Chapter III

Modern Measures of Money

According to Lloyd B.
Thomas in his book
Money, Credit and
Financial Markets, today’s
industrial nations employ
fairly standard measures
of money that include the
volume of currency in
circulation and the volume
of deposits at any point in
time.
The Narrow Definition of Money
• Emphasizes the medium-of-exchange function

• Includes only currency in circulation and other money

equivalents that are easily convertible into cash
 physical money

 demand deposits

 checking account

 traveler’s check

 and Negotiable Order of Money (NOW) accounts.

 Negotiable Order of Withdrawal
(NOW) account

Interest bearing savings account on which limited number

of checks may be written
 Broader Measures of Money :
M2, M3
 Emphasizes store-of-value function money

 includes M1 plus all other depositor accounts that can be

readily converted to “near cash” and “near, near cash”
Weighted Measures of Money
Money measures place more weight on items
that strongly influence aggregate
expenditures.
INFLATION

 Inflation is a sustained increase in

the price level of commodities.

 ↑ prices and ↓purchasing power

Criteria of Inflation
 Whenever money supply or the level of credit
increase by more than 15%, which is a normal
increase

 Whenever the level of price index number is

more than 10%
Disadvantages of Inflation
• It is unfavorable for the fixed income group

• It may induce recession in the economy

• It disrupts debtor-creditor relationship

DEFLATION

• Decline in the general price level as a

result of undersupply of money

• ↓ prices and ↑ purchasing power

Disadvantages of Deflation

• Deflation induces curtailment in

production and activities of business
firms

• It may cause a depression in employment

and consequently a loss in purchasing
power
Aggregate demand-Aggregate supply model

 Use to explain short-run fluctuations in

economic activity around its long-run trend
 Price ( P )
Aggregate
supply
P2

Equilibrium
price

P3
Aggregate
demand

Equilibrium
Y2 quantity Y3 Quantity of output
( Y)
AGGREGATE DEMAND CURVE
 the relationship between the nation’s
price level and the amount of real output
demanded.
Why Aggregate Demand is
downward sloping ?
• The Price Level and Consumption:
The Wealth Effect
• The Price Level and Investment
• The Price Level and Net Exports
 AGGREGATE DEMAND
Consists of four components
Y= C + I + G + NX

Y = total demand for domestic output

C = Consumption spending by households
I = Investment spending
G = Government purchases
nX = Net exports
CONSUMPTION
• Determinants of consumer expenditures ( C )

• Shifts the AD curve rightward

 A reduction in income taxes

 An increase in stock and bonds prices
 Lower interest rates
 Increase in consumer confidence
INVESTMENT
 Shifts the AD curve rightward
 Lower interest rates stimulate investment
 Boosting in investment expenditures
 Providing capacity to meet future market
demand
 Tax policy toward business
GOVERNMNET PURCHASES ( G )

 Purchases of goods and services

 does not include government outlays for social

security
Net export ( X – M )

 Foreign exchange rate, income in foreign

nations, government income, and other
factors influence net exports (X-M).

 Value of exports – value of imports

 SUPPLY CURVE
 relationship between the nation’s
price level and the amount of
output firms collectively desire to
produce, other factors remaining
constant.
Price ( P ) A rise in the price level causes an
expansion of AS Aggregate
supply
P2
It is upward
sloping
because
P1 higher
prices make
output more
P3 profitable
and enable
business to
expand their
production

Quantity of output
( Y)
 Why Aggregate Supply is
upward sloping ?
 The Misperception Theory
 Sticky- Wage Theory
Aggregate Supply
• defined as the total supply of goods produced and supplied by an
economy’s firms over a period of time. It includes the supply of a
number of types of goods and services including private consumer
goods, capital goods, public, and merit goods and goods for
overseas markets.

Aggregate Supply Curve

• shows the quantity of goods and services that firms
choose to produce and sell at each price
Factors that shift the aggregate supply curve
Capital Deepening
-a situation where the
Labor Capital capital per worker is
increasing in the economy
↑ Labor, ↑ AS ↑ Capital, ↑ AS
1. Quantity of
Ex. A newspaper
Inputs company has 30
Raw Materials Natural Disaster employees. The
↑ Raw Materials, ↑ AS ↓AS company decides to
switch the people deliver
in the paper from bikes
to cars to speed up
delivery time and get
money faster.
Factors that shift the aggregate supply curve

