Chapter 5
Money is for Lunatics
Demanders and
Suppliers of Money
LEARNING OBJECTIVES
 Functions of money
 Four forms of money
 Money creation by the Bank of Canada and
chartered banks
 Relate bond prices and interest rates and explain
how money and bond markets determine the
interest rate
 Differentiate the “Yes” and “No” camps’ positions
on the monetary transmission mechanism
IS IT SMART TO NOT WANT MONEY?
DEMAND FOR MONEY
People demand money for its liquidity as a medium of
exchange, unit of account, store of value. People willingly
give up interest on bonds to hold wealth as money.
DEMAND FOR MONEY
Money
anything acceptable as means of payment; money has
three functions
a) medium of exchange
acceptability solves barter problem of
double coincidence of wants
b) unit of account
standard unit for measuring, comparing prices
c) store of value
time machine for moving purchasing power
from present to future; earn now, spend later
Bond
financial asset where borrower promises to repay
original value, and make fixed interest payments
Why hold wealth as money which pays no
interest, rather than as bonds which pay interest?
 money provides liquidity —
assets easily convert into medium of exchange
 money is most liquid asset —
acceptable by sellers as means of payment
 money pays no interest, but has liquidity;
bonds pay interest, but do not have liquidity
Why hold money as a store of value?
“Yes” camp
hold more wealth as interest-paying bonds,
since savings safely invested in loanable funds
(bonds)
“No” camp
hold more wealth as money because
fundamental uncertainty about future makes
bond investments risky
Interest rate
price of holding money;
what you give up by not holding bonds
 determined by demand and supply in both
money and bond markets
Law of demand for money
as the price of money — interest rate — rises,
quantity demanded of money decreases
Fig. 5.1
Macroeconomic Demand for Money
Price
Quantity Demanded
(interest rate)
(billions of dollars)
2%
100
4%
90
6%
80
8%
70
10%
60
Changes in real GDP or average prices cause
change in demand for money
 increase in real GDP increases demand for
money; decrease in real GDP decreases
demand
 increase in prices increases demand for
money; decrease in prices decreases
demand
Fig. 5.2: Macroeconomic Demand for Money Before and
After Real GDP Increases
Price
Quantity Demanded (QD)
QD after Real GDP
(interest rate)
billions of dollars)
Increases
(billions of dollars)
2%
100
200
4%
90
180
6%
80
160
8%
70
140
60
120
10%
SUPPLY OF MONEY
Forms of money
a)commodity money —
saleable product with alternative uses
b)convertible paper money —
paper money converted into gold on demand
c) fiat money — currency (government-issued
paper bills and coins) with no alternative uses,
valuable simply by government decree
d)deposit money — demand deposits —
balances in bank accounts depositors withdraw
on demand using debit card or cheque
Fig. 5.3 The Money Supply
BILLIONS OF $
OTHER
DEPOSITS
Supply of money is currency
and deposit money
M2
$951 b
M1
DEMAND
DEPOSITS
M1 = currency in circulation
and demand deposits
M2 = M1 plus all other less
liquid deposits
$465 b
CURRENCY IN
CIRCULATION
continued…
Bank of Canada is Canada’s central bank —
government institution responsible for
supervising chartered banks and financial
institutions and for regulating the supply of
money
Bank of Canada roles
 issuing currency
 banker to chartered banks — chartered banks
pay each other with deposits at Bank of Canada
 lender of last resort — making loans to banks
to preserve stability of financial system
 banker to government — managing government
accounts, foreign currency reserves, national
debt
 conducting monetary policy — changing money
supply and interest rates
 Chartered banks create money (demand
deposits) because of fractional reserve banking —
banks hold a fraction of deposits as reserves
 Banks face a tradeoff between profits and
prudence
– smaller fraction of reserves, more loans,
and higher-risk loans may yield more profits
 Supply of money determined by Bank of Canada
and chartered banks
– quantity of money supplied is a fixed amount
at a moment in time
– supply of money does not change when
interest rate changes
continued…
Fig. 5.4 Chartered Banks: Sources and Uses of Funds
$ billion
(August 2009)
Percentage
of deposits
1925.3
169.0
1139.1
100.0
786.2
69.0
6.2
0.5
Liquid assets
319.4
28.0
Securities and other assets
169.8
14.9
1429.9
125.5
Total Funds
Sources
Deposits
Borrowing and own capital
Uses
Reserves
Loans
Fig. 5.5
Supply of Money
Price
Quantity Supplied
(interest rate)
(billions of dollars)
2%
80
4%
80
6%
80
8%
80
10%
80
WHAT IS THE PRICE OF MONEY?
