IV' MONEY

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IV. MONEY

• EC21B - INTERMEDIATE MACROECONOMICS II

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WHAT IS MONEY?

• What is Money?
• Money can be defined as the stock of assets that
  can be readily used to make transactions (Mankiw)
• It is a universally accepted means of payment.

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WHAT IS MONEY?

• Functions of Money
• Store of Value money is a means of transferring
  purchasing power from the present to the future.
  It is an imperfect store of value if prices are
  rising the amount you can buy with any given
  quantity of money falls
• Unit of Account money provides the terms in
  which prices are quoted and debts are recorded
  (standard measures of value). It is the yard
  stick by which we measure economic activities.
• Medium of Exchange Money is used to buy goods
  and services (means of payment).

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WHAT IS MONEY?

• Types of Money?
• Fiat Money has no intrinsic value and was
  established by government decree.
• Commodity Money is money that has some
  intrinsic value. E.g. Gold which can be used for
  jewelry, dental filling as well as transactions.

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WHAT IS MONEY?

• Measures of Money
• Various measures of money have been developed by
  economists. As a result there is some level of
  ambiguity attached as it is hard to judge which
  assets should be included in the stock of money.
• Currency is the sum of outstanding paper money
  and coins. (used from day to day)
• Narrow Money (M1) currency plus demand
  deposits, travelers cheques and other checkable
  deposits.

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WHAT IS MONEY?

• Broad Money (M2) M1 plus money market mutual
  fund balances, saving deposits, and small time
  deposits.
• M3 M2 plus other deposits such as large time
  deposits, repurchase agreements, Eurodollars, and
  institution-only money market mutual fund
  balances.
• M1 and M2 is the most common measures for
  studying the impact on money on the economy.

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WHAT IS MONEY?

• Why Hold Money?
• Money holdings offers individuals no interest
  rate compared to bond holdings which is an
  interest bearing activity.
• However, people hold money due to
• Transactions motive (goods services) and there
  is a cost to constant withdrawals from the bank.
• Precautionary Motive have some money laid aside
  for rainy day
• Speculative Motive hold money for profit
  opportunities.

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THE TRANSACTIONS DEMAND FOR MONEY

• The transaction demand for money seeks to explain
  why people hold narrow measures of money, such as
  currency and checking accounts, as opposed to
  interest bearing assets.
• We will examine the Inventory Theory of money
  demand put forward by William Baumol and James
  Tobin.
• This theory emphasises the role of money as a
  medium of exchange

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THE TRANSACTIONS DEMAND FOR MONEY

• Since income is received periodically and
  expenditures occur every day, it is necessary to
  hold a stock of currency and checking deposits.
• The Baumol-Tobin model analyses the cost and
  benefit of holding money. The benefit would be
  the convenience of avoiding frequent trips to the
  bank. The cost would be the forgone interest
  which could have been earned by keeping money in
  saving accounts.

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THE TRANSACTIONS DEMAND FOR MONEY

• Assumptions
• Let Y monthly income
• Households deposit income for free in savings
  account
• A cost of k is incurred to make transfers from
  saving to chequing account
• Opportunity cost of keeping money in chequing
  account is R

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THE TRANSACTIONS DEMAND FOR MONEY

• Possibilities
• Assume that an individual spends all of his
  income (Y) in equal installments making one lump
  sum transfer then their average money balance
  would be (Y/2)
• If the individual plans to make two transfers
  each period then he would withdraw (Y/2) at the
  beginning of the month, spend this money then
  withdraw (Y/2) in the second half of the month.
  The average money balance is (Y/4). The
  individual forgoes less interest but incurs
  additional transfer costs.

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THE TRANSACTIONS DEMAND FOR MONEY

• More generally, if the individual makes N trips
  to the bank during the month then he would
  withdraw (Y/N) on each trip.
• Average money holdings would be (Y/2N) (half the
  amount transferred from savings to checking on
  each transfer)
• The higher the average money balance (M), the
  fewer transfers have to be made from savings and
  the higher would be the opportunity cost

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THE TRANSACTIONS DEMAND FOR MONEY

• The total number of transfers (N)
• M Y/2N
• So N Y/2M
• Brokerage Cost the brokerage cost is the total
  cost paid for the monthly transfers.
• k of transfers
• k (Y/2M)
• The brokerage cost is made up of stamp duty, time
  and transportation costs.

