CHAPTER TEN

10 ES 120: Introduction to
Economics

Money, Financial Institutions and

Monetary Policy
In this chapter……

◼ Introduction
◼ The Functions of Money
◼ Kinds of Money
◼ Money Supply
◼ Measures of Money
◼ Credit Creation

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In this chapter……

◼ Financial Institutions
◼ The Role of the Financial System
◼ The Role of Financial Intermediaries
◼ Zambia’s Financial Intermediaries
◼ Banking Financial Intermediaries
◼ Non-Banking Financial Intermediaries
◼ The Bank of Zambia

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In this chapter……

◼ Traditional Theory of Money Supply

◼ Money Demand and Interest Rates
◼ Equilibrium in the Money Market
◼ Monetary Policy Instruments

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Introduction

◼ Money is the symbol of success, a source of

crime, and it makes the world go round!
◼ When you walk into a restaurant to buy a meal,
you get something of value, a full stomach.
◼ Whether you pay by cash or cheque, the
restaurateur is happy to work hard to satisfy
your gastronomical desires in exchange for these
pieces of paper which, in and of themselves, are
worthless.

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Introduction

◼ Even though paper money has no intrinsic value,

the restaurateur is confident that, in the future,
some third person will accept it in exchange for
something that the restaurateur does value.
◼ And that third person is confident that some
fourth person will accept the money, with the
knowledge that yet a fifth person will accept the
money . . . and so on.

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Introduction

◼ To the restaurateur and to other people in our

society, your cash or cheque represents a claim
to goods and services in the future.
◼ The social custom of using money for
transactions is extraordinarily useful in a large
and complex society we live in today.
◼ To get your restaurant meal without money, for
instance, you would have to offer the
restaurateur something of immediate value.

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Introduction

◼ You could offer to wash some dishes, clean his

car, or give him your family’s secret recipe and
this is called the barter system.
◼ An economy that relies on barter will have
trouble allocating its scarce resources efficiently.
◼ In such an economy, trade is said to require the
double coincidence of wants.
◼ In this case, two people each have a good or
service that the other wants at the right time and
place to make an exchange.
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Introduction
◼ Therefore, trading in the barter economy is very
expensive as people have to spend time and
effort finding others with whom to make
mutually satisfactory swaps.
◼ These are scarce resources hence a barter economy
is wasteful, but the existence of money makes trade
easier and more efficient.
◼ By economising on time and effort spent in
trading, society can use these resources to produce
extra goods or services or leisure, making everyone
better off.
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Introduction

◼ With the use of money, the restaurateur does not

care whether you can produce a valuable good
or service for him.
◼ He is happy to accept your money, knowing that
other people will do the same for him.
◼ Such a convention allows trade to be
roundabout.
◼ The restaurateur accepts your money and uses it
to pay his chef; the chef uses her paycheck to
send her child to school.
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Introduction
◼ The school uses this tuition to pay a teacher; and
the teacher hires you to mow his lawn.
◼ As money flows from person to person in the
economy, it facilitates production and trade.
◼ This then allows each person to specialise in what
he or she does best and raising everyone’s standard of
living.

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Introduction
◼ When you read that millionaire Mr. X has a lot of
money, you know what that means?
◼ He is so rich that he can buy almost anything he
wants, in this sense, the term money is used to
mean wealth.
◼ Therefore, when we say that a person has a lot of
money, we usually mean that he or she is wealthy.
◼ By contrast, economists use the term money in a
more specialised way by saying that money does
not refer to all wealth but only to one type of it.

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Introduction
◼ The cash in your wallet is money because you
can use it to buy a meal at a restaurant or a shirt
at a clothing store.
◼ By contrast, if you happened to own one of the
large firms, you would be wealthy, but this asset
is not considered a form of money.
◼ You could not buy a meal or a shirt with this
wealth without first obtaining some cash.
◼ Mention the David De Gea burger story.

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Introduction

◼ Money is any generally accepted means of payment

for delivery of goods and services or for settlement of
debt.
◼ In other words, money is the stock of assets that
can be readily used to make transactions.
◼ According to the economist’s definition, money
includes only those few types of wealth that are
regularly accepted by sellers in exchange for
goods and services.

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Introduction

◼ Because money is so important in the economy,

we will devote much effort to learning how
changes in the quantity of money affects the
following:
1. Inflation,
2. Interest rates,
3. Production, and
4. Employment.
◼ Let us now discuss the known important
functions of money.
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Functions of Money

Medium of Exchange
◼ The main purpose of money is for buying and
selling goods, services such as labour and other
factor services and assets.
◼ We accept money not to consume it directly but to
use it subsequently to buy things we do wish to
consume.
◼ This transfer of money from buyer to seller
allows the transaction to take place.

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Functions of Money

Medium of Exchange
◼ The ease with which money is converted into
goods and services without loss is sometimes
called money’s liquidity.
◼ To better understand the functions of money, try
to imagine an economy without it: a barter
economy.
◼ In such a world, trade requires the double
coincidence of goods so a barter economy permits only
simple transactions.
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Functions of Money

Unit of Account
◼ Money provides the terms in which prices are
quoted and debts are recorded.
◼ When you go shopping, you might observe that a
shirt costs K20 and a burger costs K10.
◼ Even though it would be accurate to say that the
price of a shirt is 2 burgers and the price of a
burger is 1/2 of a shirt, but prices are never
quoted in this way.

