CHAPTER ONE

1. THE MONEY MARKET

1.1. Meaning of Money

Dear students! Have you ever heard about money? Ok. In this chapter, you are going to learn
about money.

Dear learner! This chapter is aimed to introduce you with the concept of money in general, and
the equilibrium conditions. The chapter has two sections. Specifically, the first section will
present you basic concepts of money, its functions, and the evolution of money and approaches
of money. The second section will discuss money supply, money demand, and equilibrium
condition.

Objectives:

By the end of this unit you will be able to know:

 The meaning of money,
 The evolution of money,
 The approaches of money,
 The money supply theories,
 The process of monetary expansion
 Theories of money demand,
 How interest rate is determined in money market.

To economists money has a very specific meaning though there is no single definition. Money is
anything that is generally accepted in payment for goods or services or in the repayment of debts;
a stock concept. Money supply is the total amount of money available in the economy. “Money,”
is used synonymously with currency. For example, “your money, or your life!”, but it is only one
type of M (others include checks, saving deposits) to narrow.

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Wealth- e.g., “Mr. X is rich, he has a lot of money,’’ but Wealth is the total collection of pieces
of property that serve to store value (stock) too much broad! Wealth includes not only money,
but also anything subject to ownership (called assets), such as bonds, common stock, art, land,
furniture, cars, or houses.

Income- e.g. “Rahel has been employed in the UN head quarter, she earns a lot of money”, but
Income is flow of earnings per unit of time (flow) while money is stock; that is, it is a certain
amount at a given point in time

As the word money is used in everyday conversation, it can mean many things but to economists
it has a very specific meaning.

Economists define money (also referred to as the money supply) as anything that is generally
accepted in payment for goods or services or in the repayment of debts when most people talk
about money, they are talking about currency. If for example, someone comes up to you and
says, “your money or your life” you should quickly handover all your life you should quickly
handover all your currency rather than ask, “what exactly do you mean by money?.”

To define money merely as currency is much too narrow for economists. Because checks are also
accepted as payment for purchases, checking account deposits are considered money as well. As
you can see, there is no single, precise definition of money or the money supply, even for
economists.

However, you need to keep in mind that the money (which is a stock-a certain amount a given
point in time) discussed in this refers to anything that is generally accepted in payment for goods
and services or (as a medium of exchange). In the repayment of debts and is distinct from income
(a flow of earnings per unit of time) and wealth (total collection of pieces of property that serve
to store value).

The one essential characteristic which money has is this: It is immediately exchangeable for all
other kinds of marketable assets-goods and services, real estate, stocks and bonds or whatever.
That means, money is the most liquid asset (or money has liquidity advantage).

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The term liquidity refers to the ease with which an asset can be exchanged for other assets. A
highly liquid asset is one which can be exchanged for other assets (or for money), quickly, and
without loss of value different assets (houses, cars, government bonds, etc) have different
degrees of liquidity. Nevertheless, money is the only asset that has perfect liquidity.

What is money made of? How does it look? It makes no difference. As long as it is performing
the functions of money-as long as it is being used as a generally accepted medium of exchange-
it is money.

1.2. The Basic Functions of Money

In every society, money performs four basic functions. All of these functions play significant
roles in the operation of the economy.

A. The Medium of Exchange Function

The most basic function of money is to serve as the medium of exchange. In almost all market
transactions in our economy, money in the form of currency or checks is a medium of exchange;
it is used to pay for goods and services. Although money has no power to satisfy human wants
directly, it commands power to purchase those things, which have utility and satisfy human
wants. The use to money as a medium of exchange promotes economic efficiency by eliminating
much of the time spent in exchanging goods and services in the barter economy.

The time spent trying to exchange goods or a service is called a transaction cost. In a barter
economy, transaction costs are high because people have to satisfy a “double coincidence of
wants” that is, they have to find someone who has a good or service they want and who also
wants the goods or services they have to offer.

Thus, money promotes economic efficiency by

 Eliminating much of the time spent exchanging goods and service.
 Allowing people to specialize in what they do best
 Avoiding the problem of double coincidence by decomposing the single transaction of barter
in to two separate transactions of sale & purchase
 Allowing freedom of choice

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Money is therefore act as a lubricant that allows the economy to run more smoothly by lowering
transactions costs there by encouraging specialization and the division of labor, which boosts
productivity.

However, the acceptance of money as a medium of exchange is a matter of social convention

each person accepts money as a means of payment because he/she is confident that other will
accept it in payment for him/her. The social convention could either be established through legal
or other means.

B. Money as a unit of account (as a standard of value)

The second role of money is to provide a unit of account that is, it is used to measure value in the
economy. We measure the value of goods and services in terms of money, just as we, measure
weight in terms of pounds or distance is terms of miles. To see why this function is important, let
us look again at a barter economy where money does not perform this function. Assume the
economy has only three goods, say, food, economics lectures, and clothes. Then, we need to
know only three prices to tell us how to exchange one for another: the price of food in terms of
economics lectures (that is, how many economics lectures you have to pay for a food), the price
of food in terms of clothes, and the price of economics lectures in terms of clothes. If there were
ten goods, we would need to know 45 prices in order to exchange one good for another; and with
l000 goods we would need 499, 500 prices.

The formula for telling us the number of prices we need when we have N goods is the same
formula that tell us the number of pairs when there are N items. It is

N
N  1
2
Imagine how hard it would be to shop in a supermarket with 1000 different items on its shelves.
To make sure that you can compare the prices of all items, the price tags of each item would
have to list up to 999 different prices, and the time spent reading them would result in very high
transaction cost.

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The solution to the problem is to introduce money in to the economy and have all prices quoted
in terms of units of that money, enabling us to quote the price of economics lectures, food and
clothes in terms of, say, dollars (or Birr). If there were only three goods in the economy, this
would not be a great advantage over the barter system because we would still need three prices to
conduct transactions. Nevertheless, for ten goods we now need only ten prices; for 100 goods,
100 prices; and soon. At the 1000 good supermarket, there are now only 1000 prices to look at,
not 499, 500.

Money units serve as a unit of measurement in terms of which the values of goods and services
exchanged in the economy are measured and expressed. Money enables an orderly pricing
system, which is essential for
 Rational economic calculation and choice
 Transmitting economic information among individuals

C. Money as a store of value (wealth holding)

Money also functions as a store of value; it is a repository of purchasing power over time. A
store of value is used to save purchasing power from the time income is received until the time it
is spent. This function of money is useful because most of us do not want to spend our income
immediately up on receiving it but rather prefer to wait until we have the time or the desire to
shop.

Money is not unique as a store of value; any asset, be it money, stocks, bonds, land, houses, art,
or jewellery, can be used to store wealth. Many such assets have advantage over money as a
store of value: they often pay the owner a higher interest rather than money, experience price
appreciation, and provide service as a house. If these assets are a more desirable store of value
than money, why do people hold money at all?

The answer to this question relates to the important economic concept of liquidity, which is the
relative ease and speed with which an asset can be converted in to a medium of exchange.
Hence, money is the liquid asset of all because; it does not have to be converted into anything
else in order to make purchases. In to anything else to make purchases other assets however,
involve transaction costs when they are converted in to money.

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The importance of money as a store of value depends on the rate of increase of the general price
level as compared to urgency for liquidity for example, if inflation doubles, the value of money
halves. That is value of money.
1
(VM )  , where   inf lation rate,
1 
then if  increases by 100%
1 1
VM    50%
1  100 2
100
Thus, doubling of all prices means that the value of money has dropped by half.