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THE TRANSACTIONS DEMAND FOR MONEY

• Interest Cost
• Is simply the opportunity cost for holding money
  RM
• An individual chooses his average balance (M) in
  order to minimize the sum of the two costs.
• Total Cost Brokerage Cost Interest Cost
• (kY/2M) RM

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THE TRANSACTIONS DEMAND FOR MONEY

• Total Cost of Holding Money

Cost
Total
Interest
Brokerage
M (average money holdings)
M
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THE TRANSACTIONS DEMAND FOR MONEY

• Example
• Given an individual who earns 60,0000 per month.
  He deposits his money for free into his savings
  account and makes 3 equal transfers for the month
  at a minimal cost of 50. if the 15 interest is
  paid per annum on his savings account. Determine
• Average money holdings
• Brokerage cost
• Interest cost
• Total cost

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THE TRANSACTIONS DEMAND FOR MONEY

• The Demand for Money
• Money demand can be derived by finding the
  average money holdings (M) that minimizes total
  cost (?TC ?M)
• The money demand equations shows that as the
  opportunity cost for holding money increases the
  individual would reduce his money holdings.
• Money demand also depends positively on the
  square root of total income

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THE TRANSACTIONS DEMAND FOR MONEY

• Interest Rate Money Demand
• If the interest rate increases this means that
  the opportunity cost of holding money increases
  shifting the interest cost curve outwards.
• Interest Cost RM
• An individual money holdings would therefore fall
  when the interest rate increases.

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THE TRANSACTIONS DEMAND FOR MONEY

• Interest Rate Money Demand

Cost
Interest
Brokerage
M (average money holdings)
M0
M1
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THE TRANSACTIONS DEMAND FOR MONEY

• Income Money Demand
• As the individuals income increases the higher
  would be the brokerage cost incurred for
  transferring income from a saving to a chequing
  account.
• Brokerage Cost (kY /2M)
• An individuals money holding would therefore
  increase when income increases

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THE TRANSACTIONS DEMAND FOR MONEY

• Income Money Demand

Cost
Interest
Brokerage
M (average money holdings)
M0
M1
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OTHER INFLUENCES ON MONEY DEMAND

• Institutional Factors
• Has some impact on money demand but it is not
  significant as they change rather slowly.
• Frequency of Pay the more frequently pay is
  received the lower would be the average money
  balance.
• Credit Cards more credit card is used leads to
  lower average money balance. As individuals would
  now withdraw funds as needed thru the credit card

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OTHER INFLUENCES ON MONEY DEMAND

• Precautionary Motive
• Under the precautionary motive individual save
  some wealth in the form of money in case of an
  emergency need for funds.
• Speculation Motive
• Examines money holdings vs. bond holdings when
  interest rate changes.
• Since the price of bonds is inversely related to
  the interest rate when interest rates are high
  investors would switch from money holdings to
  bond holdings. This occurs due to their
  expectations that bond prices would rise in the
  future.
• Therefore money demand declines as interest rates
  increase

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THE MECHANICS OF THE MONEY SUPPLY

• The money supply includes both currency in the
  hands of the public and deposits at banks that
  households can use on demand.
• Money supply Currency Deposits
• M C D
• To understand the money supply we need to
  understand how policies put forward by the
  central bank influences the components of the
  money supply

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THE MECHANICS OF THE MONEY SUPPLY

• The Deposit Creation Process
• The deposit or money creation process is started
  by the banks thru the loans of excess reserves.
• Each new deposit increases the monetary base. As
  a result this increases the reserves at the bank.
  The banks makes loans to customers out of their
  excess reserves and these loans are usually
  re-deposited into the banks.
• Banks continue making loans of excess reserves
  until actual reserves equal the required
  reserves.

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THE MECHANICS OF THE MONEY SUPPLY

• 4 conditions necessary for the deposit creation
  process
• Equivalence of coins and deposits checks
  treated as equivalent to dollars
• Redeposit of proceeds from loan any customer
  who receives cash or cheque payment must deposit
  it into an account at the same bank.
• Holdings of Cash reserves banks must hold some
  fraction of reserves in the form of cash
• Willing borrowers someone must be willing to
  borrow from the bank at an interest rate that
  covers the banks cost of operation.

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THE MECHANICS OF THE MONEY SUPPLY

• The Monetary Base (MB) is the total number of
  dollars held by the public as currency and by the
  banks as reserves. The monetary base is directly
  controlled by the central bank.
• MB C RE
• There is a direct relationship between the
  monetary base and the money supply which is due
  to
• Reserve-requirement ratio
• Currency-deposit ratio.

