Sheet # 4

Money and Monetary Policy

Definition of Money:
Money is anything that services as a commonly accepted medium of exchange or means of payment.
Commodities (cattle, olive oil, beer or wine, copper, iron, gold, silver, rings, diamonds and cigarettes) were
the earliest kind of money, but over time money evolved into paper currencies and checking accounts. All
these have the same essential quality: they are accepted as payment for goods and services. Each of the
above has advantages and disadvantages.

Barter System:
Barter system of exchange in which people directly trade one good for another, without using money as an
intermediate step.

The conceptual definition of Money:

Money is the standard object used in exchanging goods and services. In short, money is the medium of
exchange. But once it has become accepted as the medium of exchange, whatever serves as money is
bound to serve other functions as well.

Interest Rates: The Price of Money:

Interest is the payment made for the use of money. The interest rate is the amount of interest paid per unit
of time. In other words, people must pay for the opportunity to borrow money. The cost of borrowing money,
measured in dollars per year per dollar borrowed, is the interest rate.
Interest rates differ mainly in terms of the characteristics of the loan or of the borrower. The major
differences are:
1. Term of maturity- Loans differ in their term or maturity –the length of time they must be paid off.
The shortest loans are overnight. For example, a bank may lend funds to a firm that is expecting
payment the next day. Short-term securities are for periods up to a year. Companies often issue
bonds that have maturities of 10 to 30 years, and mortgages are typically up to 30 years in
maturity. Longer-term securities generally command a higher interest rate than do short-term
issues because people are willing to sacrifice quick access to their funds only if they can increase
their yield.
2. Risk-Some loans are virtually risk less, while others are highly speculative. Investors require that a
premium be paid when they invest in risky ventures. The safest loans in the world are the securities
of the U.S. government. These bonds and bills are backed by the full faith. They are safe because
interest on the government debt will almost certainly be paid.
3. Liquidity-An asset is said to be liquid if it can be converted into cash quickly and with little loss in
value. Most marketable securities, including common stocks and corporate and government bonds,
can be turned into cash quickly for close to their current value.
4. Administrative costs-Loans differ in terms of the time and diligence needed for their oversight
and administration. Some loans simply require cashing interest checks periodically. Others, such
as student loans, mortgages, of credit-card advances, require ensuring timely payments. Loans
with high administrative costs may command interest rates from 5 to 10 percent per year higher
than other interest rates.

1
Money’s Function:
1. By far the most important function of money is to serve as a medium of exchange. Without
money we would be constantly roving around looking for someone to barter with. We are
often reminded of money’s utility when it does not work properly, as in Russia in the early
1990s, when people spent hours in line waiting for goods and tried to get dollars or other
foreign currencies because the ruble ceased functioning as an acceptable means of
exchange.
2. Money is also used as the unit of account, the unit by which we measure the value of
things. Just as we measure weight in kilograms, we measure value in money. The use of
a common unit of account simplifies economic life enormously.
3. Money is sometimes used as a store of value; it allows value to be held over time. In
comparison with risky assets like stocks or real estate or gold, money is relatively riskless.
In earlier days, people held currency as a safe form of wealth. Today, when people seek a
safe haven for their wealth, they put it in assets like checking deposits (M 1) and money
market mutual funds (M2). However, the vast preponderance of wealth is held in other
assets, such as savings accounts, stocks, bonds, and real estate.
4. People often want to agree today the price of some future payment. eg. workers and
managers will want to sign contracts with their suppliers specifying the price of raw
materials and other supplies. Money prices are the most convenient means of measuring
future claims.

The Supply of Money:

One popular definition of the money supply draws the line early and includes only coins, paper money,
traveler’s checks, conventional checking accounts and certain other checkable deposits in banks and
savings institutions. In the official U.S. statistics, this narrowly defined concept of money is called M1.
That is, M1= Cash in circulation with the public +overnight deposits.
The broadly defined money supply, usually abbreviated M2, is the sum of all coins and paper money in
circulation, plus all types of checking account balances, plus most forms of savings account balances, plus
shares in money market mutual funds.
That is, M2=M1+ deposits with agreed maturity up to 2 years + deposits redeemable up to 3months notice.
Some economists do not want to stop counting at M2 they prefer still broader definitions of money (M3 and
so on).
M3= M2+repos + money market funds and paper + debt securities residual maturity up to 2 years.

Broad Money:
Broad money is in most cases includes both time and sight deposits, retail and wholesale deposits and bank
and building society (savings institution) deposits.
In the UK this measure of broad money is known as M4. In most other European countries and the USA it is
known as M3.