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Functions of Money

Unit of Account
◼ Similarly, if you take out a loan from a bank, the
size of your future loan repayments will be
measured in kwacha, not in a quantity of goods
and services.
◼ When we want to measure and record economic
value, we use money as the unit of account.
◼ Money also allows the value of goods, services or
assets to be compared.

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Functions of Money

Unit of Account
◼ Money also allows dissimilar things, such as a
person’s wealth or a company’s assets, to be added
up.
◼ Similarly, a country’s GDP is expressed in
monetary terms.
◼ Remember our discussion of GDP?

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Functions of Money

A Store of Value
◼ A store of value is an item that people can use to
transfer purchasing power from the present to the
future.
◼ When a seller accepts money today in exchange
for a good or service, that seller can hold the
money and become a buyer of another good or
service at another time.

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Functions of Money

A Store of Value
◼ Of course, money is not the only store of value in the
economy, for a person can also transfer
purchasing power from the present to the future
by holding other assets.
◼ The term wealth is used to refer to the total of all
stores of value, including both money and non-
monetary assets.

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Functions of Money

A Store of Value
◼ When people decide in what form to hold their
wealth, they have to balance the liquidity of each
possible asset against the asset’s usefulness as a
store of value.
◼ Money is the most liquid asset, but it is far from
perfect as a store of value as it pays no interest and its
real purchasing power is eroded by inflation.

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Functions of Money

A Standard of Deferred Payment

◼ This function involves the use of money both as
a medium of exchange and as a unit of accounting.
◼ When you borrow, the amount to be repaid next
year, it is specified and measured in kwacha.
◼ For example, workers and managers will want to
agree the wage rate for the coming year.

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Kinds of Money
Money takes many forms and in the Zambian
economy, we make transactions with an item whose
sole function is to act as money: kwacha.
1. Commodity Money
◼ In prisoner-of-war camps, cigarettes were money.
◼ In the nineteenth century, money was mainly
gold and silver coins.
◼ These are examples of commodity money,
ordinary goods with industrial uses (gold) and
consumption uses (cigarettes).
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Kinds of Money

1. Commodity Money
◼ To use commodity money, society must either
cut back on other uses of that commodity or
devote the scarce resources to additional
production of the commodity.
◼ There are cheaper ways for society to make
money and these include token or fiat money.

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Kinds of Money
2. Token Money
◼ Token money is a means of payment whose value or
purchasing power as money greatly exceeds its cost of
production or value in uses other than as money.
◼ A K100 note is worth far more than a high
quality piece of paper.
◼ Similarly, the monetary value of most coins
exceeds what you would get by melting them
down and selling off the metal e.g. can you sell
many K1 coins as scrap metal?
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Kinds of Money

2. Token Money
◼ By collectively agreeing to use token money,
society economises on the scarce resources
required to produce it.
◼ The survival of token money requires a
restriction on the right to supply it.
◼ Society enforces the use of token money by
making it legal tender.
◼ That is, by law, it must be accepted as a means of
payment.
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Kinds of Money

2. Token Money
◼ These pieces of paper we use with the freedom
statue, a picture of an eagle would have little
value if they were not widely accepted as
money.
◼ Token money that has no intrinsic value is also
called fiat money because it is established as
money by government decree or fiat.

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Kinds of Money

3. IOU Money
◼ In modern economies, token money is
supplemented by IOU money, principally bank
deposits, which are debts of private banks.
◼ When you have a bank deposit, the bank owes
you money and is obliged to pay your cheque.
◼ This shows that money is more than just notes
and coins.

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Kinds of Money

3. IOU Money
◼ In fact, the main component of a country’s
money supply is not cash, but deposits in banks
and other financial institutions.
◼ Only a very small proportion of these deposits
are kept by the banks in their safes or tills in the
form of cash.
◼ The bulk of the deposits appear merely as
bookkeeping entries in the banks’ accounts.

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Kinds of Money

3. IOU Money
◼ This may sound very worrying but a bank almost
always have enough cash to meet its customers’
demands.
◼ This is because only a small fraction of a bank’s
total deposits will be withdrawn at any one time.
◼ Banks always make sure that they have the
ability to meet their customers’ demands.
◼ The chances of banks running out of cash are
practically nil.
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Kinds of Money

3. IOU Money
◼ In fact, the bulk of all but very small transactions
are not conducted in cash at all.
◼ By the use of cheques, credit cards and debit
cards, most money is simply transferred from
the purchaser’s to the seller’s bank account.
without the need for first withdrawing it in cash
◼ To identify the items that should be included in
the definition of money, we need to refer to the
functions of money.
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Kinds of Money
“Complaints" about money by citizens and bankers

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Money Supply

◼ Measures of Money
◼ If money supply is to be monitored and possibly
controlled, it is obviously necessary to measure
it.
◼ But what should be included in the measure of
money?
◼ We need to distinguish between the monetary base
(narrow money) and broad money.