1.3. Evolution of money

Even though, primitive societies of the past were able to function without money, it is difficult to
visualize today an economic system, which can function without money. Today, what is called
money is not invented overnight. It is the result of a process of evolution through several
hundred years.

In the early period, society had been exchanging goods and services in kind. In this system of
exchange, people give their good(s) and take others’ from those who want to exchange their
commodity with others’. This type/system of exchange is known as barter system. As the
production, consumption and other economic activities of the world become larger and more
complex, exchanges of the growing size of goods and services became complex and more
difficult. It was also observed from that the barter system was not capable of satisfying this
complicated demand for exchange.

1.3.1. Defects of barter system

There are several problems associated with the barter system that forced the world to develop
efficient ways of making exchange, which is the development or evolution of money. Some of
these are:

1. Lack of common units of measurement: Due to the absence of any unit of account-
numeracies, the value of each commodity in the market could not be stated simply as one
quantity. The value of each commodity must be expressed in terms of all other commodities

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 available in the market for N commodities N (N-1)/2 relative prices. The introduction of
money into the economy solved this problem.
2. A barter system requires a double coincidence of wants. It is lack of coincidence of needs
between two buyers, to exchange the commodities. It is difficult to find a person with the
commodity you need and willing to give you the commodity in exchange of yours.
3. Bulkiness of the commodities to be exchanged is another problem of the barter system.
Carrying the commodities to exchange all the time to the place of exchange is difficult.
4. There is difficulty in saving wealth for future in barter system. It is very difficult under barter
system for someone to sell his/her product whenever and as much as he/she likes and to save
the amount of the other commodity for future.
5. Lack of credit system or services for investment and consumption activities is also a problem
in barter system.
6. Exchanging commodities under barter system consumes a lot of time and energy; and so on.

To understand the evolution of money, let us try to classify the stages as follows.
Commodity money → Metallic money → Paper money → Cheque → Electronic money

A. Commodity money

It includes like spears, skins, stones, animals, axes, tea, shells, tobacco, precious stones, Amole
salt that were used as money. Though choice of such commodities was determined by factors
like location of the commodity, climatic conditions stage of cultural and economic development,
etc. However, commodity money suffered from several defects. For example;
- Lack of standardization
- Difficult and costly to store as store of wealth
- Subject to fluctuation in value
- Difficulty of portability and handling qualities
- Amenable to uncertain supply

B. Metallic money

Metallic money is those items, which are considered as medium of exchange or as money and at
the same time, can be purchased, and sold themselves as commodities. Some examples of such
money are gold, silver, and other precious metals. Note that commodity money has intrinsic
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value. The economy during the period or in a country, which uses gold as money, is called Gold
standard economy. It also suffered from a few disadvantage;

 It was unsafe to carry the metals- liable to theft;

 It was heavy and expensive to carry it in huge amount;
 It necessitates frequently approaching a black smith to test the quality of the metals and
to get them in smaller pieces.

C. Paper money

It is the third stage in the evolution of money. Initially merchants leave their gold or silver with
the gold smith and take a written document. This set a stepping-stone for the beginning of
fractional reserve system and the emergence of banking system. The first paper money is used in
11th century in China. The major drawbacks of paper currency and coins are that they are easily
stolen and can be expensive to transport.

D. Checks

Checks are payable on demand that allows transactions to take place without the need to carry
around large amounts of currency. The major advantages of checks are;

- The use of checks reduces the transportation costs associated with the payments system and
improves economic efficiency;
- Can be written for any amount up to the balance in the account, making transactions for large
amounts much easier;
- Loss from theft is greatly reduced.

The Drawbacks of checks are;

- It takes time to get checks from one place to another, which is particularly serious if you are
paying someone in a different location who needs to be paid, quickly crediting takes time.
- All the paper shuffling required to process checks is costy.

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E. Electronic money

Money is now at the stage where it is intangible b/c of information development. Using this
money can be transferred directly by debiting and crediting accounts e.g. credit cards, Visa cards.

Generally, the good qualities of money can be summarized as follows.

o General acceptability
o Durability
o Portability
o Homogeneity
o Divisibility
o Stability

1.4. Types of Money

There are different classifications of money.

i. Legal tender money versus Customary money

Legal tender money is one, which is generally accepted by people as a means of payment. It is
derived from its legal status. It has legal sanction behind it and everyone within the geographical
boundaries of a country is bound to accept it. Debtor can compel creditor to accept it.

Customary money serves as a medium of exchange merely due to the social convention. There is
no legal power to enforce its acceptability.

ii. Full bodied money versus Token money

A currency has two values: Value as money called Face value and Value inherent in the currency
(as a commodity) called intrinsic value. Face value is the value defined by the government
(central bank) and intrinsic value (commodity value) is the cost of the materials from which
money unit is made. When face value = intrinsic value it is called full- bodied money. For
example, metal money like gold and silver. If the face value > intrinsic value it is called token
money. The difference between the intrinsic and face value of the money is called Seignorege.

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iii. Credit money or bank money:

This represents types of financial documents such as credit cards and bills of exchange that
banks provide to people and use in making transactions. Credit money is created by commercial
banks.

iv. International money

Such money has wider acceptance than the local money, which has acceptability only within the
territorial limits of countries. In the past Gold was international money. Currently, U.S. dollar
Pound, Euro etc., are considered as international money

1.5. Definition and Measuring money

The definition of money as anything that is generally accepted in payment for goods and services
tells us that money is defined by people’s behavior. What makes asset money is that people
believe it will be accepted by others when making payment.

Money is something, which is very difficult to define since it belongs to the category of things,
which are not amenable to any single definition. It is so partly because it performs more than
three functions in the economy. It is, therefore, easier to understand what money consists of than
to give any universally accepted definition of money. Accordingly, there are four important
approaches to the definition or measurement of money (money supply).

1. Conventional approach
2. Chicago approach
3. Gurley and Shaw approach

1. The Conventional Approach (Classical and Neo-classical Approach)

This is the oldest approach. According to this, the most important function of money in society is
to act as a medium of exchange. Money is what it uniquely does. Keynes defined money as “that
by delivery of which debt contracts and price contracts are discharged and in the shape of which
general purchasing power is held”. The types of assets that satisfy these criteria are

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a. Currency (c)
b. Demand deposits in commercial banks (DD)

Thus, according to the conventional definition

M1 = C + DD, this is the narrow definition of money. It excludes time deposits in the commercial
banks because such deposits must first be converted in to either currency or demand deposits
before they can be spent.

Note that demand deposits are deposits payable on demand through cheque or otherwise. It is
important to note that among deposits it is only demand deposits, which serve as a medium of
exchange.

M1 is also called narrow money. The conventional approach is superior to other approaches,
because,

i. Easily measurable: - this is because of the fact that it includes only the most liquid assets i.e.,
currency in circulation and demand deposits.
ii. Easily controllable: - the central bank has better control over M1 than any other monetary
aggregates.

2. The Chicago approach

The Chicago economists led by Professor Milton Friedman adopted a broader definition of
money by defining it more broadly as “a temporary abode of purchasing power”. Their argument
is that since in the economy money income and spending flow streams are not perfectly
synchronized in time in order to function as a medium of exchange, money should be
temporarily stored as a general purchasing power. This could be in the form of currency, demand
deposits, or time deposits (including saving deposits).

M2 = C + DD + SD + TD,

Where C – Currency SD – Saving deposits

DD – Demand deposits (Checking deposits) TD – Time deposits

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The Chicago economist advanced two reasons for including time and saving deposits in the
definition of money.

