Money

This is anything that is generally accepted as a medium of exchange and/or in settlement

of a debt.

Type of money

1. Fiat – it has no intrinsic value and is not backed by any physical commodity. This

is the legal tender because the government said it must be accepted in settlement

of a debt. Eg. Paper money and coins.

2. Token – this is a token or paper certificate that can be exchanged for a fixed

quantity of goods. It has no intrinsic value eg. Tickets to go to a fair, gift

certificates and food stamps

3. Commodity money – this derives its value from the value of the physical

commodity, ie they are both commodities as well as money. It has real or intrinsic

value eg. Gold, silver, cigarettes, alcohol etc.

Characteristics of money

1. acceptable – as a medium of exchange and settlement of a debt

2. durable – it does not wear out so wealth can be transferred from one time period

to the next

3. portable – can be easily transported

4. homogenous/uniformed – units of money is identical for instance all Jamaica

$100 bill looks the same.

5. divisible – can be broken done into smaller units

6. stability – overtime it should maintain its value

7. difficult to duplicate/counterfeit –this would erode its importance as a medium of

exchange

Functions of money

1. Medium of exchange - accepted in exchange for goods and services.

2. Store of value – allows purchasing power to be transferred from one period to the

next. Therefore current income can be set aside as savings.

3. Unit of account – a standard unit in which relative prices of goods and services

can be quoted and compared. This makes the accounting system possible.

4. Standard of deferred payment – allows payment for goods and services consumed

today in a future time period. It makes the credit system possible.

Demand for money

This refers to people’s desire to hold money ie to keep wealth in the form of money

(cash) rather than spending it an goods and services or using it to purchase financial

assets such as bonds and shares. ‘Money is the most liquid form of wealth’. Only money

can be changed into some other form without cost or delay.

Liquidity preference theory

Keynes identified 3 motives for holding money:

Transaction motives – money is held to carry out ordinary everyday transactions for

instance buying lunch. As income increases transactionary balances increases and vice

versa. Transaction motive is not affected by Interest rate.

Precautionary motives – money balances held as a safeguard against unforeseen events

like hurricanes, illnesses and so on. This is determined by income and not the interest rate

as income increases precautionary balances increases and vice versa.

Speculative/ Asset motives – used as an asset or provide funds for borrowers. Speculating

means foregoing present opportunities to earn interest. Interest rate plays an important

role in this motive. Bond prices and interest are inversely related as IR falls demand for

holding money balances increases. High IR reduces the desire to hold money.

Curve

Bonds Prices and Interest rate

As the price of bonds decreases the actual rate of returns or interest rate increases. Eg If

the price of bonds is $100 and the earnings is $10 the percentage earnings on the bond is

10% .However, if the price of the bond were to fall to $50 then interest earn would be

greater say 20%, which is a better investment. The market interest rate is inversely related

to the price of old or existing bonds. When considering the liquidity trap the reason an

increase in the MS does not result in an excess supply of money at a low IR is that

individuals believe bond prices are so high that an investment in bonds is likely to be a

bad investment.

Transaction motives and Precautionary motives are active money balances while

speculative/ Asset motives are idle money balances.

In deriving the liquidity preference curve:

The liquidity preference curve is the horizontal summation of Tm, Pm and Sm at each

IR.

Liquidity Preference Theory

Shows that the demand for money is determined by Tm, Pm and Sm these added

together give a single demand curve called the liquidity preference curve. Tm and Pm

are not influenced by IR but Sm is hence the shape of the curve.

Keynesian, monetarist and the demand for money

Keynesians see money as an alternative to holding bonds and financial assets.

Monetarists believe that money is an alternative to a broader range of alternatives

including physical goods. Monetarists believe that any excess liquidity will lead to a

direct increase in spending on goods as well as switching into financial assets.

Monetarists believe that money is not a close substitute for other assets and therefore

changes in IR have relatively little effect on money. Therefore demand for money is

interest inelastic.

Keynesian Transmission mechanism

This looks at the impact changes in the money market have on the goods and services

market whether the impact is direct or indirect.

Keynes believes that there is an indirect relationship between changes in the money

market and the goods and services market. He noted that when Ms increases IR falls

causing investment to increase and AD to shift to the right (increase), real GDP

increases (real growth occurs as price is constant), unemployment will fall.

