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 valuePage 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 X X X

Deposits with an agreed maturity up to 2 years

  X X

Deposits redeemable at a period of notice up to 3 months

  X X

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 theoriesPortfolio theories

emphasize “store of value” function relevant for M2, M3 not relevant for M1. (As a store of value,

M1 is dominated by other assets.)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/Vwhere 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. by the level of transactions generated by the

level of nominal income PY and 2. 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 and notations:Household expenditure at time t is Y (=C.P)

C is quantity of goods and services consumed and P is their price

All purchases are evenly spread over the periodAll 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.

N = 1

Y

Money holdings

Time

1

Average = Y/ 2

Money holdings

Time11/2

Average = Y/ 4

Y/ 2

Y

N = 2

Average = Y/ 6

1/3 2/3

Money holdings

Time

1

Y/ 3

Y

N = 3

In general, households’ average money holdings = Y/2N

Foregone interest = Rt (Y/2N ) Cost of N trips to bank = F N

Thus,

Given Y, i, and F, consumer chooses N to minimize total cost

)(2

FxNN

YxRCostTotal t

M= Y/ 2N

Finding the cost-minimizing N

N

Cost Foregoneinterest =iY/2N

Cost of trips= FN

Total cost

Take the derivative of total cost with respect to N, set it equal to zero:

Solve for the cost-minimizing N*

This is the cost minimizing value of N

)(2

FxNN

YxRCostTotal t

02 2

FN

YRt

F

YRN t

2

To obtain the money demand function, plug N* into the expression for average money holdings:

Money demand depends positively on Y and F, and negatively on R.

R

YFHoldingMoneyAverage

2

The Baumol-Tobin money demand function:

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

),,(2

FYRLR

YFM d

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/Ddepends on regulations & bank policies

Currency-deposit ratio, cr = C/Ddepends on households’ preferences

SOLVING FOR THE MONEY SUPPLY:

M C D C D

BB

m B

C DC R

1crcr rr

C Dm

B

where

C D D D

C D R D

m is called the money multiplier Note: If rr < 1, then m > 1

1crm

cr rr

Thus,

THE MONEY MULTIPLIER

the money multiplier (m), is the increase in the money supply resulting from a one-dollar 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 policy1. Open-market operations2. Reserve requirements3. 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: most frequently used.

Changes in reserve requirements: 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

kt and cr can be assumed exogenous to the MA Thus,

),,( ttrt rkcfB

M

)(

),,(

t

ttrt

rf

rkcfB

M

Money demand on the other hand is

In practice, however, the expected value may not be the correct figure. So, there is always a problem in using expected values.

)(,

)(,

),(

*

t

tete

t

t

t

tt

t

t

ttt

t

B

MfYL

p

M

B

MfYL

p

M

RYLp

M

Hence, the MA has two problems: Their expectation of Md may not be exact

Because it depends on Ye and Pe

The targets can not be achieved even when the government try to supply Mt

*

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? Which of the instrument is superior depends on

the nature of error made by MA Note that:

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

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!

Case-1: MA makes a larger mistake in predicting Ms than Md

MSmin

MSmax

MS

MDmax

MDmin

MD

Mt

Rt

Rt

M1 M2 M* M3 M4

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

Hence in this case, money targeting is superior!

Case 2-MA makes larger error in predicting Md than Ms

M1 M2 M* M3 M4

MSmax

MSmin

MS

MDmax

MDmin

MD

Mt

Rt

Rt

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****************