Chapter IV

The Narrow Definition of

MONEY

Traditionally, most economists have preferred the “narrow”,

or transactions, measure of money, M1, which includes only
currency, and consists notes, coins, demand deposits, other
checking accounts, and travelers check.
Broader Measures of Money:
M2, M3
In constructing M2, certain highly liquid assets are added to
M1. Savings deposits, small time deposits, and money market
deposit accounts in banks are quite liquid and are also included
in M2.

M3 is constructed by adding certain slightly less liquid financial

assets to M2. M3 includes M2 plus large time deposits, certain
repurchase agreements and Eurodollar deposits, and money
market mutual fund shares.
Inflation and Deflation
 Is a sustained increase in the price level
commodities. It is and economic disorder which is
characterized by spiraling of prices as a result of
over issuance of money.
DEFLATION
 Is characterized by an uncontrolled decline in the
general price level as a result of undersupply of
money. Because there is so much money with plenty
of goods available, the tendency is for prices to go
down.
 INFLATION
 Whenever money supply or the level of credit
increase by more than 15%, which is a normal
increase.

 Whenever the level of price index number is more

than 10%.
DISADVANTAGES OF INFLATION
 It is unfavorable for the fixed income group
because the abnormal increase in prices would
mean they would enjoy less consumer goods wia
given income.
 It may induce the occurrence of (business cycle)
recession in the economy.
 It disrupts debtor-creditor relationship
DISADVANTAGES OF DEFLATION
 Deflation induces curtailment in production and
activities of business firm, since a significant
decrease in prices will cut down all profits and may
eventually cause losses.
 It may cause a depression in employment and
consequently a loss in purchasing power.
 DEMAND

 Is defined as the relationship between nations ‘s

price level and the amount of real output
demanded, other factors remaining constant.
 Consumption
 Investment
 Government purchases of Goods and Services
 Net Exports of Goods and Services
 Quantity of Input
 Prices of Inputs
 Technological Change
The Demand for Money and Velocity
of Money.
 The velocity of money refers to the rate of turnover
of money or the frequency of spending money. The
determinants of velocity of money may be qrouped
into six categories:
1. Institutional factors that underlie the synchronization between receipt and
expenditures.
2. The state of financial technology
3. Interest rate levels
4. The prevailing degree of economic uncertainty or state of economic confidence
5. Inflation expectation; and
6. Income level
A useful way of illustrating the connection between
Money and economic activity is the
Equation of Exchange
M = the average money supply in existence in a given year
VT= the transactions velocity of money – that is, the number of
times the average dollar is spent per year (VT=PT/M)
P= the average price of the transaction that take place during
the year
T= the number of transactions occurring during the year
M= the average money supply in existence in a given year
VT= the income velocity of money , or the number of times the
average peso is spent on final goods and services per year
(VY*PY/M or GDP/M)
P= the average price of all final goods and services purchased
during the year – the average price of all goods and services
constituting GDP, or an index of such prices relative to some
base year.
Y= the number of final goods and services produced in the
year, or an index of real GDP relative to the base year
Each measure of the money supply(M1,M2, and M3)
has a corresponding measure of income velocity.
The amount of money(M1 or M2) that people desire
to maintain is known as the DEMAND FOR MONEY
1. Velocity and the Demand for Money
2. The Demand for Money
3. Motives for Holding Money
4. Transactions Demand
5. Precautionary Demand
6. Speculative Demand
1. Interest Rates and the Transactions Demands
2. Interest Rates and the Precautionary Demand
3. Interest Rates and the Speculative Demand
 We have learned that the demand to hold money may be
responsive to the opportunity cost of holding money – the
market rate of interest. Each motives of holding money may
depend in part on the interest rate, and it’s increase makes
holding money most costly. This is because money pays a
relatively non-competitive rate of interest, if any. To the extent
that the demand for money and therefore its velocity vary
with interest rates, the link between money supply and GDP
expenditures becomes more uncertain because interest rates
fluctuate significantly overtime.