A. National income is more highly correlated with money that includes saving and time
deposits than money narrowly defined.
B. According to economic theory, perfect or near perfect substitutes of a commodity should be
included in the definition of a single commodity. According to Chicago, economist time
deposits (deposits which are not payable on demand and on which cheque can be drawn) are
very close substitutes for currency and demand deposits.

3. Gurley and Shaw approach

This approach is associated with the names of Professor John G. Gurley and Edwards Shaw.
According to these economists, there exists a large spectrum of financial assets, which are close
substitutes for money. They emphasized the close substitution relationship between currency,
demand deposits, commercial deposits, saving deposits; credit issued by credit institution, shares,
and government bonds all of which are regarded as alternative liquid stores of value by the
public.

A rapid growth of deposits held by non-bank financial institutions (n.b.f.is) has increased their
practical importance as a source of credit.

M3 = C + DD + SD + TD + Bond + Share

The definition includes all deposits of and the claims of all types of financial intermediaries. It
assigns weights to each asset in the definition of money to come up with the total supply of
money. That is assignment of weights according to the degree of substitution. For instance, it
gives a weight of one to currency and demand deposits as they are perfect substitutes and zero to
houses, which are imperfect substitute’s weights such as 0. 25, 0.5, 0.75, 0.8, etc would be
assigned to different assets according to the degree of substitution. Theoretically, this approach is
superior to the Chicago, which assigns equal weights to all items in the definition of money
ranging from currency to time deposits. However practically it is difficult to implement it.

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1.6. The Money Supply

1.6.1. Players in the money supply process

There are three main economic agents with a power to affect money supply of the economy.
1. Central bank of the country: it is the government agency, which oversees the banking system
and is responsible for the conduct of monetary policy.
2. Various financial institutions: it is the financial intermediaries, which accept deposits from
individuals and make loans.
3. Public at large: it includes depositors and borrowers. Depositors are individuals and
institution that hold deposit in banks. Moreover, borrowers are individuals and institutions
that borrow from the depository institutions or institutions that issue bonds that are purchased
by the depository institutions.

The most two liabilities in the balance sheet, currency in circulation and reserves, are often
referred to as the monetary liabilities of the central bank. They are important part of the money
supply, because, increase in either or both will lead to an increase in money supply, ceteris
paribus. The sum of the central bank’s monetary liabilities (currency in circulation and reserves)
is called the monetary base.

Currency in circulation: the central bank issues the currency. Currency in circulation is the
amount of currency circulation in the hand of the public (outside of banks) – an important of the
money supply.

Reserves: all banks have an account at the central bank in which they hold deposits. Reserves
include deposits at the central bank plus currency that is physically held by banks (called vault
cash because it is stored in bank vaults). Reserves are assets for the banks but liabilities of the
central bank because the banks can demand payment on them at any time and the central bank is
obliged to satisfy its obligation by passing notes.

Total reserves can be divided in to two categories. These are:

Required reserves: these are reserves that the central bank requires all banks to hold and
Excess reserves: these are additional reserves that, the commercial banks chose to hold.

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1.7. The Central Bank’s Policy Tools and the control of the monetary base

The three main policy tools are:

A. Open market operations
B. Discount loan
C. Reserve Requirements

A. Open market operations (OMO)

One way the central bank causes changes in the monetary base is to purchase or sell government
bonds through an open market operation. This refers to the buying and selling of governments
and other secured securities by the central bank in the money and capital market. A purchase of
bonds by the central bank is called an open market purchase, while a sale of bonds by the central
bank is called an open market sale.

The ability of the central bank to influence the money market through its open market operation
is limited by the total supply of the suitable securities. Because, it can upload in the market to
check inflation and by its own preparedness to purchase securities at high prices to check slump
and incur losses by selling them at low prices to check boom. When the central bank conducts an
open market purchase, currency in circulation and/or reserves of banks increases.

B. Discount loan

The central bank can provide reserves to the banking system by making discount loan to banks.
An increase in discount loans can also be the source of an increase in the money supply. The
interest rate charged banks for these loans is called the discount rate. The discount rate is the rate
that commercial banks pay when they borrow funds from the central bank. The central bank can
affect the monetary base by increasing (thus decreasing the MB) or decreasing (thus expanding
the MB) the discount rate. When the central bank raises the discount rate, it raises the cost of
borrowing reserves, reducing the amount of reserves borrowed.

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C. Reserve requirement

By specifying the minimum reserve deposit requirement, the central bank can also affect the
monetary base. What it does is to increase (thus declining the MB) or decreases (thus increasing
the MB) the reserve requirement to directly affect the expansionary (concretionary) power of the
bank. Commercial banks affect the money supply using the excess reserves, which results from
deducting reserve requirements from the total reserves.

R= ER+RR

Where ER is excess reserve & RR is the reserve requirement.

If the central bank lowers reserve requirements, banks will hold excess reserves, which they can
then lend. Such lending triggers the expansion multiplier, increasing the money supply.

1.8. Multiple Deposit Creation

When the central bank supply the banking system with one Birr of additional reserve, deposits
will increase by a multiple of this amount & the process is called multiple deposit creation. On
the other hand, banks accept deposit from the public. The multiple deposit creation is based on a
number of assumptions.

Assumptions:

 The public is in equilibrium. That is the public holds as much money as it desires to hold i.e.
the people would simply transfer the additional money to banks: C/D=0

 The commercial banks lend all the deposits up to the minimum legal cash reserve
requirement determined by the central bank.

 The commercial bank’s assets are only in the form of cash reserves and loans, and their only
liabilities comprise of the demand deposits.

The central bank can provide additional reserves to the banking system in two ways:

- It can make a loan to the banks and

- It can purchase government bonds.

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Suppose national bank of Ethiopia makes a 100-discount loan to the first commercial bank. Once
the national bank, it immediately credits the proceeds from the loan to the account of the first
commercial bank. The bank’s reserves rise by birr ETB, while its borrowing from the national
bank has increase by 100 ETB.

1.8.1. Deposit Creation: Banking System

Let us assume that the 100 ETB of deposits created by first commercial bank’s loan is deposited
at bank A and that this bank and all other banks hold no excess reserves. If the required reserve
ratio is 10%, this bank will now find itself with a 10 ETB increase in required reserve, leaving it
90 ETB of excess reserves. Because, the first commercial bank does not want to hold on to
excess reserves, it will loan out entire money. Its loans and checkable deposits will then increase
by 90 ETB. The process continues just like this. Since the demand deposits created at every bank
are the component of money, we just add all deposits together to arrive at the change in deposit
(Money supply).

ΔMB=100+90+81+72.9+…

The multiple increases generated from an increase in the banking system’s reserves are called the
simple deposit multiplier. In our example, with a 10% required reserve ratio, the simple deposit
multiplier equals the reciprocal of the required reserve ratio expressed as a fraction (10 = 1/0.10).
It is simple geometric series where the common ratio is between 0 and 1.

ΔD = 1/rD*ΔR, where ΔD = change in deposit in the banking system

rD = R/D= Reserve deposit ratio (0.10 in the example)
ΔR = Change in reserve for the banking system (100ETB in the example above)
E.g. In the above example: ΔD= 1/0.1 (100) = 1000
1/rD is the simple money multiplier

Whether a bank chooses to use its excess reserves to make loans or to purchase securities, the
effect on deposit expansion is the same. The banking system as a whole, however, can generate
multiple expansions of deposits, because when a bank loses its excess reserves, these reserves do
not leave the banking system even though they are lost to an individual bank. Therefore, as each

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bank makes a loan and creates deposits, the reserves find their way to another bank, which uses
them to make additional loans and create additional deposits. This process continues until the
initial increase in reserves results in a multiple increase in deposits.

