BNK501Sem:

FUNDAMENTALS OF
BANKING

TOPIC 2
THE ROLE OF MONEY IN THE
MACRO ECONOMY
Semester 2 2018

Page 1
 LECTURE OUTLINE
Introduction, Definition and Importance of Money
Functions and Characteristics of money
Demand and Supply Money
Measures and Components of Money Supply
Monetary Base
Classification of Money
Money, the Economy and Inflation

Page 2
 INTRODUCTION
“Lack of money is the root of all evil”
By
George Bernard Shaw.

• Yes, because at ‘its most corrupt, the greed for

money can motivate to murder. It can make you
embezzle (commit Fraud), fiddle (cheat), got to
war, and even colonize (take over) other
countries to control their resources.

Page 3
 INTRODUCTION
• Money is the greatest knowledgeable discovery
in history by humankind.
• Without money, the production and exchange of
anything such as the most fundamental goods
and services is impossible. It is not difficult, or
time consuming, or inefficient, it is IMPOSSIBLE!

Page 4
 MONEY DEFINED
• Most people don't spend much time wondering
what money is, their major concern is how much
they have, and how to get more.
• Usually, the question of what money IS arises
only when money ceases to function properly.
• In economics (properly understood), the answer
to the question - what is money? - consists of
three words:
Money is a "medium of exchange"

Page 5
 MONEY DEFINED
• In any society, money is the asset, commodity or
token, that serves as a medium of exchange.

• Money is a commodity or token that everyone

will accept in exchange for the things they have
to sell (Adam Smith).

Page 6
 IMPORTANCE OF MONEY
• Money can prevent the sufferings that come with
poverty like diseases and hunger.

• While sickness can not be totally eliminated by

money, it can be considerably relieved by it.

• Generating wealth and giving away money to

charity can also provide us with the satisfaction
of relieving others from suffering.

Page 7
 IMPORTANCE OF MONEY
• With money, we can obtain an advanced
education that may aid us in the development of
quality achievements.
• It gives us the leisure to devote a part of our
time to culture and art.
• Money is the means by which we may fulfill our
purpose in a larger and better way.

Page 8
 IMPORTANCE OF MONEY
• Everyone should, in his own way, make an effort
to collect some money.

• Whatever the reason, everyone capable of

earning money should learn how to manage it
properly in order to ensure that they will have
enough of it to apply to the causes that they
choose.

Page 9
FUNCTIONS OF MONEY

Page 10
 FUNCTIONS OF MONEY
• Medium of Exchange: promotes economic
efficiency by minimizing the time spent in
exchanging goods and services.
 Must be easily standardized.
 Must be widely accepted.
 Must be divisible.
 Must be easy to carry.
 Must not deteriorate quickly.
• Unit of Account: used to measure value in
the economy.
• Store of Value: used to save purchasing power;
most liquid of all assets but loses value during
inflation.
Page 11
 CHARACTERISTICS OF
MONEY
• Divisibility: Ability to be broken down into
smaller units.
• Portability: Ability to be easily moved from place
to place.
• Durability: Ability to survive repeated usage over
time.
• Difficulty in Counterfeiting: Currency should be
hard for anyone, other than the government, to
produce.
• Stability: Should maintain a relatively stable
value.

Page 12
 CHARACTERISTICS OF
MONEY
• Recognizable: money is easily recognized and
differentiated from other assets to its size,
shape, colour, texture and associated features.
• Homogenous: all coins, notes of the same
denominations are identical.
• Scarcity: money is scarce in supply in the
economy at any point in time.

Page 13
 MONEY DEMAND
• TRANSACTIONS DEMAND
 For daily transactions of buying and selling
goods and services.
• PRECAUTIONARY DEMAND
 To save for future or for unpredictable events.
• ASSET/SPECULATIVE DEMAND
 For investment purposes.

Page 14
 MONEY DEMAND
• The amount of money demanded for transaction
and speculative purposes depends: personal
income and interest rate.
• At any level of personal income, quantity
demanded of money is a negative function of
interest rate; (M/P)d = L(i, Y).

Page 15
 MONEY DEMAND

Interest Rate (%) M/P = L(Y, i)

Y = income
i = interest rate

10

5
(M/P)d
80 100
Quantity of Money

Page 16
 MONEY SUPPLY
M=C+D

• C = Currency: coins & bills.

