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Economics I
Money and Money Market (4h)
Money and Money Market
• The aim of the first lecture is to define money, their forms and functions that
the money performs in the economy. Next, we will focus on the origin and
evolution of money and the current components of the money supply. In the
next step the objective is to define the banking system and to explain the
creation of bank deposits (using simple money multiplier). This lecture will
form the basis for subsequent interpretation devoted to the money market.
• The goal of the second lecture is to characterize the money market, define
the money supply and money demand and explain the factors that influence
them. Moreover, next step is to explain the equation of exchange, the
quantitative theory of money and interpret what neutrality of money means.
Content
•
introduction – defining the goals
•
money - definition, origin and evolution of money, functions of money
•
contemporary money and monetary aggregates
•
banking system
•
creation of banking deposits - deposit multiplication
•
money market - money demand and money supply
•
equation of exchange and the quantitative theory of money
•
conclusion – summary, homework
Money - definition, origin and evolution of money,
functions of money
•
money: a generally accepted equivalent exchange, means of payment, the most
liquid form of assets
•
two basic approaches to money: functional and empirical
•
exogeneity and endogeneity of money
•
origin and evolution of money (depends on the development of exchange)
•
three main functions of money:
1. medium of exchange
2. unit of account
3. store of value
Contemporary money and monetary aggregates
• definition of current money: money is not currently covered (by gold),
with forced circulation, money is accepted because they are legally
prescribed currency
• basic forms of current money:
i.
coins
ii.
bills
iii.
deposit money (accounting, fictitious, bank, giro)
• monetary aggregates:
According the EU methodology:
M1: currency in circulation, overnight deposits
M2: M1 + deposits with agreed maturity up to 2 years and deposits redeemable at notice up to 3 months
M3: M2 + repos, shares/units of money market funds, money market paper and debt securities up to 2
years
•
general classification: aggregate M0, M1, M2, M3 (L).
The sense of breakdown of these monetary aggregates
• the resolution of monetary aggregates is not identical in all countries
• a central bank wants to know the size of the money supply - money that
businesses really hold and which affect the behavior of market actors and
therefore the course of economic events
• monetary policy can respond quickly and appropriately to adverse
economic shocks - events
6
Banking system
•
the existence of the financial market is assumed
•
direct and indirect funding (there is an efficiency of utilization of resources)
•
the banking system in the developed market economies - usually two basic levels:
•
I.
a central bank
II.
the net of commerial banks
the main functions of the central bank:
a. emission function
b. supervision of commercial banks
c. monetary policy
d. bank of all commercial banks
e. state bank
f. management of foreign exchange reserves
g. representation of the banking system and the state in the field of international
monetary relations and organizations
•
the goal of a central bank vs. the goal of commercial banks
Creation of banking deposits - deposit multiplication
•
the deposit multiplication: the process of generating deposits to bank accounts
•
deposit multiplication means the conversion of deposits and reserves in loans and
their return on deposits (deposits multiplication condition). The following is the
process of converting the mortgage in expenses, which are sales of another
economic entity, and these sales will appear again as bank deposits (in banks of
“next stage”)
•
Increase in bank deposits is reduced by reserves in next stage (i. e. PMR = reserve
requirements) and converges to zero
•
the formula: ΔD = ΔR . 1/r
ΔD = incremental deposits
ΔR = increment of reserves
r = rate of required reserves
1/r...simple money multiplier
•
the process of making the deposit money works in the opposite direction
•
powerful money: reserves + currency outside the banking sector, or the monetary
base, these powerful money passes through multiplication
8
Money market - money demand and money supply
• demand for money: it expresses the amount of money at the price
(interest rate) that economic operators are willing to hold
• requested amount of money may not equal the amount of money offered
• the theory of liquidity preference - motives of money holding:
I.
transaction motive
II.
precautionary motive
III.
speculative motive
9
Keynesian money demand function:
transaction and speculative motive
L = k.Yr – h.i
i
L
L´ when
L = demand for money
Yr or P
k = sensitivity to change in
real income (Yr)
h = sensitivity to changes in
interest rates (i)
i1
i2
The demand for money
grows when growing real
output or price level.