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THE MECHANICS OF THE MONEY SUPPLY

• Currency-Deposit Ratio (c)
• The currency deposit ratio is the amount of
  currency people hold as a fraction of their
  holdings of demand deposits. It reflects the
  preference of households about whether to hold
  currency or demand deposits.
• C cD
• The currency deposit ratio is generally constant
  but reacts to seasonal variations (e.g. Christmas)

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THE MECHANICS OF THE MONEY SUPPLY

• During the Christmas season consumers have a
  preference for holding currency rather than
  demand deposits
• M 1 c MB
• r c
• To offset this decrease in the MS the central
  bank increase the monetary base at Christmas time.

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THE MECHANICS OF THE MONEY SUPPLY

• Reserve-Deposit Ratio (r)
• The reserve-deposit ratio is the fraction of
  deposits that banks hold in reserve. It is
  determined by the business policies of banks and
  the laws regulating banks.
• RE rD
• In Jamaica the reserve-deposit ratio is set by
  BOJ
• The purpose of reserves is to be used for
  withdrawal and cheque settlement as well as to
  maintain control of the monetary balance and the
  money supply.

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THE MECHANICS OF THE MONEY SUPPLY

• The Money Multiplier
• M C D
• MB C RE
• To solve for money supply
• M C D cD D 1 c
• MB C RE cD rD r c
• M 1 c MB
• r c

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THE MECHANICS OF THE MONEY SUPPLY

• The money multiplier (m), is the coefficient
  attached to the monetary base.
• We can write M mMB
• Each dollar of the monetary base produces m
  dollars of money.

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THE MECHANICS OF THE MONEY SUPPLY

• The Monetary Base Identity
• M 1 c MB
• r c
• M mMB
• So changes in the three exogenous variables
  monetary base, reserve-requirement and
  currency-deposit ratio changes the money supply.

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THE MECHANICS OF THE MONEY SUPPLY

• Note
• Money supply proportional to monetary base. So an
  increase in MB increases MS by same .
• The lower the reserve-requirement ratio, the more
  loans banks make, and the more money created by
  banks from every dollar of reserve. So increases
  money multiplier and the MS.
• The lower the currency-deposit ratio, fewer
  dollars of MB held by the public as currency, so
  increases money multiplier and MS.

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INSTRUMENTS OF MONETARY CONTROL

• We will now examine how the central bank changes
  money supply by changing either the money
  multiplier or the monetary base.
• Open Market Operations
• Open market operations are the purchases and
  sales of government bonds by the central bank.
  Using open market operations the central bank can
  add to or subtract from the total amount of bank
  reserves plus currency whenever it chooses.

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INSTRUMENTS OF MONETARY CONTROL

• If the CB buys bonds from the public there is n
  increase in the currency holdings, the MB and the
  MS. The purchase of bonds by the CB adds
  liquidity to the market.
• If the CB sells bonds there is a reduction in
  currency holdings, the MB and the MS. The sale of
  bonds by the CB takes money out of the hands of
  consumers so removing excess liquidity from the
  market.
• Open market operations are carried out using
  Bonds, REPOs and even T-Bills.

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INSTRUMENTS OF MONETARY CONTROL

• Cash Liquid Assets Requirement
• Cash reserves refer to the currency deposited at
  central bank. It gives the commercial bank access
  to funds on call at short notice when needed. In
  Jamaica the cash reserves is normally about 15.
• Non-cash reserves include treasury bills and
  others and is normally 3 of specified
  liabilities.
• Liquid assets is equal to cash reserves plus
  non-cash reserves and is normally around 18

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INSTRUMENTS OF MONETARY CONTROL

• Non-Bank Financial Institutions have cash and non
  cash reserves of about 1 and 4 respectively.
• An increase in the reserve requirement lowers the
  money multiplier and the MS. As a higher reserve
  requirement ratio means that commercial bank
  would have less excess reserves to issue as
  loans.
• Changes in the reserve requirement ratios are the
  least frequently used of the central bank policy
  instruments.

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INSTRUMENTS OF MONETARY CONTROL

• Other Instruments
• Discount rate this is the interest rate that
  the central bank charges when it makes loans to
  banks. Banks borrow when they have few reserves
  with which to meet their reserve requirement. The
  lower the discount rate, the cheaper are borrowed
  reserves so it increases the money multiplier,
  the MB and the MS.