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Money Supply

◼ Measures of Money
◼ Economists have struggled to reach an
agreement about how to measure money.
◼ There are two basic approaches:
◼ Transactions approach: Stresses the role of money
as a medium of exchange.
◼ Liquidity approach: Stresses the role of money as a
temporary store of value.
◼ Let us now consider the measures of money which
are the monetary base and the broad money.
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Money Supply

Narrow Money
◼ This refers to money balances which are easily
available to finance day-to-day spending i.e. for
transactions purposes.
◼ This definition of narrow money is also known as
the monetary base or ‘high-powered money’ consists
of cash (notes and coin) in circulation outside the
central bank.
◼ But there is another version of this definition
referred to as wide monetary base.
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Measures of Money

Narrow Money
◼ The wide monetary base includes commercial
banks’ balances with the Bank of Zambia.
◼ This wide monetary base, denoted as M0,
includes those assets that are, or could be, used
as cash reserves by the banking system.
◼ In other words, M0 includes notes and coins held
by the public and cash in banks’ tills plus banks’
operational balances at the central bank.
◼ Usually, notes and coins held by the public account for about 90% of M0.
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Measures of Money
Narrow Money
◼ The monetary base gives us a very poor
indication of the effective money supply.
◼ This is because it excludes the most important
source of liquidity for spending, namely, bank
deposits.
◼ The problem we are faced with is to know which
deposits to include.

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Measures of Money

Narrow Money
◼ In this regard, we need to answer three
questions:
◼ Should we include just sight deposits, or time deposits as
well?
◼ Should we include just retail deposits, or wholesale
deposits as well?
◼ Should we include just bank deposits, or building society
(savings institution) deposits as well?

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Measures of Money

Narrow Money
◼ In the past, there has been a whole range of
measures, each including different combinations
of these accounts.
◼ However, financial deregulation, the abolition of
foreign exchange controls and the development
of computer technology have led to huge changes
in the financial sector throughout the world.
◼ This has led to a blurring of the distinctions between
different types of accounts.
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Measures of Money
Broad Money
◼ It has also made it very easy to switch deposits
from one type of account to another hence the
most usual measure that countries use for money
supply is broad money.
◼ In most cases, it includes:
◼ Both time and sight deposits, retail and wholesale deposits, and
bank and building society (savings institution) deposits.
◼ It refers to money held by both for transactions purposes and as a
form of saving.
◼ It includes assets that could easily be converted with relative ease
and without capital loss into spending on goods and services.
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Measures of Money
Broad Money
◼ Thus the broad definition of money takes into
account the store of value function in addition to
the medium of exchange function of money.
◼ In some countries, this measure of broad money is known as
M4.
◼ For our purposes in this course, we need not dwell on the
differences between the various measures of money.
◼ The important point is that the money stock or supply for the
economy includes:
◼ Currency but also deposits in banks and other financial institutions
that can be readily accessed and used to buy goods and services.
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Credit Creation
◼ Banks create money but this does not mean that
they have smoke-filled back rooms in which
counterfeiters are busily working.
◼ Remember that most money is deposits, not
currency.
◼ What banks create is deposits and they do so by
making loans but the amount of deposits they
can create is limited by their reserves.
◼ Banks and building societies are able to create
new deposits through a process known as credit
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Credit Creation
◼ To see how banks influence the money supply, it
is useful to imagine first a world without any
banks at all.
◼ In this simple world, currency is the only form of
money.
◼ To be concrete, let’s suppose that the total
quantity of currency is K100.
◼ The supply of money is, therefore, K100.

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Credit Creation

◼ Now suppose that someone opens a bank called

CBU Bank.
◼ Let us assume that CBU bank is only a
depository institution, that is, it accepts deposits
but does not make loans.
◼ The purpose of the bank is to give depositors a
safe place to keep their money.
◼ Whenever a person deposits some money, the
bank keeps the money in its vault.

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Credit Creation

◼ It keeps the money until the depositor comes to

withdraw it or writes a cheque against his or her
balance.
◼ Deposits that banks have received but have not
loaned out are called reserves.
◼ In this imaginary economy, all deposits are held
as reserves, so this system is called 100% reserve
banking.

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Credit Creation

◼ We can express the financial position of CBU

Bank with a T-account.
◼ This is a simplified accounting statement that
shows changes in a bank’s assets and liabilities.
◼ We illustrate this in the next slide and then
change the assumptions later to give a more
realistic version of how modern banks create
money.

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Credit Creation

CBU Bank

Assets (K) Liabilities (K)

Reserves 100 Deposits 100

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Credit Creation

◼ Now consider the money supply in this

imaginary economy.
◼ Before CBU bank opens, the money supply is the
K100 of currency that people are holding.
◼ After the bank opens and people deposit their
currency, the money supply is the K100 of
demand deposits.
◼ There is no longer any currency outstanding, for
it is all in the bank vault.

