measured over time – we receive a certain income per week or month or
per term; while the amount of money we have is a stock, that is it is known at a
particular point in time – it is the amount of notes and coins we have in our
possession and the amount we have in certain bank accounts at a particular date.
Some students, for instance, may spend nearly all of their money in the first few
weeks of term and have little in the bank; their level of monetary balances is very
low at that point. Thus (c), (e), and (g) are correct while (b) and (f) are not.
C
Economists analyse markets in terms of demand, supply and equilibrium. This is true
of the ‘money market’ as well as the market for other goods and services, although
there may be particular features of this market that are different and affect the
outcomes. We start this exercise by considering how we can consider money in a
standard demand and supply framework as this is the most familiar to us, before
going on to consider particular features under different schools of thought. (a) is
correct.
D
If inflation increases we will have to pay more for goods and services in general and
will need to hold more money to pay for these. Money, as well as being the means
of exchange, is the unit of account – how we measure the prices of other goods
and services.
However, in demand and supply analysis we do not want to measure the quantity of
money without taking out the effect of inflation. We want to measure the quantity
of money in terms of the quantity of goods and services it will buy. (We use the idea
of a ‘basket’ of goods, by which we mean the large variety of goods that we buy on
average.) Thus (b) and (c) are correct. The quantity of money is known as ‘real
money balances’ and is usually symbolised as M/P (where M is nominal money
balances and P is the price level).
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
5
Feedback Section 1: Setting the framework (cont)
E
If we keep money in our bank account it means that we are not keeping our wealth
in other ways, for instance in other financial assets (stocks and bonds) or in real
assets (houses, cars, etc). We have an opportunity cost of holding money from
considering these alternatives. This is often measured by the interest rate on an
alternative financial asset – if we keep our wealth in money we forgo this return. If
inflation is high that is an alternative measure. Thus (b), (c) and (d) are correct.
F The money market
An increase in income will increase the demand for money as we will want to use
more money to buy additional goods and services with our extra income. This
moves the demand curve for money to the right (the same as increases in income
for any normal good in demand and supply analysis). This means that the interest
rate rises and the real quantity of money increases as in the diagram below: (b) is
correct.
Interest
rate (r)
S
r2
r1
D2
D1
(M/P)1 (M/P)2
Real money balances
(M/P)
Reflection In your explanation:
1.
Did you identify the correct diagram?
2.
Did you correctly label the axis and the curves?
3.
Did you get the shift correct?
Copyright: Embedding Threshold Concepts Project
Yes
Partly
No
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
6
Feedback Section 2: The approach of economics
Distinguish which of the propositions relate to Keynesian/Monetarist views
(a) Monetarist
(b) Keynesian
How do we draw the diagrams to show the two cases?
There are differences in how Keynesians and Monetarists view the supply of money,
but here we concentrate on the demand for money and keep a standard sloped
supply curve that is the same in each case in the diagram.
We amend the diagram in section E by:
* comparing the two cases with the monetarist’s unresponsive (inelastic) demand.
This is shown as steeper than the Keynesian responsive (elastic) demand (which
assumes the graphs are on the same scale). The more inelastic the demand curve
the less a particular change in the interest rate will affect the demand for real
money balances.
*The increase in income will shift in demand and is shown by the same rightward shift
in both cases (shown by the arrow).
Keynesian (b)
Monetarist (a)
Rate of
interest
Rate of
interest
D1
D2
S
S
r2
r1
r2
r1
D2
D1
(M/P)2
(M/P)1
(M/P)2
(M/P)1
Real Money
Balances
Real Money
Balances
What are the resulting effects?
The resulting changes in the interest rate are very different:
(a) In the Keynesian case the increased demand from the increase in income is
offset by only a small increase in interest rates. The elastic demand for money
means that a small rise in interest rates, from r1 to r2, greatly reduces the quantity of
money demanded to restore equilibrium.
(b) In the Monetarist case the change in the interest rate is relatively large since the
increase in demand from the increased income is only made equal to the supply of
money by a large increase in the price of money (the interest rate), from r1 to r3 since
it is relatively inelastic.
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
Reflection
1.
2.
3.
4.
5.
7
Yes
Partly No
Did you correctly illustrate the difference in the
elasticities of demand of money on the diagrams?
Did you show the same rightward shift in the
demand curve for comparison?
Did you show the effect of the change in income on
the interest rate?
Did you use the diagram in your explanation?
Do you understand why equilibrium is important in
answering this question?
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Money –just another good?
8
Notes for lecturers
Objectives of the exercise and prerequisites
Learning Focus: Developing an understanding of the money market. The exercise
starts by encouraging students to think of the money market in a standard demand
and supply framework. It covers aspects of the money market that cause students
problems: stocks/flows, real/nominal and the ‘price’ of money. It goes on to
consider some of the differences in the demand for money given Keynesian and
Monetarist views. (Section 1 of the exercise can be carried out independently of
Section 2.)
Threshold Concepts that are important to this learning are incentives, opportunity
cost, elasticity and economic modelling.
Prior Knowledge Required
Students need to be familiar with demand, supply and for section 2, elasticity.
The exercise can be used to introduce the money market or to reinforce
aspects covered in lectures.
Sequencing and timing
1.
With this exercise, the feedback to section 1 parts A, B, C, D and E is
better given to students before they attempt section 1 part F. Students
need the correct diagram in section 1E before going on to section 2 and
it may be useful to encourage them to complete the feedback after this
section to ensure their understanding of the diagram before proceeding.
2.
The completed feedback to section 1 should be given before students
attempt section 2.
3.
At the start of section 2 students are asked to distinguish Monetarist and
Keynesian positions and it is important they can do this before
proceeding. We suggest that this is covered verbally in the class.
4.
The exercise will take around 45 minutes to complete.
5.
Although our reflective exercises have usually been designed so that it is
necessary to complete section 1 and 2, in this case it is possible to get
students to complete section 1 only if you do not want them to go on to
the Keynesian/Monetarist differences.
Copyright: Embedding Threshold Concepts Project
21/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.