2. Prices of 3. Technological
Improvements in
Inputs Supply of goods is Change
technology
negatively related
increase the
to the price of the
amount of output
inputs used to
the workforce can
make that good.
produce.
The aggregate supply
curve is upward sloping
in the short-run because
of the factors mentioned
above but in the long-run,
it is vertical at the natural
rate of output.
Natural rate of output is the level of output
corresponding to natural unemployment rate. Natural
unemployment rate is defined as the lowest rate of
unemployment that could be sustained without
producing an acceleration of the nation’s inflation rate. It
is the unemployment rate an economy normally
experiences but doesn’t correspond to a rate of zero. This
is also referred to as full employment output level (YE).
Full employment output level must be distinguished
from the equilibrium output level (YF).
When recessionary gap
exists, equilibrium
output level falls short
of full employment
output (YEYF). This
may call for simulative
measures in order to
shift aggregate
demand curve.
When experiencing
inflationary gap, equilibrium
output exceeds the full
employment output level
(YFYE). Such situation may
call for a restrictive action on
the part of the monetary
authorities to shift aggregate
demand curve to the left.
Stabilization Policies

An increase and decrease

Monetary in the money supply will
ultimately lead to ADC
Policy shifting to the right and
left respectively.

An increase in government
purchases or cut in taxes
shifts ADC to the right. Fiscal
A decrease in government
purchases or an increase in
Policy
taxes shifts ADC to the left.
 THE DILEMMA POSED BY ADVERSE
AGGREGATE SUPPLY SHOCKS
A supply shock is an event that directly affects
firms’ costs of production and thus the prices they
charge; it shifts the economy’s aggregate supply
curve.
The reduction in supply as
represented by the leftward
shift in the aggregate-
supply curve from AS to
𝐴𝑆1 . Output falls from Y to
𝑌1 , and the price level rises
from P to 𝑃1 .

The combination of falling

output (stagnation) and
rising prices (inflation) is
sometimes called stagflation
Confronted with an adverse shift in aggregate supply,
policymakers face a difficult choice between fighting
inflation and fighting unemployment. If they contract
aggregate demand to fight inflation, they will raise
unemployment further. If they expand aggregate demand to
fight unemployment, they will raise inflation further. In
other words, policymakers face a less favorable trade-off
between inflation and unemployment than they did before
the shift in aggregate supply. They have to live with a higher
rate of inflation for a given rate of unemployment, a higher
rate of unemployment for a given rate of inflation, or some
combination of higher unemployment and higher inflation.
The theory of the Value
of Money
Demand for Money
 The demand for money is the desired holding of financial
assets in the form of money: that is cash or bank deposits. It
can refer to the demand for money narrowly defined as M1,
or for money in the broader sense of M2 or M3.
 Lloyd B. Thomas says that the value of money is measured
by what a unit of money will buy in terms of a representative
group of economic goods.
 It is a customary approach in the study of the theory of the
value of money by examining price.
 The concept of the value of money is not simple rather, it is
dependent whose money one is talking about.
The Velocity of Money
The velocity of money refers to the rate
of turnover of money or the frequency of
spending money.
It results from people's desire to hold
money. When the money is held — not
spent or invested — then it does not
contribute to the velocity of money.
Determinants of Velocity of Money
1. Institutional factors that underlie the synchronization
between receipt and expenditure
Institutional considerations such as: frequency of paydays;
payment habits; price and employment behavior; investment
opportunities; the use of credit cards, are determinants for and
velocity of money.
Example. More frequent paydays gives the
opportunity to spend more money thus velocity of
money increases and stops them from holding
money or borrowing money since they have more
sufficient fund to finance their needs thus demand
for money decreases.
Determinants of Velocity of Money
2. The state of financial technology.
Financial technology comprising of availability of substitutes for
money and the cost involve in using those money as well as
technical mechanisms developed by banks allow individuals and
firm to hold less money.
Example. Technology can reduce the demand for
money by reducing the cost or time to convert assets
into a means of payment. For instance, if a bank
provides an electronic method of transferring funds
from your savings account into your checking
account, then you will tend to hold less money in
your checking account so that you can earn more
interest.
Determinants of Velocity of Money
3. Interest rate levels
When interest rates rise, demand for money decreases and the
rate of turnover of money increases that is because the demand
for and velocity of money are inversely proportional.
Example. If there is an increase for interest rates people will stop
borrowing from banks since it would be burdensome for them to pay an
obligation with a high interest thus demand for money decreases. Also,
it is logical, because as the interest rate rises, rather than holding money
people will try gaining advantages from the high interest rate. Hence,
the reduction in average holding of money causes the velocity of money
to rise. Basically, if the rise in interest rate reduces the real money
balance relative to the volume of personal consumption (spending), then
the velocity increases.
Determinants of Velocity of Money
4. Economic uncertainty
Money is the safest of all assets in the sense that its nominal value
remains constant no matter what happens in the economy.