L1
L2
L
10
Money supply, the monetary base,
the equilibrium at the money market
•
money supply: the amount of money that the economy has available, = currency in
circulation and demand deposits (M1)
•
monetary base, powerful money (MB) reserves + currency outside the banking
sector; monetary base (MB) undergoing multiplication and depending on the money
multiplier (m) the money supply (SM) is created:
SM = MB.m
•
money multiplier “m” is not constant and predictable
•
the money multiplier is influenced by other effects (behavior of the central bank,
commercial banks and depositors)
•
equilibrium at the money market is the result of an intersection of the money supply
and money demand
SM = DM
or M/P = L
t11
Equilibrium at money market
SM
iN
iN = nominal interest rate (the
average)
M = amount of money
i1
SM = money supply
(controlled by a central bank)
E
i2
DM = demand for money
DM
i3
M1
M2
M3
M
12
Equation of exchange and the quantitative theory of
money
•
P.Y=M.V
P = Price level
Y = real GDP
M = nominal quantity of money in circulation
V = velocity of monetary unit
• the predecessor of the quantitative theory of money: David Hume (17111776)
• the author of the classical quantitative theory of money (the so-called
transaction variant): Irving Fisher (am. Economist, 1867-1947); began with
a simple analysis that every transaction has both a buyer and also the
seller
• the value of all sales in the economy equals the value of all purchases:
(AS = AD)
13
The assumptions and conclusions of the quantity theory of
money
• the quantitative theory of money: if the velocity of money is given by the
practice of the payment and payment technology in a society – it is a
stable variable, money supply is given, it is checked by the central bank,
and the volume of all transactions (sales) is constant, and the economy is
on the level of potential product:
then increase the amount of money supply in the economy will cause
the rise in price level in the economy
• reformulation of the quantity theory of money (by conservative
economics - Monetarism, an important conclusion of the Monetarism:
money can affect real macroeconomic variables in the short term only)
14
Literature
•
FRANK, R. H., BERNANKE, B. S. Principles of Macroeconomics. 3rd Edition. McGrawHill/Irwin: NY, 2007. ISBN 978-0-07-319397-7. 561 p.
•
MANKIW, G. N. Principles of Macroeconomics. 4 th ed. USA: Thomson SouthWestern, 2007. 583 p. ISBN 978-0-324-23695-8.
•
McCONNELL, C. R., BRUE, S. L. Economics: Principles, Problems, and Policies. 17th
ed. NY: McGraw/Irwin. 716 p. ISBN 978-0-07-312663-0.
•
SAMUELSON, P. A., NORDHAUS, W. D. Economics. 15th ed. McGraw-Hill, 1995.
Homework
Exercise “Money and banking deposit creation”
•
Assume Mr. Thrifty had sold treasury bills to the central bank in the amount of
500,- monetary units and after it he deposited this amount in one of the
commercial banks. The level of required reserves is 7.5 %. Calculate the money
generated by increases in the first 5 stages of deposit multiplication and figure out
the overall monetary increase in the banking system - after all stages.
•
Find out the actual level of minimum reserves in your country and calculate simple
deposit multiplier. For the Czech Republic, visit the website of the Czech National
Bank (http://www.cnb.cz).
Homework
Exercise “Money Market”
•
In the economy output (GDP) was to increase and the households received
additional income. Draw a change at the money market and discuss the new
equilibrium at the market - determining the equilibrium interest rate and the
amount of money supply in the economy.
•
Assume that the economy shows these statistical figures: real GDP = 379,000 mil.,
average price level (P) = 2.45 and money supply (M) = 362,000 mil. Calculate the
velocity of monetary unit.