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Credit Creation

◼ Each deposit in the bank reduces currency and

raises demand deposits by exactly the same
amount, leaving the money supply unchanged.
◼ Thus, if banks hold all deposits in reserve, banks
do not influence the supply of money.
◼ Eventually, the bankers at CBU bank may start to
reconsider their policy of 100% reserve banking.
◼ Leaving all that money sitting idle in their vaults
seems unnecessary.

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Credit Creation

◼ Why not use some of it to make loans?

1. Families want to buy houses.
2. Firms want to build new factories.
3. Students want to pay for college would all be
happy to pay interest to borrow some of that
money.
◼ Of course, CBU bank has to keep some reserves
so that currency is available if depositors want to
make withdrawals.

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Credit Creation

◼ But if the flow of new deposits is roughly the

same as the flow of withdrawals, the bank needs
to keep only a fraction of its deposits in reserve.
◼ Thus, the bank adopts a system called fractional-
reserve banking.
◼ The fraction of total deposits that a bank holds as
reserves is called the reserve ratio.
◼ This ratio is determined by a combination of
government regulation and bank policy.

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Credit Creation

◼ There are two determinants of the size of this

ratio:
◼ The Central Bank places a minimum on the
amount of reserves that banks hold, called
required reserves.
◼ The banks may voluntarily wish to hold whatever
additional amount of reserves, known as excess
reserves.
◼ Since banks may hold excess reserves above the
legal minimum, they can be more confident that
they will not run short of cash.
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Credit Creation

◼ For our purpose here, we just take reserve ratio

as given and examine what fractional-reserve
banking means for the money supply.
◼ Let us suppose that CBU bank has a reserve ratio
of 10%.
◼ This means that it keeps 10% of its deposits in
reserve and loans out the rest.
◼ Now let’s look again at CBU bank’s T-account.

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Credit Creation

CBU Bank
Assets (K) Liabilities (K)

Reserves 10 Deposits 100

Loans 90

Total 100 100

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Credit Creation

◼ The bank still has K100 in liabilities because

making the loans did not alter the bank’s
obligation to its depositors.
◼ But now the bank has two kinds of assets:
◼ It has K10 of reserves in its vault, and it has loans
of K90.
◼ The loans of K90 are liabilities of the people
taking out the loans but they are assets of the
bank making the loans, because the borrowers
will later repay the bank.
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Credit Creation

◼ In total, bank’s assets still equal its liabilities.

◼ Once again, consider the supply of money in the
economy where before the bank makes any
loans, the money supply is the K100 of deposits
in the bank.
◼ Yet when the bank makes these loans, the money
supply increases.

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Credit Creation

◼ The depositors still have demand deposits

totaling K100, but now the borrowers hold K90 in
currency.
◼ The money supply, which equals currency plus
demand deposits, equals K190.
◼ Thus, when banks hold only a fraction of
deposits in reserve, they create money.

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The Financial System

◼ The basic rationale of a financial system is to

bring together those who have accumulated an
excess of money and who wish to save with
those who have a requirement to borrow in
order to finance investment.
◼ The process arguably helps to better utilise
society’s scarce resources, increase productive
efficiency and ultimately raise the standard of
living.

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The Financial System
◼ 1. Lenders and borrowers – these include persons,
companies and government.
◼ 2. Financial intermediaries – consisting of financial
institutions which act as intermediaries between
lenders and borrowers.
◼ 3. Financial markets – where money is lent and
borrowed through the sale and purchase of
financial instruments.
◼ They play an essential role in reducing the cost of placing, pricing and
trading such instruments.
◼ The financial markets can be defined as short-term money markets and
long-term capital markets.
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The Financial System

◼ When individuals choose to hold some of their

savings in new bonds issued by a corporation,
their purchases of the bonds are in effect direct
loans to the business.
◼ This is an example of direct finance, in which
people lend funds directly to a business.
◼ Business financing is not always direct as
individuals might choose instead to hold a time
deposit at a bank.

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The Financial System

◼ The bank may then lend to the same company

that the individual would have learnt to.
◼ In this way, the same people can provide indirect
finance to a business.
◼ The bank makes this possible by intermediating
the financing of the company.
◼ Thus, banks and other financial institutions are
known as financial intermediaries.

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The Financial System

◼ They all have the common function of providing

a link between those who wish to lend and those
who wish to borrow.
◼ In other words, they act as the mechanism
whereby the supply of funds is matched to the
demand for funds.
◼ The interconnections are summarised in Figure
10.1.

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The Financial System
Figure 10.1

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The Financial System

◼ In Figure 10.1, the ultimate lenders and ultimate

borrowers are the same economic units:
households, businesses, and governments, but
not necessarily the same individuals.
◼ Whereas individual households can be net
lenders or borrowers, households as an economic
unit typically are net lenders.
◼ Specific businesses or governments similarly can
be net lenders or borrowers.
◼ As economic units, both are net borrowers.
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The Financial System

◼ Why might people wish to direct their funds

through a bank instead of lending them directly
to a business?
◼ One important reason is asymmetric information
which arises due to the fact that the business may
have better knowledge of its own current and
future prospects than potential lenders do.
◼ Asymmetric information is caused by two things
in the financial system.