Example. If there are reported economic

uncertainties, investors tend to sell their stocks and
prefer to hold money resulting to an increase on the
demand for money. On the contrary, if there is an
improvement on public confidence, people become
more interested in holding other assets than money
and investments will increase resulting to an increase
on the velocity of money
Determinants of Velocity of Money
5. Inflation expectations
Inflation reduces the real value of money at a rate equal to the
difference between the annual inflation rate and the interest paid
on money.
Example. If the inflation rate I is running at 15% a year
and the interest rate is 10% the real value of money
depreciates at a rate of 5% per year. To escape inflation
tax people will reduce their demand for money. When
there is hyperinflation the value of money depreciates
rapidly so people get rid of money quickly by spending
it on holding other assets resulting to a decreasing
demand for money and increasing velocity.
Determinants of Velocity of Money
6. Income level
 On an economists’ view of money as a luxury good, an increase
in income may boost the demand for money because it is likely
to increase the value that one puts on leisure time to
accommodate higher expenditure.
 On the other hand, there are “economies of scale” in cash
management that helps to finance double of expenditure with
less money when doubling of income occurs.
 We can say that if income elasticity is:

less than one,

greater than one, long run income
higher income growth leads to
leads to a an increase on the
decrease on the velocity of money
velocity of money
 EQUATION OF EXCHANGE is an
economic equation that showcases the
relationship between money supply,
velocity of money, the price level and an
index of expenditures. It is developed by
(the most eminent American economist
of the first half of the 20th century)
Professor Irving Fisher.
 MVT =PT
M = the average money supply in existence in a given year
VT =PT/M = the transaction velocity of money- that is the number
of times the average dollar is spent.
P = the average price of the transactions that take place during the
year
T = the number of transaction occurring during the year.
MVT and PT both express the value of annual
transactions. It is just that the left side (MVT) is in terms of
the money stock and the transaction velocity of money.
The equation simply states that annual expenditure
(MVT) is equal to annual expenditure(PT). from this
equation we can get the formula in finding the velocity of
money:

𝑨𝒏𝒏𝒖𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝑷𝑻
VT = =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒎𝒐𝒏𝒆𝒚 𝒉𝒐𝒍𝒅𝒊𝒏𝒈 𝑴
Example. Suppose that in a given year
your total expenditure is 100,000 php
and during the year you maintain an
average money balance (demand
deposit plus currency) of 50,000 Php.
Find the velocity of money. The transaction velocity is
Given. PT=100,000 Php and 2/year which means an
M=50,000 Php average peso must be spent
𝑨𝒏𝒏𝒖𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 or turned over 2 times
VT = annually if an average
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒎𝒐𝒏𝒆𝒚 𝒉𝒐𝒍𝒅𝒊𝒏𝒈
𝟏𝟎𝟎, 𝟎𝟎𝟎𝒑𝒉𝒑/𝒚𝒆𝒂𝒓 money balance of 50,000
= Php is to accommodate a
𝟓𝟎, 𝟎𝟎𝟎𝒑𝒉𝒑
= 𝟐/𝒚𝒆𝒂𝒓 total transactions of 100,000
Php per year.
The Income Velocity of Money
MVY =PY
M = the average money supply in existence in a given year
VY =PY/M = the income velocity of money- that is the number of times the
average peso is spent on final goods and services per year.
P = the average price of all goods and services during the year- the average
price of all goods and services constituting GDP
Y = the number of transaction occurring during the year.

MVY stands for the aggregate

spending on the final goods and
services while PY stands for the peso
value of GDP expenditures.
If money supply changes (M), one of two things happens:
1. Velocity (VY) must change proportionally in the opposite
direction, so that aggregate GDP expenditures (MVY and PY)
remain unchanged.
If money supply decreases 10% we should increase the income
velocity of money by 10% to leave the GDP expenditures the
same.
2. GDP expenditure must move in the same direction as the
money supply.
If there is a decrease in the money supply we must lessen the
expenditures on final goods and services.
MONETARY POLICY consists of the actions of a central bank,
currency board or other regulatory committee that determine the
size and rate of growth of the money supply, which in turn affects
interest rates. Monetary policy is maintained through actions such
as modifying the interest rate, buying or selling government
bonds, and changing the amount of money banks are required to
keep in the vault (bank reserves). This will also help in the
changing behavior of the velocity of money.
FISCAL POLICY is the means by which a
government adjusts its spending levels and tax
rates to monitor and influence a nation's
economy. It is the sister strategy to monetary
policy through which a central bank influences a
nation's money supply.
▪If VY is constant, money supply is the sole determinant of the
level of nominal GDP expenditures and only its control is
needed to control GDP expenditures accurately. So if we want
to lower the GDP expenditure, the money supply should be
reduced and that is with the help of monetary policy.