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INSTRUMENTS OF MONETARY CONTROL

• Selective Credit Controls CB can implement
  selective credit controls on the amount and
  direction of credit as well as the interest on
  deposits.
• Moral Suasion the CB can also use moral suasion
  to maintain its control of the MB. Moral suasion
  involves discussions and mutual agreements
  between the central bank and the commercial bank.

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INSTRUMENTS OF MONETARY CONTROL

• Although the three instruments examined so far
  give the central bank substantial power to
  influence the money supply, they do not have
  perfect control.
• E.G. Banks may choose to hold excess reserves.
  The higher the excess reserves, the higher the
  reserve-deposit ratio and the lower the MS.
• Similarly, CB cannot control the amount banks
  borrow. The less banks borrow, the smaller the MB
  and the smaller the MS.
• We will now examine two more involuntary sources
  of changes in the Monetary base.

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INSTRUMENTS OF MONETARY CONTROL

• Foreign Exchange Operations
• Is an involuntary source of change in the money
  supply. Foreign exchange transactions affect the
  reserve base.
• A central bank can offset a potential
  depreciation of it currency by selling foreign
  reserves. This would reduce money supply, rise
  interest rates and offset the potential
  depreciation.

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INSTRUMENTS OF MONETARY CONTROL

• Financing Fiscal Deficits
• Budget deficit G T gt 0
• To finance a deficit the government would have to
  borrow from
• Domestic market (Public debt) government would
  sell treasury bills to the CB which would
  increase MS. The level of monetary control is
  dependent on how independent the CB is from the
  government.
• Foreign Market (International debt)
• Monetary Accommodation by the CB.

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MONETARY POLICY RULES

• The objective of monetary targets is to ensure
  price and foreign exchange stability.
• Money Supply Target
• Under a money supply target the central bank
  decides how they want to increase or decrease
  money supply using instruments of monetary
  control. (M mMB)

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MONETARY POLICY RULES

• Example
• If the money multiplier is 5 and the CB wants to
  increase the money supply by 15 billion, then it
  would use instruments to increase the monetary
  base by 3 billion.
• Using the money supply target is very difficult
  due to the ambiguity involved in measuring money.
• In addition changes in MS will cause fluctuations
  in the GDP, interest rate and inflation level.

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MONETARY POLICY RULES

• Interest Rate Target
• The central bank may decide to target the short
  term interest rates. This method is preferred by
  the central bank in Jamaica.
• The short term interest rate is very easy to
  adjust.
• If the CB calls for a reduction in the interest
  rate, there would be a purchase of bonds. This
  would increase the MS and reduce the interest
  rates.

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MONETARY POLICY RULES

• GDP Target
• Under a GDP target the central bank targets
  output through monetary policies.

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MONEY AND BOND MARKETS

• Money Bonds
• There are many different forms of wealth money,
  bonds, stocks, houses etc.
• There are only two main things to do with
  domestic wealth
• Hold as money either as cash or in checking
  accounts
• Lend it out either by placing funds in savings
  accounts, placing money on CDs, purchase bonds
  etc.

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MONEY AND BOND MARKETS

• A bond is a document representing an
  interest-bearing debt of the issuer, usually a
  corporation or the government.
• Bonds earn a uniform rate of interest. This
  interest represents the price for deferred
  utility.

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MONEY AND BOND MARKETS

• The Bond Market
• The place where newly issued and existing bonds
  are bought and sold, usually before maturity, by
  investors looking for income. This market can be
  a physical trading area, but more often the bonds
  are traded electronically by investors using
  computers and telephone communications.
• The bond market is the market for lonable funds
  such as
• Savings accounts
• Time deposits
• T-bills
• CDs
• Government bonds
• Commercial bonds

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MONEY AND BOND MARKETS

• A negative relationship exists between the
  interest rate and the price of bonds.
• An increase in the interest rate causes the price
  of bonds to fall.
• If the CB wishes to borrow money they sell bonds.

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MONEY AND BOND MARKETS

• The Money Market
• The money market, in macroeconomics and
  international finance, refers to the
  equilibration of demand for a country's domestic
  money to its money supply. Both refer to the
  quantity of money that people in the country hold
  (a stock), not to the quantity that people both
  in and out of the country choose to acquire
  during a period in the exchange market, mostly
  for the purpose of then using it to buy something
  else.
• A negative relationship exists between interest
  rate and the money supply.