INTEREST RATES, MONEY, AND BONDS
Bond prices and interest rates are inversely related
and determined together in money and bond markets.
MONEY AND BONDS
a) Interest rate is the price of money
– opportunity cost of holding money
– cost of borrowing money
b) Bonds promise to pay back original value plus
fixed dollar amount of money
– bonds do not promise fixed interest percent
– when interest rates rise, market price of
bond falls, vis-à-vis
– holding a bond until maturity, you receive
fixed dollar payments plus original value
Fig. 5.6 Macroeconomic Demand and Supply for Money
Price
Quantity of Money
Quantity of Money
(interest rate)
Demanded
Supplied
(billions of dollars)
(billions of dollars)
2%
100
80
4%
90
80
6%
80
80
8%
70
80
60
80
10%
Interest rate determined by demand and supply
in money and bond markets
 at market-clearing interest rate, quantity of
money demanded equals quantity of money
supplied
 when interest rate below market-clearing rate,
excess demand for money; people sell bonds to
get money; increased supply of bonds causes
bond prices to fall, interest rate to rise
 Many different interest rates on financial assets,
but most interest rates rise and fall together
continued…
J.B. SAY AND J.M. KEYNES AS FACEBOOK FRIENDS?
MONEY, INTEREST RATES, INVESTMENT, & REAL GDP
“Yes” and “No” camps disagree about money’s effect on the
frequency of business cycles and on how quickly markets adjust.
MONEY AND BUSINESS CYCLES
Does money affect key macroeconomic
outcomes of real GDP per person,
unemployment, inflation?
– money can affect inflation, according to
quantity theory of money
– money does not directly increase aggregate
supply or economic growth
continued…
Money indirectly affects real GDP and unemployment
through monetary transmission mechanism —
how impact of money transmitted to real GDP
– demand & supply of money determine interest rate
– when interest rate falls, interest-sensitive
purchases become cheaper so consumer spending
(C) and business investment spending (I) increase
– increases in C and I increase aggregate demand
continued…
Fig. 5.7 Transmission
Mechanism from
Money Demand and
Supply to Real GDP
 lower interest rates are positive demand shock,
increasing aggregate demand, increasing real GDP,
decreasing unemployment, causing inflation
 higher interest rates are negative demand shock,
decreasing aggregate demand, decreasing real GDP,
increasing unemployment, causing deflation
continued…
Economists disagree on the question “How much
does money change the economy when economy is
not in equilibrium?”
 Say and “Yes, markets quickly self-adjust” camp
answer “not much.”
o money does not affect external supply shocks
that are main source of business-cycles
o money allows savings to flow easily through
loanable funds market for business borrowing,
for investment spending
o money helps quick adjustments to equilibrium
continued…
 Keynes and “No, markets fail to adjust”
camp answer “a lot”
o money gives people a way to save, creating
possibility of financial crises and new internal
demand shocks for business cycles
o money gives people a way not to spend, blocking
transmission mechanism so loanable funds market
does not match spending to savings
o money slows market adjustments to equilibrium
Fig. 5.8 How Much Does Money Matter for Business Cycles?
Camp
Compared to a
barter economy,
how does money
affect:
Yes — Left Alone,
Markets Quickly SelfAdjust (Say)
No — Left Alone,
Markets Fail to Adjust
(Keynes)
How Often Business
Cycles Happen
Money has no effect.
Money does not affect
external supply shocks
that are main source of
business cycles.
Money creates new
shocks.
Money gives people
a way not to spend,
adding new internal
demand shocks.
How Quickly
Markets Adjust
Money helps loanable
funds market quickly
adjust to equilibrium.
Money blocks
transmission
mechanism, slowing
adjustment to
equilibrium.