123.Ijxsqxs2MChapter 2

8/7/2019 123.Ijxsqxs2MChapter 2

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Monetary Economics

Basic Concepts

Chapter 2

Main Text Book:

Monetary Economics Theory and Policy by

Bennett McCallum

Maxwell Macmillan Internation Editions, 1989


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Introduction

Motivation:

The course will help develop theoretical

and analytical skills to understandmonetary models and policies and their

effects on real variables.


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Introduction

Definition: Monetary economics investigates the

connection between

- real economic variables (such as real output,real interest rate, employment, real exchangerate) AND

- nominal variables (such as inflation rate,nominal interest rate nominal exchange rates,supply of money)


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Introduction

Nature of monetary issues:

Monetary theory is therefore is related with

- determination of nominal variables

- their movements over time

- their influences on real variables and

- any effects of the actions of monetary authoritieson real aggregate variables

(level of employment and or output)


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Introduction Monetary economics considerably overlaps with

macroeconomics but is not same especially after

seminal work of Lucas(1972) which provided

theoretical models of economic fluctuations in

which money was the fundamental factorbehind movements in real output (Business

Cycles)

During 1980s &1990s reals business cycle (BC)

models focused on nonmonetary factors as the

deriving forces of BC and led to separation of

monetary economics from macroeconomics.


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Functions of Money

Three functions of money are;

1) Medium of exchange 2) Medium of account

3) Store of value


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Functions of money

1) Medium of Exchange:(Characteristics of Money)

Barter of Goods & Services: (Direct exchange of goods/s)

Assuming each individual produces one good,

individuals in a society need to directly exchange the

goods they produce for others for their consumption.

Direct exchange of goods for consumption is costly as itrequires Double coincidence of wants and is time

consuming.


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Functions of money

Using Medium of Exchange: (Monetary Exchange)

A certain durable and transportable commodity

is generally accepted in exchange of any other good.

This commodity is referred to as the economys

medium of exchange.

- reduces cost and time of shopping so

- individuals are now able to use their released

time and energy to produce grater quantities

of goods & serv.


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Functions of money

This special commodity which is used as

medium of exchange is called MONEY

Money facilitates transactions and thus

individuals can enjoy greater quantities of

goods/s. or leasure time.

Presence or absence of monetary exchange hasimportant effects on the equilibrium quantities of

the economy.


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Functions of money

NOTE: Monetary commodity does not have tobe intrinsically valuable (desirable for

consumption or useful in production)

Monetary money can be paper tokens all

matters is that it has to be generray acceptable

as medium of exchange.


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Functions of money

2) Medium of Account:In an economy where there N number of commodities

there are N(N-1)/2 relative prices of goods in terms of

each other for each pair of goods for exchange.

i.e For 100 goods, number of relative prices is 4,950.

With money, prices of goods are expressed in terms of

money only (a common unit of account) and thus need

to know only 99 money prices.

Note: This role can be given to some other good.


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Functions of money

3) Store of Value:Saving part of income can be made by holding

money for future consumption, thus storing

value over the period. There are many other assets that serve as store ofvalue: bods, stocks, real estate etc.

Money is inferioras a store of value compared to these

assets as it pays no interest to its holdereven when

prices are unchanged.

So, there is less tendency to hold money in times of

inlation.


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2.2 Empirical Measures:

At present, the principal medium of exchange is

- currency ( paper notes and coins)

- checkable deposits at banks and other financial

institutions

Centrals banks publish statistics on measures of

money supply, M1 which reflects the medium ofexchange concept of money.


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Measures of Money

Components of M1:- currency

- sight deposits

- other checkable deposits

- travellers checks

NOTE: M1 does not include credit card transactions. Acredit card purhase is not a transfer of medium of

exchange, rather it is a prenegotiated right to borrowfrom and repay the credit card company. Credit cardarrangements reduce the quantity of medium ofexchange.


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Measures of Money

A larger measure of money M2 includes;

- M1 plus- savings account deposits

- small denomination time deposits

- money market mutual funds (MMMF)

- overnight repurchase agreements (REPO)


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Measures of Money

Largest measure M3 includes;

- M2 plus- larger denominatrion of time deposits.

M3 is the least liquid measure of money.


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Measures of Money

Monetary Base: (High powered money)This measure is less inclusive even compared to

M1 but is important for analytical purposes.

Monetary Base includes;

- currency outside banks

- bank reserves (currency held by banks and

banks deposits with the central bank)


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Measures of Money

Monetary base is a determinant of the

quantity of M1.

If central bank takes an action that

increases the monetary base, this will lead

to an increase in M1. The process is not

mechanivcal, will be introduced in Capter

4.


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Measures of Money in Turkey

M1 consists of;

- Currency in circulation (bank notes and coins

and Bank vaults)- Sight deposits at banks and the central bank.

M2 includes

- M1 plus times deposits with banks and thecentral bank


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M3 includes;- M2 plus REPOs and money market

funds.

Monetary base includes;

- currency

- deposits of banking sector (required reserves &

free deposits)- Extra budgetary funds

- deposits of non-bank sector


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After 1989, Turkey is adopting the use of central bank

money (CBM) as an aggregate for monetary base where

CBM = currency + required reserves and freedeposits of depository bank with the CB

+ extra budgetary funds + deposits of non

bank sector with the CB + net liabilities

arising from open market operations

+ public deposits at the central bank.


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2.3 Monetary Standards: Fiat vs Commodity

Money

The currency used at our time is Fiat money,

money by arbitrary order of decree (notes and coins

are much more valuable than the material they are

made of.)

These items of currency do not constitute claims on

gold or any other precious metal.

this brings the distingtion between fiat money

and commodity-money systems.


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Monetary Standards: Fiat vs Commodity

Money

Commodity-money system:

Medium of exchange (and medium of account)

is a good that is valuable even if it is not used as

money.

In this system, value of money (inverse of the

price level) is the price of the good whoseproduction is costly (determined by demand and

supply).


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Money

Commodity-money system: In full competitive equilibrium condition,value of

the monetary good equals the marginal cost

(MC) of producing that good. Thus the price

level is determined by technological constraints.

In such systems, commodity money itself does

not have to circulate as a medium of exchange,instead paper token will circulate.

Ex. International Gold Standard used till 1914


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Money

Fiat Money System:

Circulating money is paper money with low costof production and low value in non-monetary

uses. It does not represent claims to other

commodities of values. The quantity of fiatmoney is controlled by the monetary authorityin

the economy as to keep the purchasing power ofa unit of money very high relative to its cost ofproduction.

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123.Ijxsqxs2MChapter 2