2
The Demand for Money:
The demand for money refers to the desire to hold money: to keep your wealth in the form of money, rather than
spending it on goods and services or using it to purchase financial assets such as bonds or shares. It is usual to
distinguish three reasons why people want to hold their assets in the form of money.
1. The transactions demand for money: Since money is a medium of exchange, it is required for
conducting transactions. But since people receive money only at intervals. ( e.g. weekly or monthly) and
not continuously, they require to hold balances of money in cash.
2. The precautionary demand for money: Unforeseen circumstances can arise, such as a car
breakdown. Thus individuals often hold some additional money as a precaution.
3. The speculative demand for money: Certain firms and individuals who wish to purchase financial
assets such as bonds, shares or other securities, may prefer to wait of they feel that their price is likely to
fall.
These three types of demand of demand for money is a demand for real money balances, which depends on the level
of real income because individuals hold money to pay for their purchases. The demand for money depends also on the
cost of holding money. The cost of holding money is the interest rate. The interest rate is 1%, there is very little benefit
from holding bonds rather than money. However when the interest rate is 10%, it is worth some effort not to hold more
money than is needed to finance day-to-day transactions.
On these simple grounds, then, the demand for real balances increases with the level of real income and
decreases with the interest rate.
The demand for real balances, which we denoted as L, is accordingly expressed as-
L=ky-hi k, h>0 -----------------(i)
Where,
L=The demand for money;
k=The sensitivity of the demand for real balances to the level of income;
y=The level of income;
h= The sensitivity of the demand for real balances to the interest rate;
i = The interest rate.
e.g. a $5 increase in real income raises money demand by kx5 real dollars. An increase in the interest rate of
1% point reduces real money demand by h real dollars.
This relation can be shown in the following figure:

This implies that for a given level of income, the quantity demanded is a decreasing function of the rate of interest.
Such a demand curve is L1 for a level of income Y1. The higher the level of income, the larger the demand for real
balances and therefore, the further to the right the demand curve. The demand curve for higher level of real
income Y2, is L2.

3
Equilibrium in the Money Market:

Equilibrium in the money market is where the demand for money (L) is equal to the supply of money (Ms).
This equilibrium is achieved through changes in the rate of interest.
In the following figure, equilibrium is achieved with a rate of interest re and a quantity of money Me. If the
rate of interest were above re people would have balances surplus to their needs. They would use these to
buy shares, bonds and other assets. This would drive up the price of these assets and drive down the rate
of interest. As the rate of interest fell, so there would be a contraction of the money supply (a movement
down along the Ms curve) and an increase in the demand for money balances, especially speculative
balances (a movement down along the liquidity preference curve). The interest rate would go on falling until
it reached re. Equilibrium would then be achieved.
Similarly, if the rate of interest were below re, people would have insufficient money balances. They would
sell securities, thus lowering their prices and raising the rate of interest until it reached re.
A shift in either the Ms or the L curve will lead to a new equilibrium quantity of money and rate of interest at
the new intersection of the curves. In practice, there is no one single rate of interest. Different assets have
different rates of interest, which is shown in the figure:

Other Determinants of Demand for Money:

1) Income
2) Propensity to consume
3) Propensity to save
4) Nature of Income Earning
5) Developed Money Market
6) Rate of Interest
7) Price level
8) Social security
9) Expectation
10) Banking system

4
The Quantity Theory of Money:
People hold money to buy goods and services. The more money they need for such transactions, the more
money they hold. Thus, the quantity of money in the economy is related to the number of dollars exchanged
in transactions.
The link between transactions and money is expressed in the following equation, called the quantity
equation:
Money x Velocity=Price x Transactions
M x V =P x T
Let’s examine each of the four variables in this equation.
The right-hand side of the quantity equation tells us about transactions. T represents the total number of
transactions during some period of time, say, a year. In other words, T is the number of times in a year that
goods or services are exchanged for money. P is the price of a typical transaction-the number of dollars
exchanged. The product of the price of a transaction and the number of transactions, PT, equals the number
of dollars exchanged in a year.
The left-hand side of the quantity equation tells us about the money used to make the transactions. M is the
quantity of money. V is called the transactions velocity of money and measures the rate at which money
circulates in the economy. In other words, velocity tells us the number of times a dollar bill changes hands in
a given period of time.
For example, suppose the 60 loaves of bread are sold in a given year at $0.50 per loaf. Then T equals 60
loaves per year, and P equals $0.50 per loaf. The total number of dollars exchanged is
PT=$0.50/loaf x 60 loaves/year=$30/year.
The right-hand side of the quantity equation equals $30 per year, which is the dollar value of all
transactions.
Suppose further that the quantity of money in the economy is $10. By rear-ranging the quantity equation, we
can compute velocity as-
V= PT/M
= ($30/year)/($10)
= 3 times per year.
That is, for $30 of transactions per year to take with $10 of money, each dollar must change hands 3 times
per year.
The quantity equation is an identity: the definitions of the four variables make it true. The equation is useful
because it shows that if one of the variables changes, one or more of the others must also change to
maintain the equality. For example, if the quantity of money increases and the velocity of money stay
unchanged, then either the price or the number of transactions must rise.
But the problem with the first equation is that the number of transactions is difficult to measure. To solve this
problem, the number of transactions T is replaced by the total output of the economy Y.
Transactions and output are related, because the more the economy produces, the more goods are bought
and sold. They are not the same, however. When one person sells a used car to another person, for
example, they make a transaction using money, even though the used car is not part of current output.
Nonetheless, the dollar value of transactions is roughly proportional to the dollar value of output.
If Y denotes the amount of output and P denotes the price of one unit of output, then the dollar value of
output is PY. We encountered measures for these variables. Y is real GDP, P is the GDP deflator, and PY is
nominal GDP. The quantity equation becomes
Money x Velocity= Price x Output
M x V = P x Y