1.9. The money supply model and the money multiplier

In the real world, people do not keep their entire income in the banking system and banks do not
lend out all the money. In general, the assumptions we made at the process of deposit creation
are unrealistic because;
- The public will convert some part of the loan based derivative deposits in cash balances by
making withdrawal from the banks.

- Due to different reasons, the commercial banks may not succeed to lend all of their excess
reserves.

1.9.1. Deriving the money multiplies for M 1 (the narrow definition of money)

Because the central bank can control the monetary base better that it can control reserves, it
makes sense to link the money supply (M) to the monetary base (MB) through a relationship
such as the following;
M = m*MB

The variable m is the money multiplier, which tells us how much the money supply changes for a
given change in the monetary base (MB). Because the money multiplier is found to be larger
than one, the alternative name for the monetary base, “high-powered money,” is logical a dollar
change in the monetary base leads to more than a dollar change in the money supply.

To show that there are parties other than the central bank such as households, which affect
money supply, and how they affect money supply we can use a simple money supply model.
This model involves three exogenous variables: monetary base, reserve and demand deposits.

1. Monetary Base (B): This is a total amount of money held by the public as currency (C)
under control of (or decided for what purpose to use by) the public; and the amount kept by
banks as reserves (R) its size and use is determined or controlled by central bank.

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 MB = C +R

2. Reserve requirement: - This is the proportion of deposits that commercial banks keep with
central bank. Reserve – deposit ratio (R/D) = rr is the ratio of reserves to the deposit kept
with banks. It is determined by business policies (Federal policies) of banks. Thus, this
component of the money supply is controlled by the National bank (central bank).

3. Currency – deposit ratio = cr = (C/D): This represents the preference of the public
(consumers and producers) about how much money to hold in the form of currency (C) and
how much to hold in the form of demand deposits (D) which is deposited in banks in
checking account from which they withdraw when they need. The sum of the two represents
the money supply in circulation either in the form of currency or deposit in banks given by
the following relation.

Recall that narrow money is (M1 = C + D)

Taking the ratio of the two equations, we can obtain more precise equation for money supply.

1 
M  
CD
2 B  CR

By dividing both numerators and denominators by ‘D’, we obtain the following:

C D
M
 D D  cr  1
B C R cr  rr
D D

By multiplying both sides by ‘B’ again, we obtain:

 cr  1 
Letting   = m, the simple money supply is given as follows:
 cr  rr 

Where M = Money Supply and

 cr  1 
m=   called money multiplier.
 cr  rr 

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The meaning of the multiplier is that each birr of monetary base produces ‘m’ birr of money.
When B increases by a unit, money supply increases by ‘m’ factor or unit. The lower the reserve
deposit ratio (rr), the more loans banks would make and the more money they would create from
every birr. This means, a decrease in rr leads to an increase in money supply.

For instance, if currency deposit ratio = 0.4 (currency = 40% of total deposit) and reserve
 cr  1 
requirement = 10 % of deposit then m =  
 cr  rr 

 0 .4  1 
= 
 0 .4  0 .1 

m = 2.8

And then, this simple money supply function is given by M = 2.8B

The three major components/determinants of money supply in this simple money supply model
(B, cr, and rr) are again affected by different actors. ‘B’ is affected by National bank
(government) action through R. the value of rr is also determined by the act of the government
(National bank). ‘cr’ is determined by the households’ behaviors. This implies that money supply
is not determined by government decision alone but also by households’ decision.

For instance, if households decide to deposit more money instead of holding, money supply
increases even if government takes no action. This is because, this makes the money circulate
more and multiply more. If we take open market operation, which is about purchases and sales of
government bonds by the National bank:

a. Government purchase of bonds expands monetary base (B), (government gives money to the
public).

b. Government sales of bonds (government collects money from the public) reduces monetary
base and thereby reduces money supply.

 cr  1   cr  1 
M  B => M   C  R  .
 cr  rr   cr  rr 

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The effect of open market operation is reflected in base money B = C + R.

If the required reserve and excess reserve is included in to money multiplier,

CD cr  1
M  D D * MB  * MB
C  RR  ER cr  rr  Er
D D D

Ms = f (C/D (-), ER/D (-), rD (-), MB (+))

This derivation shows that, the money supply in the economy is determined by the decision of
three agents: public, Central Bank and Commercial Banks.

Example: rD = required reserve ratio = 0.10

C = currency in circulation = 400 billion ETB
D = checkable deposits = 800 billion ETB
ER = excess reserves = 0.8 billion ETB
M = money supply (M1) = C + D = 12 billion ETB

From this, C/D is = 400/800 = 0.5

ER/D is 0.8/800 = 0.001

Therefore,

0.5  1 1.5
m m  2.5
0.10  0.001  0.5 0.061
This means, a 1 ETB increase in the monetary base leads to a 2.50 ETB increase in the money
supply (M1).

INDIVIDUAL ASSIGNMENT (10%)

1. Derive the money multiplier using M2 (the Chicago approach to the definition of money).
2. Assuming C/D = 0.5, S/D = 3, T/D= 0.5, ER/D= 0.05, ΔMB = 100, rd = 10%
a. Calculate the money multiplier and money supply due to the change in MB
b. Changing rD to 20%, C/D to 1.0, T/D to 1, S/D to 3.5, and ER/D to 0.1, observe what
would have happened to money supply in each case separately.

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1.10. The Theory of Demand for Money

The most important feature that differentiates money from other assets- financial and real- is
liquidity. Unlike government bonds, money does not yield interest income to its possessors.
Unlike equities, it does not promise dividends, capital gains, or insurance against inflation to its
owner. It also does not yield services, which make real assets Such as land, house, machine, etc
worth possessing. Why do people demand money? Different schools of thought have put forward
different explanations

Why has money become so popular in our world? The answer lies in the functions of money.
There are three major functions of money. These are:

a. Money as a Medium of Exchange,

b. Money as a Unit of Account, and
c. Money as Store of Value

1.10.1. Theories of Demand for Money

Why we demand money? Many of us may answer this question by saying that in our economy
almost everyone including firms sells goods and services for money and in turn uses money to
buy the goods and services. If this is the answer, then we are necessarily referring to money as a
medium of exchange. Classical theory of demand for money exactly uses this answer, but there
are other uses of money, which is explained by various theories of money demand. The major
theories of money demand are:
a. Classical theory of money demand,
b. Keynesian theories of money demand, and

a. Classical theory of money demand

For classical economists, who represent the early stage of development of theories of money
demand, people need or demand money solely for transaction purpose called transaction motive
of money demand. Later, other dimensions of the money demand were discovered and other
theories were developed by Keynesians. Since the transaction motive of money demand is also
considered, by Keynesian economists let us directly pass to that and discuss the transaction
theory of money demand along with other theories.

