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Lecture 4
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Money and its functions
 1. the medium of exchange
 2. the unit of account
 3. a store of value
 4. money as a standard of deferred payment
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The medium of exchange
 Used as one-half of almost all exchanges
 We want it to buy goods and services now or in the future
 Makes the exchange of goods and services more efficient
 A barter economy- one without any commonly accepted
medium of exchange
 A double coincidence of wants before exchange can take
place in a barter economy: costly or not possible,
 Could you imagine paying tuition in a barter economy?
 time used to find goods which are acceptable = waste of
resources
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The unit of account
 The unit in which prices are quoted and accounts are
kept
 What in the situation of a high inflation? Prices
quoted in foreign money
 Case of German economy 1922-1923 prices kept in
dollars but payments made in local currency
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Money a store of value
 Money is a store of value because it can be used to
make purchases in the future
 It has to be accepted in exchange
 Houses, automobiles, stocks, stamp collections can
also serve as stores of value, some time better than
money
 Money as a standard of deferred payment – future
payments usually specified in terms of money
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Medium of exchange function
most important
Money need not be the
unit of account or the
standard of deferred
payment, but it usually is
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A commodity money
 Is used as a medium of exchange and also bought or
sold as an ordinary good
 Cigarettes, cocoa, gold or silver
 If cocoa would be more valuable as money no one
would have drunk it.
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Token money
 Those means of payments whose value as money exceeds
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the cost of production and the value in alternative uses
What is the value 100$ bill as a piece of high quality paper?
Coins as token monies, but when prices of silver or copper
went up banks offering $1.15 for a bag of 100 pennies
Control over the right to produce money
Modern money accepted because the law requires them to
be accepted – what when the inflation very high?
Supply controlled by the state
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An IOU money
 Medium of exchange that is the debt of a private firm
or person
 An example: bank deposit, because the bank has to
give the deposit holder euro, zloty whenever she
demands them.
 It is medium of exchange because people are willing to
accept checks in payment
 Traveler’s checks are IOU money
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Banking
 Modern banks are profit making financial intermediaries
 F.I. is the institution that stands between lenders and borrowers
 A commercial bank borrows currency from the public, issuing deposits
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in exchange
Money that is borrowed used to make loans to firms , individuals or
government
Other financial intermediaries: life insurance companies and pension
funds
Banks as other businesses aim to maximize profit
To be competitive bank offers favorable terms to potential depositors:
low fees , a free toaster perhaps?, high interest rate
To maximize profit –1)profitable ways of lending to others what it has
been borrowed: a) reserves, b) credits to firms, c) part lent to students
or people buying houses, d) securities; 2)good bank management:
appropriate structure of loans
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How money is created
bank
Required
reserves
Excess reserves=
loans
Demand
deposits
A
1000
9000
10.000
9.000
B
900
8100
8100
C
810
7290
7290
D
729
6561
6561
E
656
…
…
10.000
5905
5905
90.000
100.000
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The money multiplier
 gives the change in the money stock caused by the unit
change of high-powered money
 High-powered money (monetary base) – the most
liquid money = the total amount of currency (coins +
paper money) that is either circulated in the hands of
the public or in the commercial banks deposits held in
the central bank reserves
 Money supply (money stock) = money multiplier x
monetary base
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How to calculate money
multiplier?
 Money stock M= C+D, where C –cash (currency) circulated
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in the hands of public, D – deposits of commercial banks
C=c x D,
M=c x D + D=D(c+1), where c =liquidity preference (how
much currency (cash), how much deposits)
Monetary base H=cash (C) + banking reserves (R), where
R=rrr x D, rrr= required reserves ratio
Monetary base H=C+R =c x D + rrr x D= D(c +rrr)
Multiplier (change of money stock M caused by unit
change of monetary base H)
multiplier=M/H= D(c + 1)/D(c + rrr)
Multiplier=(c+1)/(c + rrr) > 1
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Factors having impact on money
multiplier
 Money multiplier = (c+1)/(rrr + c) is higher when:
 1) liquidity preference (c) higher
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 2) reserve ratio (rrr) lower
 An example:
 c = 0.03, rrr = 0.008
 M/H = 1.03/0.038 = 27
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The role of the Central Bank
 money supply control, cooperation with commercial
banks, public debt management
 Instruments used to control money stock: 1.reserve
requirements, 2. discount rate, 3. open market
operation
 Instrument 1 and 2 have an impact on value of
multiplier,
 Instrument 3. is changing monetary base H = C + R
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1. Reserve requirements
 Cash reserve ratio: central bank regulation that sets
the minimum reserves each commercial bank must
hold of customer deposits ( in form of cash in bank
vault or deposits with central bank deposit
 If amount of cash in commercial banks < reserve
requirements → banks have to borrow cash
 Reserve ratio a kind of tax diminishing amount of
loans issued by banks
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2. The discount rate
 The rate at which the central bank lends to banks
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borrowing to meet reserve shortfalls
If the discount rate > average interest rate→ banks
motivated voluntary keep additional cash. Why?