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The Financial System

1. Adverse selection
◼ The business may know that it intends to use
borrowed funds for projects with a high risk of
failure that would make repaying the loan
difficult.
◼ This potential for borrowers to use the borrowed
funds in high-risk projects is known as adverse
selection.

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The Financial System

2. Moral hazard
◼ A business that had intended to undertake low-
risk projects may change management after
receiving a loan, and the new managers may use
the borrowed funds in riskier ways.
◼ The possibility that a borrower might engage in
behavior that increases risk after borrowing
funds is called moral hazard.

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The Role of Financial Intermediaries

◼ In the process of intermediation, four important

services are provided:
1. Expert advice
◼ They advise customers on financial matters such
as on the best way of investing their funds and
on alternative ways of obtaining finance.
◼ This should help to encourage the flow of
savings and the efficient use of them.

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The Role of Financial Intermediaries

2. Brokerage
◼ A broker is an intermediary who brings together
lenders and borrowers who have complementary
needs and does this by assessing and evaluating
information.
◼ The lender may have neither the time nor the
ability to undertake search activities in order to
assess whether a potential borrower is
trustworthy.

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The Role of Financial Intermediaries

2. Brokerage
◼ Other questions include whether the borrower is
likely to use the funds for a project that is
credible and profitable, and is able to pay the
promised interest on the due date.
◼ By depositing funds with a financial
intermediary, the household avoids such
information gathering, monitoring and
evaluation costs, which are now undertaken by
the specialised financial intermediary.
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The Role of Financial Intermediaries

2. Brokerage
◼ The borrower needs to know that a promised
loan will be received at the time and under the
conditions specified in any agreement.
◼ By bringing lenders and borrowers together in
these ways, the various information and
transactions costs are reduced so that this
brokerage function can command a ‘fee’.

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The Role of Financial Intermediaries

3. Expertise in channeling funds

◼ Funds are channeled to those areas that yield the
highest return encouraging the flow of savings as
it gives savers the confidence that their savings
will earn a good rate of interest.
◼ Financial intermediaries also help to ensure that
projects that are potentially profitable will be
able to obtain finance.
◼ They help to increase allocative efficiency.

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The Role of Financial Intermediaries

4. Maturity transformation
◼ Many people and firms want to borrow money
for long periods of time, and yet many depositors
want to be able to withdraw their deposits on
demand or at short notice.
◼ If people had to rely on borrowing directly from
other people, there would be a problem here
because the lenders would not be prepared to
lend for a long enough period.

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The Role of Financial Intermediaries

5. Risk transformation
◼ Since you may be unwilling to lend money
directly to another person in case they do not pay
up, financial intermediaries transform the risk.
◼ They do so by lending to large numbers of
people who are willing to risk the odd case of
default.
◼ They can absorb the loss because of the interest
they earn on all the other loans.

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Zambia’s Financial Intermediaries

◼ Self reading:
◼ Zambia’s Financial Intermediaries
◼ Banking Financial Intermediaries
◼ Non-Banking Financial Intermediaries
◼ The Bank of Zambia

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Financial Crises
◼ Almost everybody knows what the banks are
doing but people do not mind.
◼ However, if people believe that a bank has lent
too much and will be unable to meet depositor’s
claims, there will be a run on the bank or
financial panic.
◼ If the bank cannot pay all depositors, you try to
get your money out first while the bank can still
pay.
◼ Some of its loans will be too illiquid to get back
in time. 1 - 78
Financial Crises

◼ Note that there are two kinds of financial crises.

◼ First, a bank may have made loans that turn out
to be worthless i.e. they are no longer valuable
assets of the bank.
◼ Liabilities now exceed assets and the bank is
insolvent, this is called the solvency crisis.
◼ Unless rapidly bailed out by injections of new
assets by shareholders or the government, the
bank will be declared bankrupt and will close
down.
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Financial Crises

◼ In such circumstances, depositors are simply

being smart trying to get their money out before
it happens.
◼ However, there may also be self-fulfilling panics
even when the bank’s assets are fine and the
bank is not insolvent.

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Financial Crises

◼ If a depositor believes the other depositors will

panic and withdraw money, it makes no sense to
be the last in the queue and this is called the
liquidity crisis.
◼ This is because the bank may have trouble selling
enough liquid assets quickly enough to meet all
the withdrawals.

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Financial Crises

◼ Whether it is a liquidity or a solvency crisis

determines which arm of government might
potentially be involved in a solution.

◼ Do it yourself: Which arm of government helps

solve each of these crises?
◼ Read about the Financial Crisis of 2009 and its
aftermath.
◼ What about the closing down of Intermarket Bank?

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Traditional Theory of Money Supply

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Traditional Theory of Money Supply

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Traditional Theory of Money Supply

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Traditional Theory of Money Supply

Example
◼ If the public hold cash to the value of 3% of their
deposits and the if banks hold reserves equal to
1% of deposits.
◼ a) Calculate the money multiplier.
◼ b) Calculate the bank deposit multiplier.

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Money Demand and Interest Rates

◼ The demand for money refers to the desire to

hold money.
◼ That means 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.
◼ There are basically two functions of money that
provide the reasons why people hold money.