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b. Keynesian theories of Demand for Money

According to the Keynesian theory money, is demanded not only because of medium of
exchange to facilitate transaction, but also because people demand money for speculative
purpose and as security against unforeseen needs for cash reserves called precautionary demand
for money. This breaks down the demand for money into transaction, precautionary and
speculative demands. Let us explain these theories of money demand one by one.

i. Transaction demand

Almost everyone needs to hold some amount of money to carry out ordinary day-to-day
transactions (selling and buying). The amount of money to be kept for transaction depends on the
timing of receipts and the timing of payments. For example, if a person gets daily wage, the
amount he wants to keep with him for transaction is different from a person who gets monthly
salary. In this case, on an average level a daily labour would keep fewer amounts for transaction.
Money demand primarily determined by the level of people’s transactions, which is proportional
to income, like the classical economists, he took the transactions component of the demand for
money to be proportional to income

ii. Precautionary Demand for Money

This demand for money arises due to uncertainty of future receipts and expenditures. For
example, if a family wants to spend its vacation aboard then they would keep more money than
the required amount. This is to meet the unexpected expenses. For instance, unexpected expenses
include:
 Purchases of something interesting you get on your way without your intention.
 Missing bus and paying more money to travel by minibuses.
 Getting car trouble unexpectedly and paying for mechanics for maintenance.
 Losing your bag on your way and purchasing new materials for use on your journey.
 Staying more days away from home unexpectedly and pay more for food and bed and
 Getting trouble with your home phone or electricity system and paying for maintenance.
And so on.

This demand for money can also be linked to income. As their income increases, people are
expected to keep more money than the lower income group for precautionary purpose. Thus one

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can say that precautionary money demand is also a function of income and can be written as:
Mp  f (Y ) . However, in the present world (except in countries like Ethiopia where the money
market is less developed), credit cards are more popular than the precautionary demand as people
can get credits at a cheap rate.

Since both transaction and precautionary demand for money are functions of income and
precautionary, money is finally used for transaction purpose, we can club together and write as:
M t  f (Y )

Where, Mt includes both transaction and precautionary demand for money.

iii. Speculative Demand for Money (M s)

So far, we have seen that money is demanded for transaction and until now, classical theory is
true. However, Keynes introduced another motive of holding money called speculative motive.
If the future rate of interests is known with certainty, there would be no speculation. However, in
real world situation, people gain or loss due to the fluctuation of interest rates. For example if the
current rate of interest is 6 percent but a person is expecting it to be 8 percent soon then he would
keep more money to take advantage of the current lower interest rate before it increases.
Moreover, by waiting until the interest rate reaches 8 percent, bonds with higher yields can be
purchased at lower price. In other words, since interest rate and bond prices are inversely related,
the person is able to purchase bonds at a lower price. Since speculation depends on the interest
rate (they are inversely related), we can write the relation as M s  f (r ) ; where ‘r’ is the rate of
interest.

Combining all the demands for money, we can write a general Keynesian formula for demand
for money as: Md = Mt + Ms or
= k(Y) + h(r), since Mt = f(Y) and Ms = f(r)

This relation simply means that money demand is a function of income (Y) and interest rate (r).
Money demand increases as income increases and decreases as interest rate increases. Thus,
money demand is positively related to income and negatively related to interest rate.

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Table 1. Total Demand for money

For any given price level, we know from k(Y) what Mt will be for each level of Y. Similarly, for
any given price level, we know from h(r) what Ms will be for each level of r. We can therefore,
know from k(Y) and h(r) what the total demand for money will be for every possible
combination of Y and r. The reason why the declining line begins from the vertical broken line is
that the transaction and precautionary demand for money does not depend on interest rate
measured along the vertical axis. Finally, note that speculative theory of money demand is more
valid in countries with developed money market.

Money Market Equilibrium

Money market equilibrium is determined by interaction between the level of money supply
generally determined by central bank and money demand, which is determined by different
factors such as income, and interest rate.

Money supply (MS) is assumed to be given in this case as it depends on the central bank and as it
is independent of interest rate. That is why it is straight line shown by vertical broken line. Once
we have a total demand for money and supply of money then we can find the equilibrium in
money market by equating both demand and supply curve. The equilibrium rate of interest is r e
whereas the equilibrium demand for money is Mde determined at point ‘e’ where the two
functions intersect.

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Table 2. Equilibrium interest rate

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 CHAPTER TWO

2. AGGREGATE DEMAND IN CLOSED ECONOMY

Dear students! Did you remember, the times if great depression in US.

Of all the economic fluctuations in world history, the one that stands out as particularly large,
painful, and intellectually significant is the Great Depression of the 1930s. During this time, the
United States and many other countries experienced massive unemployment and greatly reduced
incomes. In the worst year, 1933, one-fourth of the U.S. labor force was unemployed, and real
GDP was 30 percent below its 1929 level.

This devastating episode caused many economists to question the validity of classical economic
theory. Classical theory seemed incapable of explaining the Depression. According to that
theory, national income depends on factor supplies and the available technology, neither of
which changed substantially from 1929 to 1933. After the onset of the Depression, many
economists believed that a new model was needed to explain such a large and sudden economic
downturn and to suggest government policies that might reduce the economic hardship so many
people faced.

In 1936 the British economist John Maynard Keynes revolutionized economics with his book
The General Theory of Employment, Interest, and Money. Keynes proposed a new way to
analyze the economy, which he presented as an alternative to classical theory. His vision of how
the economy works quickly became a center of controversy. Yet, as economists debated The
General Theory, a new understanding of economic fluctuations gradually developed.

Keynes proposed that low aggregate demand is responsible for the low income and high
unemployment that characterize economic downturns. He criticized classical theory for assuming
that aggregate supply alone such as capital, labor, and technology determines national income.

Economists today reconcile these two views with the model of aggregate demand and aggregate
supply.

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In classical macroeconomic theory, the amount of output depends on the economy’s ability to
supply goods and services, which in turn depends on the supplies of capital and labor and on the
available production technology. Flexible prices are a crucial assumption of classical theory. The
theory posits, sometimes implicitly, that prices adjust to ensure that the quantity of output
demanded equals the quantity supplied.

The economy works quite differently when prices are sticky. In this case, as we will see, output
also depends on the demand for goods and services. Demand, in turn, is influenced by monetary
policy, fiscal policy, and various other factors. Because monetary and fiscal policy can influence
the economy’s output over the time horizon when prices are sticky, price stickiness provides a
rationale for why these policies may be useful in stabilizing the economy in the short run.

The model of supply and demand shows how the supply and demand for any good jointly
determine the good’s price and the quantity sold. Moreover, it shows how shifts in supply and
demand affect the price and quantity. This macroeconomic model allows us to study how the
aggregate price level and the quantity of aggregate output are determined.

2.1. Aggregate Demand

Aggregate demand (AD) is the relationship between the quantity of output demanded and the
aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods
and services people want to buy at any given level of prices.

The Quantity Equation as Aggregate Demand

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 × Velocity = Price × Output
M × V = P × Y.

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Let’s examine each of the four variables in this equation. The right-hand side of the quantity
equation tells us about nominal GDP. Y denotes the amount of output or total income and P
denotes the price of one unit of output, then the dollar value of output is PY.

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 income 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 that 60 loaves of bread are sold in a given year at $0.50 per loaf. Then Y
equals 60 loaves per year, and P equals $0.50 per loaf. The total number of dollars exchanged is
PY = $0.50/loaf × 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 rearranging 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 place with $10 of money, each dollar must
change hands 3 times per year. 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 output must rise.

The Money Demand Function and the Quantity Equation

When we analyze how money affects the economy, it is often useful to express the quantity of
money in terms of the quantity of goods and services it can buy. This amount, M/P, is called real
money balances.
Real money balances measure the purchasing power of the stock of money. For example,
consider an economy that produces only bread. If the quantity of money is $10, and the price of a

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loaf is $0.50, then real money balances are 20 loaves of bread. That is, at current prices, the stock
of money in the economy is able to buy 20 loaves.