5
Because Y is also total income, V in this version of the quantity equation is called the income velocity of
money. The income velocity of money tells us the number of times a dollar bill enters someone’s income in
a given period of time.

Q. What is expansionary monetary policy and contractionary monetary policy? How does monetary
policy work? [ the role of monetary policy in the Keynesian model].

Ans. Monetary policy refers to actions that the Federal Reserve System takes to change the money supply, move
interest rates or both. It is aimed at affecting the economy. Monetary policy works in the following way in the Keynesian
model: Raising the money supply (M) leads to lower r, the lower interest rates stimulate investment spending; and this
investment stimulus, via the multiplier, then raises aggregate demand. This type of monetary policy is called
expansionary monetary policy, which is shown in fig 1(a). And the contractionary policy have the opposite effect, i.e.
decreasing the money supply (M) leads to higher r, the higher interest rates reduce investment spending then
decreases aggregate demand, which is shown in the fig:1(b):

Monetary policy works:

We know aggregate demand is the sum of consumption spending (c), investment spending (I), government purchases
of goods and services (G) and net exports (X-M). We know that fiscal policy controls G directly and influences both C
and I through the tax laws. Now we find out how monetary policy affects total spending.
Higher interest rates lead to lower investment spending. But investment (I) is a component of total spending C+I+G+(X-
M). Therefore, when interest rates rise, total spending falls. In terms of the 45 0 line, a higher interest rate leads to a
lower expenditure schedule. Conversely, a lower interest rate leads to a higher expenditure schedule. This situation is
depicted in the following fig:

Monetary policy effect the total expenditure:

6
Suppose the Federal Reserve, seeing the economy stuck with unemployment and a recessionary gap, increases the
money supply. It would normally do so by purchasing government securities in the open market, thereby shifting the
money supply schedule outward-as shown by the shift from M 0S0 to M1S1 in the fig 2(a). With the demand schedule for
money, MD temporarily fixed, such a shift in the supply curve for money has the effect that an increase in supply
always has in a free market: It lowers the price. In this case, the price of renting money is the rate of interest, r, so falls
from r0 to r1.

In fig 2(b), investment spending (I) rises in response to the lower interest rates. But such an autonomous rise in
investment kicks off a multiplier chain of increases in output and employment. Finally, we have completed the links
from the money supply to the level of aggregate demand. In brief- a higher money supply (M) leads to lower interest
rates (r), and these lower interest rates encourage investment (I), which has multiplier effects on aggregate demand:

Federal I
FF Policy
Reserve M and R C+I+G+(X-M) GDP

Real vs. Nominal Interest Rates:

The nominal interest rate (sometimes also called the money interest rate) is the interest rate on money in
terms of money. At nominal interest rates, it gives the dollar return per dollar of investment.
In contrast, the real interest rate is corrected for inflation and is calculated as the nominal interest minus the
rate of inflation. As an example, suppose the nominal the interest is 8 percent per year and the inflation rate
is 3 percent per year, we can calculate the real interest rate as 8-3=5 percent per year. In other words, if you
lend out 100 market baskets of goods today, you will next year get back only 105 (and not 108) market
baskets of goods as principal and real interest payments.
During inflationary periods, we must use real interest rates, not nominal or money interest rates, to calculate
the yield on investments in terms of goods earned per year on goods invested. The real interest rate is the
nominal interest rate less the rate of inflation.

7
8