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Money Demand and Interest Rates

◼ Money is the medium of exchange, for which it

must also be a store of value.
◼ People can hold their wealth in various forms:
money, bills, bonds, equities and property.
◼ For simplicity, assume that there are only two
assets:
◼ money the medium of exchange that pays no
interest and bonds.
◼ bonds will stand for all interest-bearing assets
that are not directly a means of payment.
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Money Demand and Interest Rates
◼ As wealth increases, individuals divide their
wealth between money and bonds.
◼ People hold money only if there is a benefit to
offset the cost.
◼ But what is that benefit or cost?
◼ The rate of interest has two roles:
1. To a borrower, the rate of interest is the payment
which has to be made in order to obtain liquid
assets, namely cash.
2. To the lender, it is the reward received for parting
with liquid assets.
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Money Demand and Interest Rates

◼ When the term ‘the rate of interest’ is used, it

appears to imply a single rate of interest.
◼ There are, however, many rates of interest on
such things as mortgages, bank loans and
government securities.
◼ The rate of interest depends on such factors as
how credit-worthy the borrower is and the
length of time the loan is required for.

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Money Demand and Interest Rates

◼ The level of inflation present in the economy will

also affect the rate of interest.
◼ If inflation is increasing, then one would expect
lenders to seek a higher rate of interest to
compensate for the expected future loss in the
real value of their capital.
◼ It is important to distinguish between nominal and
real rates of interest.

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Money Demand and Interest Rates

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Money Demand and Interest Rates
◼ It is usual to distinguish three reasons why
people want to hold their assets in the form of
money as proposed by Keynes Maynard.
◼ The Keynesian and the ‘Loanable funds’ and
other theories of interest seek to emphasize
rather different factors involved in the demand
for money.
◼ A common thread running through all the
theories is the suggestion that the demand for
money to hold is sensitive to both the level of
household income and the rate of interest.
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Money Demand and Interest Rates

The transactions motive

◼ Since money is a medium of exchange, it is
required for conducting transactions.
◼ But people receive money only at intervals (e.g.
weekly or monthly) and not continuously but
their expenditure is spread over the whole
period.
◼ Therefore, individuals require to hold balances of
money in cash or in current accounts.

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Money Demand and Interest Rates

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Money Demand and Interest Rates

The transactions motive

◼ Money is a nominal not a real variable because
the average amount held for transactions
purposes depends upon the:
1. Level of money income,
2. Price level and
3. Frequency of pay days.

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Money Demand and Interest Rates

The transactions motive

◼ In terms of money income, the higher the money
income, the greater the average expenditure on
goods and services over the time period, and
therefore the higher the level of transactions
balances required.
◼ How about the price level and the frequency of pay
days?

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Money Demand and Interest Rates

The precautionary motive

◼ The demand for money is also based on the
desire to provide for the unexpected or
unforeseen circumstances.
◼ Unforeseen circumstances can arise, such as:
◼ A car breakdown,
◼ A lengthy period off work through illness, or
◼ an unexpected redundancy thus individuals often
hold some additional money as a precaution.

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Money Demand and Interest Rates
The precautionary motive
◼ Firms too keep precautionary balances because
of uncertainties about the timing of their receipts
and payments.
◼ If a large customer is late in making payment, a
firm may be unable to pay its suppliers unless it
has spare liquidity.
◼ How does this motive relate to the:
◼ Level of money income,
◼ Price level and
◼ Frequency of pay days?
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Money Demand and Interest Rates
The precautionary motive
◼ The higher the income received per time period,
the more costly any unforeseen event (e.g. loss
of employment) is likely to be.
◼ Therefore, the higher the income, the greater the
precautionary demand for money to hold.

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Money Demand and Interest Rates
The precautionary motive
◼ Of course it is also likely to be the case that as
the rate of interest rises, the precautionary
demand for money will contract.
◼ This is because the opportunity cost of ‘holding’
idle money has risen in terms of income forgone.
◼ We see that the level of income is directly related to the
transactions and precautionary demand for money.
◼ Therefore, in what follows, transactions demand
should be understood as including precautionary
demand.
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Money Demand and Interest Rates

The speculative or assets motive

◼ This motive for holding money differs from the
other two.
◼ The transactions and precautionary motives
relate to the function of money as a medium of
exchange.
◼ Whereas the speculative demand for money is
based on the expectation of making a speculative
gain or avoiding a speculative loss.

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Money Demand and Interest Rates

The speculative or assets motive

◼ Keynes outlined the speculative demand for
money in terms of the desire to hold either
money or fixed income bonds.
◼ In order to explain the speculative demand for
money, it is necessary to outline the relationship
between the price of bonds and the rate of
interest.

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Money Demand and Interest Rates

The speculative or assets motive

◼ It is important to note that the price of bonds and
the rate of interest are inversely related.
◼ For example, consider a bond with a nominal
face value of K100 which yields K10 per year
forever (a perpetual bond).
◼ If the price of the bond is K100 on the market
then the effective rate of interest from holding
the bond for one year is 10%.