A money demand function is an equation that shows what determines the quantity of real
money balances people wish to hold. A simple money demand function is

(M/P) d = kY,

Where k is a constant that tells us how much money people want to hold for every dollar of
income. This equation states that the quantity of real money balances demanded is proportional
to real income.

The money demand function is like the demand function for a particular good. Here the “good’’
is the convenience of holding real money balances. Just as owning an automobile makes it easier
for a person to travel, holding money makes it easier to make transactions. Therefore, just as
higher income leads to a greater demand for automobiles, higher income also leads to a greater
demand for real money balances.

M/P = (M/P) d = kY,

Where k = 1/V is a parameter determining how much money people want to hold for every dollar
of income. In this form, the quantity equation states that the supply of real money balances M/P
equals the demand (M/P) d and that the demand is proportional to output Y.

For any fixed money supply and velocity, the quantity equation yields a negative relationship
between the price level P and output Y. The following graph shows the combinations of P and Y
that satisfy the quantity equation holding M and V constant. This downward-sloping curve is
called the aggregate demand curve.

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Figure 1. Aggregate demand

Why the Aggregate Demand Curve Slopes Downward

As a strictly mathematical matter, the quantity equation explains the downward slope of the
aggregate demand curve very simply. Once PY is fixed, if P goes up, Y must go down. The
money supply determines the dollar value of all output in the economy. If the price level rises,
each transaction requires more dollars, so the quantity of goods and services purchased must fall.

We can also explain the downward slope of the aggregate demand curve by thinking about the
supply and demand for real money balances. For a fixed money supply M, higher real balances
imply a lower price level. Conversely, if the price level is lower, real money balances are higher;
the higher level of real balances allows a greater quantity of output demanded.

Shifts in the Aggregate Demand Curve

The aggregate demand curve is drawn for a fixed value of the money supply. In other words, it
tells us the possible combinations of P and Y for a given value of M. If the central bank changes
the money supply, then the possible combinations of P and Y change, which means the aggregate
demand, curve shifts. For example, consider what happens if the central bank reduces the money
supply. The quantity equation, MV = PY, tells us that the reduction in the money supply leads to
a proportionate reduction in the nominal value of output PY. For any given price level, the
amount of output is lower, and for any given amount of output, the price level is lower. As in
Figure 2 (a), the aggregate demand curve relating P and Y shifts inward.

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Figure 2. Shift in aggregate demand

The opposite occurs if the central bank increases the money supply. The quantity equation tells
us that an increase in M leads to an increase in PY. For any given price level, the amount of
output is higher, and for any given amount of output, the price level is higher. As shown in
Figure 2 (b), the aggregate demand curve shifts outward.

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2.2. IS-LM Model

The goal of the model is to show what determines national income for any given price level. IS
stands for “investment’’ and “saving,’’ and the IS curve represents what is happening to the
market for goods and services. LM stands for “liquidity’’ and “money,’’ and the LM curve
represents what’s happening to the supply and demand for money.

Because the interest rate influences both investment and money demand, it is the variable that
links the two halves of the IS–LM model. The model shows how interactions between these
markets determine the position and slope of the aggregate demand curve and, therefore, the level
of national income in the short run.

2.2.1. The Goods Market and the IS Curve

The IS curve plots the relationship between the interest rate and the level of income that arises in
the market for goods and services.

Dear students! To develop this relationship, we start with a basic model called the Keynesian
cross. This model is the simplest interpretation of Keynes’s theory of national income and is a
building block for the more complex and realistic IS–LM model.

The Keynesian Cross

In The General Theory, Keynes proposed that an economy’s total income was, in the short run,
determined largely by the desire to spend by households, firms, and the government. The more
people want to spend, the more goods and services firms can sell. The more firms can sell, the
more output they will choose to produce and the more workers they will choose to hire. Thus, the
problem during recessions and depressions, according to Keynes, was inadequate spending.

The Keynesian cross is an attempt to model this insight.

Planned Expenditure We begin our derivation of the Keynesian cross by drawing a distinction
between actual and planned expenditure. Actual expenditure is the amount households, firms,
and the government spend on goods and services, and it equals the economy’s gross domestic
product (GDP).

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Planned expenditure is the amount households, firms, and the government would like to spend
on goods and services.

Why would actual expenditure ever differ from planned expenditure? The answer is that firms
might engage in unplanned inventory investment because their sales do not meet their
expectations. When firms sell less of their product than they planned, their stock of inventories
automatically rises; conversely, when firms sell more than planned, their stock of inventories
falls. Because these unplanned changes in inventory are counted as investment spending by
firms, actual expenditure can be either above or below planned expenditure.

Now consider the determinants of planned expenditure. Assuming that the economy is closed, so
that net exports are zero, we write planned expenditure E as the sum of consumption C, planned
investment I, and government purchases G:

E = C + I + G.

To this equation, we add the consumption function

C = C(Y − T).

This equation states that consumption depends on disposable income (Y − T), which is total
income Y minus taxes T. To keep things simple, for now we take planned investment as
exogenously fixed:

Finally assume at the moment that the values of the other variables are fixed for simplicity:
– 1. Planned investment is fixed (i.e. I = I ).

– 2. Government purchases are fixed (i.e. G = G ).

– 3. Taxes levied are fixed (i.e. T = T ).

If we put all of the above together we get the aggregate planned expenditure curve,

PE =C+ I + G

PE = a + b(Y − T ) + I + G .
Graphically this relationship looks like,

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This equation shows that planned expenditure is a function of income Y, the level of planned

investment Iand the fiscal policy variables G

and T


The following figure, graphs planned expenditure as a function of the level of income. This line
slopes upward because higher income leads to higher consumption and thus higher planned
expenditure. The slope of this line is the marginal propensity to consume, the MPC: it shows
how much planned expenditure increases when income rises by $1. This planned-expenditure
function is the first piece of the model called the Keynesian cross.

The Economy in Equilibrium

Equilibrium in a static sense (we are not looking at an economy over time here, but at a point in
time) occurs when there is no incentive for anyone to change what they are doing. This will
happen in simple world we have constructed when;

Actual Expenditure = Planned Expenditure

or
Y=E
The 450 line on the following diagram shows the values of Y and E where equilibrium holds:

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Dear Students! How does the economy get to the equilibrium? In this model, inventories play
an important role in the adjustment process. Whenever the economy is not in equilibrium, firms
experience unplanned changes in inventories, and this induces them to change production levels.
Changes in production in turn influence total income and expenditure, moving the economy
toward equilibrium.

Income-expenditure adjustment graph

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For example, suppose the economy were ever to find itself with GDP at a level greater than the
equilibrium level, such as the level Y1. In this case, planned expenditure E1 is less than
production Y1, so firms are selling less than they are producing. Firms add the unsold goods to
their stock of inventories. This unplanned rise in inventories induces firms to lay off workers and
reduce production, and these actions in turn reduce GDP.This process of unintended inventory
accumulation and falling income continues until income Y falls to the equilibrium level.

Similarly, suppose GDP were at a level lower than the equilibrium level, such as the level Y2 in
above figure. In this case, planned expenditure E2 is greater than production Y2. Firms meet the
high level of sales by drawing down their inventories.