• D = Demand Deposits: checking account
deposits.

Page 17
 MONEY SUPPLY

Interest Rate (%)

(M/P)s
10

80 Quantity of Money
Page 18
 MONEY MARKET
EQUILIBRIUM
Interest Rate (%)

(M/P)s

(M/P)d
80 Quantity of Money

Page 19
EXPANSIONARY MONETARY
POLICY
Interest Rate (%)
(M1/P)s (M2/P)s

5
4

(M/P)d

80 85 Quantity of Money

Page 20
 EXPANSIONARY MONETARY
POLICY
• Primary Expansion of Money Supply
 managed by RBF through Open Market
Operations.
 RBF purchases financial assets (e.g. government
bonds) from the public, injecting new money into
banking system.
 also, if government transfers funds from its RB
account to its spending accounts held in
registered banks.

Page 21
 EXPANSIONARY MONETARY
POLICY
• Secondary Expansion of Money Supply
• Credit Creation Process:
Customers deposits in a bank.
banks with excess reserves make new loans to the
public.
loans are spent and deposited in recipients’ bank
accounts.
new deposits add to other banks’ reserves,
enabling other banks to make new loans.
process continues until banks no longer have
excess reserves.

Page 22
 MEASURES OF MONEY
• Components of M1:
 currency
 sight deposits- a bank deposit that can be
withdrawn immediately without notice or penalty.
 other checkable deposits
 travellers checks- is preprinted, fixed-
amount check that is accepted in many banks and exchange
offices worldwide.

•NOTE: M1 does not include credit card transactions. A

credit card purhase is not a transfer of medium of
exchange, rather it is a prenegotiated right to borrow
from and repay the credit card company. Credit card
arrangements reduce the quantity of medium of
exchange.
Page 23
MEASURES OF MONEY

Page 24
MEASURES OF MONEY

Page 25
THE MONETARY BASE

Page 26
 MONEY, ECONOMY AND
INFLATION
• Money supply is important because it is linked to
inflation by the "monetary exchange equation“

MV = PQ Where;

M = total dollars in the nation’s money supply.

V = number of times per year each dollar is spent
P = average price of all the goods and services sold
during the year.
Q = quantity of goods and services sold during the
year

Page 27
 MONEY, ECONOMY AND
INFLATION
• Velocity is the rate of turnover of the money
supply; the average number of times per year
each dollar is used to purchase goods and
services (often measured by GDP divided by the
money supply)
• Suppose the central bank increases the money
supply, the recipient of this probably spent some
of it on domestically produced goods and
services, increasing GDP. The funds thereby
move from the original recipient to the sellers of
goods and services.

Page 28
 MONEY, ECONOMY AND
INFLATION
• Now the sellers have more money than before,
and if they behave the same way as the others,
they too, are likely to spent some of it.
• GDP thus rises faster and the money moves to
yet another set of owners, who, in turn, may also
spent part of it, thereby increasing GDP again.
Over a period of time, say a year, a multiple
increase in spending and GDP could thus flow
from an initial increase in stock of money.

Page 29
 MONEY, ECONOMY AND
INFLATION
• Velocity is found after the process has ended, by
dividing the cumulative increase in GDP by the
initial increase in money supply.
Example
• Suppose GDP in an economy is $8,111billion in
the year.
• There was an average money supply of $1,080
billion during the year.
• Therefore the velocity of money was 7.5 per
annum. Each dollar, on average was spent 7.5
times in purchasing goods and services during
the year.
Page 30
 MONEY, ECONOMY AND
INFLATION
• Does more money always lead to inflation?
No, but it can under certain circumstances, and if the
increase is large enough, it probably will.
Let us look at 3 cases
• Case 1
If the Central Bank expands the money supply while
we are in a recession, the increase spending it
induces is likely to lead to more employment and a
larger output of goods and rather than higher prices.

Page 31
 MONEY, ECONOMY AND
INFLATION
• Case 2
As we approach full employment and capacity
output, increases in money supply is more and more
likely to generate rising prices. However, if this
increase is only large enough to provide funds for
the enlarged volume of transactions accompanying
real economic growth, inflation still not result.
• Case 3
only when money supply increases under the
conditions of high employment and exceeds the
requirements of economic growth can it be held
primarily responsible for generating an inflationary
cycle.
Page 32
END OF LECTURE

Page 33