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Money Demand and Interest Rates
The speculative or assets motive
◼ If the rate of interest were to rise to 20% then the
market price of this nominal K100 bond would
fall to K50, since K50 invested in an income
earning asset at 20% would yield K10
◼ We can say that if the interest rate rises then the
price of such fixed return (perpetual) bonds falls,
making bonds a less attractive proposition to
investors than money

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Money Demand and Interest Rates

The speculative or assets motive

◼ It can thus be seen that there is an inverse
relationship between the price of a fixed income
bond and the rate of interest.
◼ The speculative demand for money is influenced
by what individuals expect to happen to the rate
of interest, bearing in mind that investors will
have different expectations of how the rate of
interest, and hence bond prices, will move.

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Money Demand and Interest Rates

◼ All three motives discussed suggest that there

are benefits to holding money.
◼ But there is also a cost, the interest forgone by
not holding high-interest-earning assets instead.
◼ People hold money up to the point at which the
marginal benefit of holding another kwacha just
equals its marginal cost.

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Money Demand and Interest Rates

◼ The table below shows summarises the

discussion of demand for money as a medium of
exchange:

Effect of a rise in
Quantity Interest
demanded Price level Real income rate
Rises in
Nominal money proportion Rises Falls

Real money Unaffected Rises Falls

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Equilibrium in the Money Market

◼ Equilibrium in the money market is where the

demand for money is equal to the supply of
money.
◼ This equilibrium is achieved through changes in
the rate of interest.
◼ Equilibrium is achieved by changes in the
interest rate.
◼ If the interest rate is too high, people demand a
smaller quantity of money than the banking
system wants to supply.
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Equilibrium in the Money Market

◼ They are holding too much money.

◼ In this situation, they try to get rid of money by
buying bonds.
◼ Conversely, if the interest rate is too low, people
demand a larger quantity of money than the
quantity that the banking system wants to
supply.
◼ They are holding too little money.
◼ In this situation, they try to get more money by
selling bonds.
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Equilibrium in the Money Market

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Equilibrium in the Money Market

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Equilibrium in the Money Market

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Equilibrium in the Money Market

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Equilibrium in the Money Market
• At r1, the amount of
money in circulation
is higher than
households and firms
wish to hold. They
will attempt to reduce
their money holdings
by buying bonds.
• At r2, households
don’t have enough
money to facilitate
ordinary transactions.
They will shift assets
out of bonds and into
their checking
accounts.

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Equilibrium in the Money Market

◼ Equilibrium in the money markets, therefore, will

be:
◼ First where the total demand for and supply of
money are equal.
◼ Second, it will be where demand and supply of each
type of financial asset separately balance.
◼ If, for example, there were excess demand for short-term
loans (like money) and excess supply of money to invest
in long-term assets (like bonds), short-term rates of
interest would rise relative to long-term rates.
◼ Let us show this discussion algebraically as
follows. 1 - 116
Equilibrium in the Money Market

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Equilibrium in the Money Market

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Monetary Policy

◼ When the Central Bank takes actions that alter

the rate of growth of the money supply, it is
seeking to influence the following
macroeconomic variables:
1. Investment,
2. Consumption and
3. Total aggregate expenditures or output or income.

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Monetary Policy

◼ In taking these monetary policy actions, the

Bank in principle has three tools at its disposal:
1. Open market operations,
2. Changes in the reserve requirements, and
3. Discount rate changes.
◼ If the Central Bank tweaks any of the three, then
it is conducting monetary policy.
◼ Monetary policy is the process by which the
monetary authority of a country controls the
supply of money.
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Monetary Policy

◼ The monetary authority of Zambia which

controls the supply of money is the Bank of
Zambia.
◼ There are direct and indirect effects of monetary
policy.
◼ The direct effect is simply that an increase in the
money supply causes people to have excess
money balances.
◼ To get rid of these excess money balances, people
increase their expenditures.
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Monetary Policy

◼ The indirect effect is referred to as the interest-

rate-based monetary transmission mechanism.
◼ It occurs because some people have decided to
purchase interest-bearing assets with their excess
money balances.
◼ This causes the price of such assets say bonds, to
go up.
◼ Because of the inverse relationship between the
price of existing bonds and the interest rate, the
interest rate in the economy falls.
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Monetary Policy

◼ This lower interest rate induces people and

businesses to spend more than they otherwise
would have spent.
◼ The indirect, interest-rate-based transmission
mechanism can be seen explicitly in the Figure
10.2.
Figure 10.2

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Monetary Policy

Open Market Operations

◼ The Bank changes the amount of reserves in the
banking system by its purchases and sales of
government bonds issued to the public.
◼ To understand how these actions by the Bank
influence the market interest rate, we consider
two policy options.
◼ To increase the money supply, the Central Bank
instructs its bond traders to buy bonds in the
nation’s bond markets.
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Monetary Policy

Open Market Operations

◼ The kwachas the Central Bank pays for the bonds
increase the number of kwachas in circulation.
◼ Some of these new kwachas are held as currency,
and some are deposited in banks.
◼ Each new kwacha held as currency increases the
money supply and each new kwacha deposited
in a bank increases the money supply to an even
greater extent.