▪If VY is not constant but is independent on the money supply and

is subject to reasonable good prediction, monetary policy can still
be a good method of influencing economic activity.

▪If VY fluctuates in a totally unpredictable manner, monetary

policy would be totally ineffective. The changes on money
supply by the central bank will not have an effect on GDP
prediction.
Velocity and the Demand for Money
If Philippine money supply (M) of 120 billion php accommodates
GDP expenditures (PY) of 720 billion php. The income velocity of
money is 6 per year:
GDP=PY
MVY =PY
𝑷𝒀 𝑮𝑫𝑷
VY= OR VY=
𝑴 𝑴
𝑮𝑫𝑷 𝟕𝟐𝟎 𝒃𝒊𝒍𝒍𝒊𝒐𝒏 𝒑𝒉𝒑/𝒚𝒆𝒂𝒓
VY= = = 𝟔/𝒚𝒆𝒂𝒓
𝑴 𝟏𝟐𝟎 𝒃𝒊𝒍𝒍𝒊𝒐𝒏 𝒑𝒉𝒑
 The magnitude of money balance held relative to annual GDP
is the reciprocal of the velocity of money.

𝟏 𝑴
=
𝑽𝒀 𝑮𝑫𝑷
𝟏 𝑴 𝟏𝟐𝟎 𝒃𝒊𝒍𝒍𝒊𝒐𝒏 𝟏
= = = 𝒚𝒆𝒂𝒓
𝑽𝒀 𝑮𝑫𝑷 𝟕𝟐𝟎 𝒃𝒊𝒍𝒍𝒊𝒐𝒏/ 𝒚𝒆𝒂𝒓 𝟔
The Demand for Money
𝑴𝒅
Md=kPY where k=
𝑷𝒀
Md = demand for money
K = the fraction of GDP (or PY) that the public desires to hold money
balances

▪If economy is in equilibrium, so that THE demand for money

1 1
equals to supply of money VY= and k= .
𝐾 𝑉𝑌
▪If the demand for money (Md) rises relative to GDP, income
velocity of money (Vy) will fall. If people desire to reduce their
function of annual expenditures in money (if k falls), income velocity
of money (Vy) will increase.
Motives for Holding Money

1. Transactions demand

2. Precautionary demand

3. Speculative demand
Transaction demand for money
-a measure of how much a certain people need in order to
buy goods and services they use. Generally speaking, if an
economy is wealthy, there’s a higher transaction demand for
money because people will buy more and more goods and
services.
Precautionary demand for money
-the act of maintaining desired and appropriate balances to
meet those unforeseen circumstances. We usually keep or
save funds more than the amount we expect to use in the
future and this provides a margin or error or what is known
as precautionary balances.
Speculative demand for money
-includes money balances held with the intent of “securing
profit from knowing better than the market what the future
will bring forth”.
 THE ROLE OF INTEREST
RATES IN THE DEMAND FOR
MONEY
Opportunity cost is the cost of something you give up to get something you
want.
 INTEREST RATES AND
TRANSACTION DEMAND
Transaction demand for money is likely to be significantly influenced by
interest rates.
 INTEREST RATES AND THE
PRECAUTIONARY DEMAND
When the interest rates are very high, one may be tempted to pare down
precautionary balances and keep as much wealth invested in interest-
earning assets as possible.
 INTEREST RATES AND THE
SPECULATIVE DEMAND
“Normal” rate is the level toward which the actual interest rate is expected
to gravitate.
If the current interest rate is quite lower than the anticipated rate, people
will expect an induced interest rate in the future. This relationship between
interest rates and speculative demand for money balances is known as
liquidity preference schedule.
 THE ROLE OF INTEREST RATES IN
THE DEMAND FOR MONEY
Motives for holding money partly depend on the interest rate
and its increase makes holding money most costly.
“To learn, you must love discipline;
it is stupid to hate correction.”

-Proverbs 12:1