An example: cash = 12% of deposits, interest rate 8%,
reserve ratio=10%, discount rate 10%
No incentive to increase credits because of the possible
losses in the situation when people would withdraw cash
very fast.
Both instruments the reserve ratio and the discount rate
are not used very often. The discount rate changed in line
with market interest rate.
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3. Open market operation
 Central bank changes monetary base H=C+R buying
or selling government securities in the financial
markets
 Purchase of government securities by the central bank
increases the money stock and allows banks to
increase loans to firms and public.
 Selling government securities →smaller C or R, less
loans available
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Central bank as lender of last
resort
 Lends to financial institutions and firms at times when
panic threatens the financial system
 Decreases uncertainty in the financial policy
 An example: during last financial crisis US
government expenditure of$700 billion to save US
banks and financial institutions.
 IMF ready to bail-out governments having high debts
(Greece case)
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The demand for money
 The nominal demand for money – the number of
dollars/ zloty individuals and firms want to hold
 Two kinds of assets: money and bonds. Bonds asset
that pays interest, while money does not pay any
interest income
 The opportunity cost of holding money rather than
bonds is the amount of interest that is given up by
holding money rather than bonds
 motives to hold money: 1) the transaction motive, 2)
precautionary motive, 3) portfolio motive
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1. Transaction motive
 Effect of time lag between money received and transaction
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made
The volume of cash reserve depends on: a) transaction
value, b) synchronization of incomes and expenditures
The demand for money is demand for real balances – value
of money holdings measured in terms of their purchasing
power
Real money balances=nominal money balances/price level
a) transactions motive stronger when real GDP is higher
b) behavior of people making transactions not changing
significantly
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2. Precautionary motive
 Linked to uncertainty in income/ expenditure time
table
 Holding some money in a liquid form to cover
unexpected expenditure
 Precautionary motive stronger when number of
transactions larger/ real GPD higher
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3. Portfolio motive
 Caused because of risk aversion: one gives up higher
interest income in exchange of higher security of
deposits
 Two parts of portfolio: high and low risk assets
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Money demand and interest rates
 Comparison of costs and benefits to hold money
 Benefits explained by 3 motives to hold money
 Costs: lost interest income – people hold money instead of some alternative
assets
 Alternative assets: savings and time deposit, money market mutual funds,
bonds and stocks. All those assets called bonds for a simplification
 The interest rate = the payment (% a year), made by borrower to a lender in
exchange for the use of the amount lent
 The marginal benefit of holding money declines with the amount of money
held. When the individual is holding so much money that there is no worry
about running out of cash, holding an extra dollar brings very little benefit.
 The marginal cost (MC) equals the forgone interest, holding one extra dollar
costs the same, MC = interest rate
 The optimal amount of money : marginal cost (MC) = marginal benefit (MB)
 Demand for money is inversely related to the interest rate: demand low when
the interest rate high; demand high when the interest rate low
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Money demand and income
 Money demand depends on spending
 The level of spending depends on the real income
households earn
 Increased spending (higher income) → higher
quantity of money demanded
 Changes in spending ( income) shift the demand for
money curve to the right or to the left
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The demand for money
Increase in price
level
Increase in real
income
Increase in
opportunity cost
of holding
money (interest
rate)
Nominal money
demand
Increases demand
for nominal
money balances
proportionally
Increases demand
Reduces demand
Real money
demand
Leaves demand for Increases demand
real balances
unaffected
Reduces demand
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The money supply and equilibrium
interest rates
 The nominal money supply determined by central
bank .
 Equilibrium in the money market : money supply =
demand for money
 Central bank decision on the money supply = decision
on the equilibrium interest rate
 Contraction or expansion in the economy as a result of
central bank policy (money supply curve shifts to the
left or to the right)
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More on the effects of a change in
the money supply
 Central bank conducts open market operation: buying
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bonds→ quantity of money is increasing , with a
constant price level real money stock goes up
The supply of money shifts to the right
The interest rate is going down, new equilibrium at
the lower interest rate
Selling bonds →quantity of money is decreasing,
with a constant prices real money stock is going
down
The interest rate is going up, new equilibrium at
higher interest rate
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