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Monetary Policy

Open Market Operations

◼ This is because it increases reserves and, thereby,
the amount of money that the banking system can
create.
◼ To reduce the money supply, the Central Bank
does just the opposite.
◼ It sells government bonds to the public in the
nation’s bond markets.

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Monetary Policy

Open Market Operations

◼ The public pays for these bonds with its holdings
of currency and bank deposits, directly reducing
the amount of money in circulation.
◼ In addition, as people make withdrawals from
banks, banks find themselves with a smaller
quantity of reserves.
◼ In response, banks reduce the amount of
lending, and the process of money creation
reverses itself.
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Monetary Policy

Open Market Operations

◼ Now, if the Bank wants to conduct open market
operations, it must somehow induce
individuals, businesses, and foreign residents to
hold more or fewer bonds.
◼ The inducement must take the form of making
people better off.
◼ So, if the Bank wants to buy bonds, it will have
to offer to buy them at a higher price than exists
in the market place.
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Monetary Policy

Open Market Operations

◼ If the Bank wants to sell bonds, it will have to
offer them at a lower price than exists in the
market place.
◼ Thus, an open market operation must cause a
change in the price of bonds.

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Monetary Policy

Reserve Requirements
◼ The Bank also influences the money supply
through changing reserve requirements.
◼ Reserve requirements are regulations on the
minimum amount of reserves that commercial
banks must hold against deposits.
◼ The reserve requirement is the fraction of a
bank’s total reserves that may not be loaned out.

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Monetary Policy

Reserve Requirements
◼ Therefore, increasing the reserve requirement
decreases the money supply.
◼ When the Bank raises reserve requirements,
commercial banks make fewer loans from each
kwacha of reserves, which decreases the money
multiplier and money supply.

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Monetary Policy

Reserve Requirements
◼ Decreasing the reserve requirement increases the
money supply because commercial banks make
more loans from each kwacha of reserves, which
increases the money multiplier and money
supply.
◼ Most Central Banks rarely use reserve
requirements to control money supply as
frequent changes would disrupt banking.

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Monetary Policy
Discount Rate
◼ The discount rate is the interest rate the Bank
charges commercial banks for loans.
◼ A commercial bank borrows from the Central
Bank when it has too few reserves to meet reserve
requirements.
◼ This might occur because the bank made too
many loans or because it has experienced recent
withdrawals.
◼ Therefore, when commercial banks are running low on
reserves, they may borrow reserves from the Bank.
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Monetary Policy
Discount Rate
◼ When the Central Bank makes such a loan to a
commercial bank, the banking system has more
reserves than it otherwise would, and these
additional reserves allow the banking system to
create more money.
◼ Increasing the discount rate decreases the money
supply while decreasing the discount rate
increases the money supply.

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Monetary Policy
Discount Rate
◼ To increase money supply, the Bank can lower
the discount rate, which encourages commercial
banks to borrow more reserves from the Bank.
◼ Consequently, commercial banks can then make
more loans, which increases the money supply.
◼ To reduce money supply, the Bank can raise
discount rate which discourages commercial
banks to borrow more reserves from the Bank
and making more loans.
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Changes in Equilibrium

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Changes in Equilibrium

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Changes in Equilibrium

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Changes in Equilibrium
An Increase in Real Income
◼ An increase in real income leads to an increase in
the demand for money.
◼ Given that the supply of money does not change,
the interest rate has to increase so as to reduce
the demand for money and re-establish
equilibrium.

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Changes in Equilibrium
An Increase in Real Income
◼ Conversely, a fall in real income leads to a
decrease in the demand for money.
◼ Because the money supply remains unchanged,
the interest rate has to decrease so as to increase
the demand for money and re-establish
equilibrium.

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Changes in Equilibrium

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The Liquidity Trap

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The Liquidity Trap

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The Liquidity Trap

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Overcoming the Liquidity Trap
◼ Because conventional monetary policy becomes
ineffective in a liquidity trap, other policy
measures are suggested as a remedy to get the
economy out of the trap.
◼ The monetarist view suggests quantitative easing
as a solution to the liquidity trap.
◼ Quantitative easing usually means that the
central bank sets up a goal of high rates of
increase in the monetary base or money supply
and provides liquidity in the economy so as to
achieve the goal.
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Overcoming the Liquidity Trap

◼ It has been argued, for instance, that the Great

Depression was caused and aggravated by the
misguided policies of the Federal Reserve Board.
◼ That is, monetary contraction subsequent to the
stock market crash in 1927 (Friedman and
Schwartz 1963).

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Overcoming the Liquidity Trap

◼ According to this viewpoint, unconventional

money easing or money gift, in Friedman’s
words, would be the appropriate policy measure.
◼ Between 1933 and 1941, the U.S. monetary stock
increased by 140 percent, mainly through expansion in
the monetary base.
◼ More recently, after lowering the policy target rate to
zero in February 1999, the Bank of Japan implemented
quantitative easing policy and set a goal for the reserves
available to commercial banks from March 2001 through
March 2006.

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 END
Thank you!