Fiscal Policy and the Multiplier: Government Purchases

Now we will examine what happens when an exogenous change occurs. For example, say that
government purchase of goods and services increased (expansionary fiscal policy). The initial
increase in government expenditure causes an even greater increase in actual (and planned)
expenditure, or income, than is first implied by just looking at the increase in government
expenditure alone. The final affect of the change in an exogenous variable is a multiple of the
initial change. This particular multiple is called the government purchases multiplier.
The way to work this out is to realize that this sum is a simple infinite geometric series and so we
can use the appropriate mathematical formula. Doing this gives us:

1
ΔY  ΔG
( 1  mpc)

since we have a simple infinite geometric series to add, and can use the relevant mathematical
formula. The term,
1
( 1  mpc)
is called the government expenditure multiplier and it is greater than one because 0<MPC <1.
The following graph shows what happens:

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For example, if the marginal propensity to consume is 0.6, the multiplier is
dY/dG = 1 + 0.6 + 0.62 + 0.63 + . . .
= 1/(1 − 0.6)
= 2.5.

Fiscal Policy and the Multiplier: Taxes

Consider now how changes in taxes affect equilibrium income. A decrease in taxes of ΔT
immediately raises disposable income Y − T by ΔT and, therefore, increases consumption by
MPC × ΔT. For any given level of income Y, planned expenditure is now higher. As the
following figure shows, the planned-expenditure schedule shifts upward by MPC × ΔT. The
equilibrium of the economy moves from point A to point B.

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Just as an increase in government purchases has a multiplied effect on income, so does a
decrease in taxes. As before, the initial change in expenditure, now MPC × ΔT., is multiplied by
1/(1 − MPC).The overall effect on income of the change in taxes is

DY/DT = −MPC/(1 − MPC).

This expression is the tax multiplier, the amount income changes in response to a $1 change in
taxes. For example, if the marginal propensity to consume is 0.6, then the tax multiplier is

ΔY/ ΔT = −0.6/(1 − 0.6) = −1.5.

In this example, a $1.00 cut in taxes raises equilibrium income by $1.50.4

Deriving the IS Curve

The income-expenditure relationship is the first step in building our macro model. It shows what
determines an economy’s income, given a level of planned investment. It is very unrealistic,
however, to assume that planned investment is exogenous as it will depend on economic
variables, the values of which are determined by the actions of people. The next step is to relax
the assumption of fixed planned investment and include it in the income-expenditure model.

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Endogenous Planned Investment
We know that an important factor determining the level of investment is the (real) interest rate
(r). If the interest rate increases then the amount of business fixed investment undertaken
decreases as the increase in r causes the cost of owning capital to increase. Inventory and
residential investment were also shown to be negatively affected by changes in r.

Dear Students! Did you remember the meaning of fixed business, residential, and inventory
investments? Good.

So now assume that the level of planned investment is a negative function of the real interest
rate, or in symbols that,

I = c − dr

where c ≥ 0 is the amount of autonomous investment and d ≥ 0 determines how sensitive

investment is to the interest rate, r, which implies that,
dI (r )
0
dr

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When this additional feature is added to the income-expenditure model we get the
IS curve, which we can show graphically as:

The IS curve summarizes the relationship between r, the level of Y that results from the
investment function and the income-expenditure relationship. The IS curve displays the values of
r and Y such that aggregate planned expenditure is consistent with actual income, where income
is assumed to be derived from output produced.

In summary, the IS curve shows the combinations of the interest rate and the level of income that
are consistent with equilibrium in the market for goods and services.

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Algebra of the IS Curve
We have derived the IS curve graphically, but we can also derive it algebraically which we will
now do so. Doing so increases our understanding of the goods market relationship and also is
needed to understand some aspects of the model which cannot be easily seen on the graph. We
know that the IS curve is just pairs of r and Y such that income (Y ) equals planned expenditure
(E), or that,
Y = C + I + G.
Substituting in for C and I we get,
Y = a + b(Y − T) + c − dr + G.
Grouping the Y s together and rearranging and solving for Y we get:
 1   1   1   d 
Y   (a  c)   G   T   r
 1 b   1 b   1 b   1 b 
which is the IS curve in algebraic form.

Points to Note about the IS Curve:

1. The IS curve is downward sloping because the coefficient on r is negative (i.e. increases in r
imply that a lower value of Y is associated with being on the IS curve).
2. The slope of the IS curve is determined by the coefficient on r. If d is large (I is sensitive to
r) or b is large (the MPC is large) then the IS curve is flat. A large d means that an increase in
r will lead to a large decrease in I and hence a large decrease in Y. Similarly, if b is large then
an increase in expenditure will induce a large increase in C consumption, and hence a large
increase in Y .
3. Changes in autonomous expenditure from G, T, a, or c will shift the IS curve in or out. The
sizes of these shifts are determined by b through their impact on induced consumption. The
larger b (the MPC) then the larger the multipliers, and the larger the shift in the IS curve.
4. The government expenditure multiplier is bigger than the taxation multiplier.
That is,
 1   b 
  > 
 1 b   1 b 

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This is because if G increases it directly increases planned expenditure and then causes
subsequent increases in C, whereas if T decreases it only indirectly increases planned
expenditure by causing C to increase.

A loan able funds interpretation of the IS curve

We have developed the IS curve using income and expenditure as the key concepts, but it hides
some important economics in thinking about the meaning of the goods market equilibrium which
we will now highlight. In particular it hides the fact that firms who are buying investment goods
have to borrow to finance payment for them, either from themselves or from other economic
actors such as banks. We will now show this explicitly. In deriving the IS curve we required that
income equals expenditure, or,

Y=E

Y = C + I +G
Substituting in the terms of expenditure. Now rearrange this by subtracting C and G from both
sides, which gives us,

Y − C − G = I.
S= I

The left-hand side of this equation is national saving S, and the right-hand side is investment I.
National saving represents the supply of loan able funds, and investment represents the demand
for these funds.

Next add and subtract T on the LHS of this expression which gives us,

(Y − T − C) + (T − G ) = I.
The term Y − T − C is simply private savings while the term T − G is government savings. What
this says is that equilibrium in the goods market requires pairs of r an Y that result in the supply
of loanable funds through saving to equal the demand for loanable funds to buy investment
goods. In the IS-LM model the savings are what is left over from consumption, which is affected
by income Y, so aggregate savings are function of Y. The amount of investment is a function of r.
This means that in equilibrium Y and r need to take on values so that S[Y] = I[r] (this is where
the ‘I’ and the ‘S’ come from to make IS). This relationship is shown in the following graph:

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Dear Students! This should not surprise us. If people want to invest for the future then they have
to forgo current consumption and equilibrium requires the two to be equal.

2.2.2. The Money Market and the LM Curve

Dear Students! For the economy to be in equilibrium it will not only requires equilibrium in the
goods market, but the asset markets should be in equilibrium. If asset markets are not in
equilibrium then it will affect people’s decisions about accumulating wealth through saving,
consumption, interest rates, investment, and thus the capital stock. They are all inter-related. In
the end, the decisions about the level of S and I are the result of people’s decisions about how
much wealth they want to hold and the forms of assets in which they want to hold their wealth.
That is, the decisions about flows variables (C, S, I, and other such things) are made in
conjunction with people’s decisions about stock variables (the assets they want to hold and in
which types of assets they want to hold their wealth). The problem for us is that there are lots of
different types of assets and it would be unmanageable for us to keep track of them all.

