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The Money Market
What is Money?
At first sight the answer to this question seems obvious; the man or woman in the
street would agree on coins and banknotes, but would they accept them from any country?
What about cheques? They would probably be less willing to accept them than their own
country's coins and notes.
Money is anything commonly accepted as a means of exchange1
Forms of Money
Money does not exist in a pure barter system. Trades are negotiated by the participants as
a fair exchange of goods and services. However, there is an inconvenience here, which makes
barter only an occasional exchange system – There must be a double coincidence of wants! If
the entire economic activity is based on the social division of labor and permanent echange of
goods, services and resources, the barter system cannot facilitate exchange.
One of the most important improvements over the simplest forms of early barter was the
tendency to select one or two items in preference to others so that the preferred items became
partly accepted because of their qualities in acting as media of exchange. Commodities were
chosen as preferred barter items for a number of reasons - some because they were
conveniently and easily stored, some because they had high value densities and were easily
1
The definition that we will use in the Money and banking course, will be more precise:
Money is anything that is widely used for making payments and accounting for debts and
credits.
portable, and some because they were durable. These commodities, being widely desired,
would be easy to exchange for others and therefore they came to be accepted as money.
All sorts of things have been used as money at different times in different places. The
list below, includes some of primitive moneys, and none of the modern forms:
 livestock
 shells
 metals (gold and silver)
 cigarettes
The Basic Properties of Money
The act as money, the item should be:
 measurable
 divisible
 widely accepted
 durable
It is easy then to understand why precious metals (gold and silver) acted as money for
thousands of years. They were commodity money.
The circulation of commodity money even in the most appropriate form of gold coins
creates new problems. First of all, the production of coins involves high cost. Second, even a
gold coin loses some of its weigh and value when it is constantly used in exchange. At the
same time, when we use coins in trade, we cannot measure them precisely during every single
purchase or sale. What matters, it their nominal – the weigh which they present and which is
printed on them. Therefore, the exchange process can be served by substitutes of commodity
money. Such a substitute is a perfect substitute, if it is freely convertible into the commodity
money which it presents in circulation. This is paper money. However, an institution should
take the responsibility to issue paper money and to exchange it for the commodity money
whenever their holder wishes. Moreover, no one else should be allowed to issue paper money.
The dollar standard that was established in the world financial system, was based on a
free exchange of US dollars to a fixed quantity of gold until the early 1970s. The US dollar
was paper money.
Along with the evolution of commodity money and paper money, another form of
money developed. This is the credit money.
The economy cannot efficiently operate without credit. Firms want to sell their goods and
services as quickly as possible. In the world of scarce resources it would be a waste of time
and resources to wait until all potential buyers have the commodity (or paper) money to pay
for the purchase. This is why sellers might agree to sell today and get the money later. The
buyer has just to sigh a document as an evidence that he/she will pay at a given moment in the
future. The paper signed is a bill of exchange (or I Owe You - IOU). If someone agrees to
receive equivalent value later in exchange for his goods, he has accepted a bill of exchange. It
is a credit for the seller and a debt for the buyer. If the bill of exchange becomes negotiable,
meaning others will accept it in exchange for goods and services, it is money. This is credit
money (fiat money).
Our money today is credit money. Now we can even give a more precise definition of
money:
Money is credit that is widely accepted as a medium of exchange.
The specific nature of credit money creates a basis for the development of payments through
demand deposits at the banks. Instead of caring and paying cash, we can just order our bank to
pay our bills directly from our demand deposits. These deposits are the most widespread
form of credit money nowadays. The instrument to prove the availability of such a deposit is
the debit card. Such a card is NOT money. Niether a credit card is money. The credit card is
just an evidence, that someone else (the institution which has issued the card) will pay our
bills for us. A cheque is NOT money either. The deposit at the bank is money.
Functions of Money

Medium of exchange (Means of payment)

Unit of account

Store of value2
The first function of money derives directly from its definition.
The second function of money is that we use it to measure value. Just like we use a kilogram
to measure weight and a second to measure time, we use money to measure value. Therefore,
money is an unit of value, or unit of account. The money we use is denominated in the unit of
account established by the Central bank. That enables us to measure the value of a good or
service against another, based on what each sells for in the market. For example, we can
calculate that a pair of shoes is 20 times more expensive than a cup of coffee.
An asset will be accepted in exchange for goods and services only if it is seen as a
store of value. This is the third function of money. Money is always a store of value, but a
2
There is a fourth function of money, which is not usually given in textbooks standard of deferred payments.
store of value is not always money. For example, a bond is a store of value, but bonds are
seldom accepted as a medium of exchange, and therefore are not money.
The first function of money is performed by assets, called high power money. The second and
the third function can be performed by assets that cannot immediately be used to serve
transactions.
The easiness with which an asset could be used as a means of exchange is called liquidity.
Coins, banknotes and demand deposits are the most liquid assets. Time deposits are not that
liquid. They can be used for the first function of money at a time delay, or at a cost, and at an
inconvenience. However, they can easily perform the second and the third function of money.
Such less liquid assets are called quasi-money, or near-money.
Money supply
In the era of commodity money, the issuer was constrained by the need to hold a
sufficient supply of the underlying commodity. There is no such constraint in the case of
credit money. The value of credit money therefore depends on the policies and actions of the
issuer, normally the central bank of a country. The euro is issued by the European Central
Bank.
The Central bank’s basic monetary policy challenge is to keep the supply of credit money in
reasonable balance with the needs of producers and the availability of goods and
services. That calls for a great deal of knowledge about the economy as well as skill in
interpreting the data. Mismanagement of the price of reserves can readily drive the economy
off track towards inflation or recession.
What is meant by the money supply? The term itself implies that a certain amount of money
exists at any given time. This means that money supply is a stock.
Since credit money does not have its own value, its quantity is of crucial importance.
How much money is needed for circulation? If I want to buy 2 containers of yougourt €4 each,
one loaf of bread of €2 and a sandwich of €3, I need €13. Therefore, the quantity of money
depends on the amount of goods and services and on their prices. The Central bank has to take
into consideration one more variable to determine the money supply. This is the velocity of
money circulation (V). One and the same monetary unit, say a coin of €1, can serve many
transactions = I buy with this coin something from Ann, she uses the same coin to buy
something from George, who uses the same coin to buy something from John. Thus, the same
coin of €1 has been used to buy goods for €3. This coin has served three transactions. Its
velocity is 3.
The velocity is determined by the number of transactions, served by the same
monetary asset during the same period.
The greater the velocity, the smaller the quantity of money needed for the circulation.
Now we can determine the quantity of money, needed for circulation, or in other words –
money supply (M)
M = (P x Q) : V
MV = PQ
It is easy to realize, that P x Q is the nominal GDP. Therefore, money supply depends on the
economic activity in the country and on the velocity of money.
Monetary Aggregates
The Central Bank has to determine how much cash it will issue. For this reason it should
know the dynamics of economic activity, but it should know too what assets can people use to
serve transactions.
The Central Bank has defined three monetary aggregates M1, M2, and M3. These are the
quantitative measures of money supply.
M1
The narrowest definition of money supply - M1, the includes:

Currency in circulation (coins and banknotes)

Demand deposits

Checkable deposits

Traveler’s checks
All these assets can perform immediately the first function of money – means of exchange. It
performs it at zero time delay, zero cost, and no inconveniences.
The components of M1 have the highest liquidity. This is why M1 is called high
power money. Strictly speaking, it is the most precise measure of money as a means of
payment.
M2
Some other monetary items can be used as a means of exchange at a very low cost, at a
small inconvenience, or a little time delay. Therefore, we can broaden the definition of money
supply by including them into the money aggregate M2. This broader definition of money
supply includes:

M1

Saving accounts

Small time deposits
The Central bank monitors M1 and M2 because it is responsible for the quantity of credit
money in circulation and if there is much more money than it is necessary, it will inflate. If
there is less money, than it is needed for the economic activity, this may contribute to a
recession.
If we broaden the definition of money supply further, we will include even less liquid
monetary assets and we will have M3. It adds large time deposits, and other money market
funds. Sometimes it is called large money (L)
Money demand
The demand for money is different from the demand for other goods. People need
money as a means of exchange and for these reasons they are even ready to incur a cost in
order to hold high power money. The opportunity cost of holding money is the interest that
could be earned from less liquid assets.
Why then are not people keeping all their money in interest bearing assets? People
must be motivated to hold money, instead of interest bearing assets.
The willingness of the public to hold high power money instead of interest bearing
assets is the money demand. It is defined as the quantity of liquidity that the public
would like to hold at every level of the interest rate, ceteris paribus. This definition
indicates the role of the interest rate as the major factor determining the motivation to hold
liquidity.
Motives for money demand
Transactionary motive – no matter how high the interest rate is, people need some amount of
liquidity to serve their transactions. This is the transactionary motive for money demand. It
determines the transactionary demand for money
Precautionary motive – people need some extra liquidity to hold because of the possible lack
of synchronization of payments.
Speculative motive – the fact, that the opportunity cost of holding money is the interest rate,
motivates people to allocate part of their financial assets in interest bearing assets. When the
interest rate increases, they reduce the amount of liquidity and increase the amount of the
other financial assets. When the interest rate falls, they increase liquidity because its
availability gives them more opportunities to speculate – to make profits. This is the
speculative motive which explains why people prefer liquidity. It is called sometimes liquidity
preference. While the transactionary motive does not depend on the interest rate, the
speculative demand for money is highly sensitive to the interest rate.
Now we can present the quantity of money demanded as a function of the interest rate
graphically (Fig. 1.)
i
MS
MD
M/P
Fig. 1. The demand for money
When the interest rate increases, the willingness to hold liquidity falls. At very high
levels of the interest rate however, people cannot reduce the liquidity any further, because
they still need money for their purchases (the transactionary demand for money) and the
money demand curve becomes perfectly inelastic.
At very low levels of the interest rate it is even not worth to wear one’s shoes for
walking to the bank to put the money on an interest deposit and people prefer only liquidity,
and as much as possible. This is the liquidity trap and the money demand curve becomes
perfectly elastic.
Note, that on the horizontal axis we put the real money demanded! The importance of
the concept of real money comes from the difference between the real and the nominal
interest rate.
The nominal interest rate is the one that is paid for the money. Let it be 5%. If
however the level of the inflation is 7% and I put €100 on a bank account, in a year I will
have €105, which will not be enough to buy the same consumer basket as a year ago, because
it is now worth €107 (7% inflation). Therefore, even though my money increased nominally
by 5%, its value has been really reduced by 2%.
The real interest rate = nominal interest rate – the rate of inflation
Definitely, the demand for money depends on its purchasing power and if the rate of
inflation increases, people will want to hold more liquidity because its purchasing power is
lower. This is why in the definition of the money demand and in its graphical presentation we
mean the demand for real money, the demand for purchasing power. Thus, on the horizontal
axis we weight the money against its purchasing power (M/P)