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Money Demand

In the section on money we found that the demand for money was significantly affected by the
nominal interest rate, R, because higher levels of the nominal interest rate increase the
opportunity cost of holding money causing the quantity of money demanded to money fall. We
also found that higher levels of C increases the average amount of money held (even allowing for
an increase in the frequency of converting non-monetary assets to money). We know that C is a
function of Y , so we will miss out the middle step for simplicity and just assume that the demand
for money depends on Y (through its affect on C). We know there are other factors that affect the
quantity of money demanded but they are of secondary importance and so we will concentrate on
Y and R. If we denote the demand for real money balances or liquidity as L[R, Y ] then we have
the relationship,

L[R, Y] = eY − fR

Where e ≥ 0 measures the strength of the transactions demand for real money balances and f ≥ 0
measures the interest sensitivity of the demand for real money balances. Given the above
equation we would expect that the partial derivatives of the demand for real money balances with
respect to R and Y take the following signs:
LR = −f < 0 and LY = e > 0.

Money Supply

Dear Students! In chapter one we have discussed how monetary authority (the National
Bank/Central Bank), is able to influence the overall nominal money supply. For the moment let
us simply assume that the money supply does depend on factors outside the Central Bank control
that is we will assume that the CENTRAL BANK has some degree of control over the supply of
nominal money balances, which seems a reasonable approximation on average. We will also
assume at this stage that the price level is also fixed. These assumptions imply that the supply of
real money balances is independent of the interest rate.

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Algebraically we can express this relationship in the following way,
M
[M/P]s = ( )
P
And graphically this relationship is given by vertical line in the liquidity preference graph below.

Equilibrium in the Money Market

Equilibrium in the money market occurs when the quantity of real money balances demanded
equals their supply of them, or,

M
( ) = L[R, Y].
P
This situation is shown in the following graph with the equilibrium interest rate:

The Theory of Liquidity Preference The supply and demand for real money balances determine
the interest rate. The supply curve for real money balances is vertical because the supply does
not depend on the interest rate. The demand curve is downward sloping because a higher
interest rate raises the cost of holding money and thus lowers the quantity demanded. At the
equilibrium interest rate, the quantity of real money balances demanded equals the quantity
supplied

Dear Students! Have you realized the effect of change in Money supply up on interest rate?
Good. This graph tells us that given Y and P that the interest rate is determined in the money

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market. Consider an increase in M. This causes the supply of real money balances curve to shift
to the right and the situation is shown in the following graph:

Deriving the LM Curve

The equilibrium interest rate that clears the money market depends on the level of income
through the demand for real money balances. This implies that there is a systematic relationship
between Y and r in the money market. This is shown in the following graph:

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Higher levels of Y increase the demand for real money balances and given a fixed supply of real
money balances, ‘r’ must increase. The higher ‘r’ causes the opportunity cost of holding money
to increase, reducing the quantity of real money balances demanded, and restoring equilibrium in
the money market. This relationship between r and Y that gives equilibrium in the money market
is known as the LM curve.

Therefore, the LM curve plots the relationship between the interest rate and the level of income
that arises in the market for money balances.

Shifts in the LM curve

Changes in R and Y will be movements along the LM curve, but any change in an exogenous
variable will shift the position of the LM curve. For example, if the money supply decreases, the
interest rate increases which can shift LM curve upward.

Algebra of the LM curve

As with the IS curve we will now derive the LM curve algebraically as doing so increases our
understanding of the goods market relationship and also is needed to understand some aspects of

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the model which cannot be easily seen on the graph. We also know that money market
equilibrium requires that,
M
( )= eY-fR
P
And rearranging this expression we get,
M
R=e/f Y-( )
fP
Which is the LM curve in algebraic form.

Points to Note about the LM Curve:

1. The LM curve is upward sloping because the coefficient on Y is positive (i.e. if R increases
then a higher value of Y is associated with the money market being in equilibrium).
2. The slope of the LM curve is determined by the coefficient on Y. If e is large (changes in Y
cause large changes in the transactions demand for real money balances) then the LM curve
is relatively steep (i.e. a given increase in R will cause the demand for real money balances to
fall, if e is large then only a small increase in Y is required to produce an offsetting increase
in the demand for real money balances). If f is large (changes in R cause large changes in the
quantity of real money balances demanded) the LM curve is relatively flat (i.e. a given
increase in Y will cause the demand for real money balances to increase, if f is large then a
small increase in R is required to produce an offsetting decrease in the demand for real
money balances).
3. Changes in M or P will shift the LM curve in or out. The sizes of these shifts depend upon
the value of f. If f is large then an increase in M or decrease in P will cause a small
downward shift in the LM curve (i.e. for a given Y and a given increase in M or decrease in
P , then a large f implies a small fall in R).

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2.3. The IS-LM Equilibrium

We now have all the pieces of the IS–LM model. The two equations of this model are

Y = C(Y − T) + I(r) +G IS

M/P = L(r, Y) LM

The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous.
Given these exogenous variables, the IS curve provides the combinations of r and Y that satisfy
the equation representing the goods market, and the LM curve provides the combinations of r and
Y that satisfy the equation representing the money market. These two curves are shown together
in the following figure.

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From the IS–LM Model to the Aggregate Demand Curve

Having derived the IS and LM curves and establishing the condition for simultaneous
equilibrium in these markets we are now in a position to go one step further and use this model
to derive the aggregate demand curve which we will do next.

To understand the determinants of aggregate demand more fully, we now use the IS–LM model,
rather than the quantity theory, to derive the aggregate demand curve. First, we use the IS–LM
model to show why national income falls as the price level rises—that is, why the aggregate
demand curve is downward sloping. Second, we examine what causes the aggregate demand
curve to shift.

To explain why the aggregate demand curve slopes downward, we examine what happens in the
IS–LM model when the price level changes. This is done in the following figure. For any given
money supply M, a higher price level P reduces the supply of real money balances M/P. A lower
supply of real money balances shifts the LM curve upward, which raises the equilibrium interest

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rate and lowers the equilibrium level of income, as shown in panel (a). Here the price level rises
from P1 to P2, and income falls from Y1 to Y2.

The aggregate demand curve in panel (b) plots this negative relationship between national
income and the price level.
In other words, the aggregate demand curve shows the set of equilibrium points that arise in the
IS–LM model as we vary the price level and see what happens to income.

Algebra of the AD curve

In equilibrium r and Y have to be the same regarding the money market and the goods market.
This means that we can substitute for r from the LM curve,

e 1M 
R Y  
f fP
into the IS curve,
 1   1   b   d 
Y   (a  c)   G   T   r
 1 b   1 b   1 b   1 b 
given that R=r since we are assuming π e =0, which gives us the AD curve where Y is a function
of P, or

ac 1 b de d M 
Y  G T Y  
1 b 1 b 1 b f (1  b) f (1  b)  P 
This also means that P is no longer taken as given but is determined by the economic behaviour
of people in the model. We show this by removing the line over it. Now group together all the Ys
and solving for Y we get,
f (a  c  G  bT ) dM 1
Y   
f (1  b)  de f (1  b)  de  p 
which is AD curve in algebraic form.

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Determinants of aggregate demand

Fluctuations in the money supply are not the only source of fluctuations in aggregate demand.
The following are important determinants.

1. Changes in consumer spending, which can be caused by changes in several factors.

 Consumer wealth,
 Consumer expectations,
 Taxes.
2. Changes in investment spending, which can be caused by changes in several factors.
o Interest rates,
o Profit expectations,
o Business taxes,
o Technology, and
3. A change in government spending is another determinant.
4. Change in net export spending unrelated to price level.

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