Curve

Nb AS is constant and so too price. Therefore no inflation occurs. If AS increases at the

same rate as prices then inflation would occur. If the economy is below full employment

when AD increases output would increase and employment.

Some Keynesians believe that investment is not always responsive to IR as a result the

transmission mechanism would be short circuited/disrupted in those investment good

markets and the link between the money market and the good market will be broken.

They also argued that the demand curve for money could become horizontal at some low

IR resulting in a liquidity trap.

NB Keynesian transmission mechanism is indirect and interest insensitive investment

which leads to a liquidity trap. They believe that there isn’t a direct relationship between

IR and investment (it does not mean investors will invest because of a fall in IR).

Liquidity Trap

The increase in money supply does not affect the IR and so does not affect investment

and AD.

Curve showing the Liquidity trap

The monetarist Transmission mechanism

There is a direct link between the money market and the goods and services market. An

increase in money supply increase AD and results in an increase in Real GDP, hence

prices increase which will lead to unemployment decreasing and vice versa. They believe

that the link between money and AD is very strong. They believe that if the economy is

near or at full employment an increase in AD will lead to inflation.

Curve

Supply of money

Supply of money refers to the quantity of money in circulation in an economy at a

particular time. The money supply includes M1 and M2

M1 (narrow money) – this is money which is used as a medium of exchange and consists

of rates and coins in circulation and cash held in banks and in balances held by banks at

the central bank. It is sometimes referred to as the monetary base.

M2 (board money) – this consists of the items above plus a range of items that relates to

money’s function as a store of value such as: savings deposits, foreign currency

transferable deposits, certificates of deposit and repurchase agreements, non-institutional

money market funds.

Monetary Policy

The deliberate actions by monetary institutions to manipulate monetary instruments to

achieve macroeconomic objectives of full employment, stable prices, economic growth

and equilibrium in the balance of payment.

Or

It refers to any measures used by government to bring about changes in money supply

and interest rate so as to affect AD. IR and MS are not independent variables so it is not

possible to fix both, monetary authorities can either choose a target level MS or target a

specific interest rate see curve.

The target of monetary policy curve (pg 104)

The government may choose a money supply of M0 but then the IR will be high Ro but if

they want IR of r1 MS will increase to M1.

Monetary policies may be expansionary or contractionary. The government may expand

the economy by increasing MS which cause IR to fall and investment to rise causing AD

to rise. To contract the economy MS will fall causing IR to rise and investment to fall

causing AD to fall as in the curve above.

The role of the central bank in creating high powered money (money base)

To control the money supply the monetary base must also be controlled which includes

highly liquid assets such as cash, demand deposits and chequing accounts. The

government could control the issuing of loans by reducing the amount of cash available

in the banking system via open market operations or increasing the legal reserve

requirement. This is more effective if the money multiplier is stable. The commercial

banks must not simply adjust their cash to reserve ratio in response to a cash squeeze the

money multiplier must be stable.

The central bank must relinquish its role as a lender of last resort, otherwise money

squeezed out of the system can re-enter through the discount market.

Instruments/tools of monetary control

1. Open market Operations – this is where the central bank buys and sells

government securities in order to influence lending by the commercial banks, for

example if the central bank wants to reduce bank loans it will sell government

securities. This causes the commercial banks’ liquid assets to fall, so restricting

their ability to lend.

2. Discount rates – this is the rate at which commercial banks borrow from the

central bank. To decrease the MS the rate increase and to increase the MS the rate

falls. These loans are short term.

3. Repo rate – the rate the central bank charges the commercial banks for overnight

loans. To reduce the MS the rate is increased.

4. Reserve requirement – banks are required to keep a minimum proportion of their

deposits at the central bank, for instance 11% of their deposits. By increasing the

reserve requirement the ability of the commercial banks to lend decreases thus

decreasing the MS.

5. Moral Suasion – where the central banks through discussions tries to influence the

commercial banks to comply with its goals of reaching macroeconomic targets of

expanding or contracting the economy.

6. Financing fiscal deficits – increasing MS or printing more money. This may result

in inflation and crowd out private investment.

7. Special deposits – commercial banks may be required to hold additional cash at

the central bank so as to restrict loans and advances.

8. Interest rates – increasing IR reduces loans and contracts the money supply and

vice versa.

Excess Reserves

Reserves held by the commercial banks in excess of the stipulated reserve

requirement.

Credit creation

The process by which the commercial banks through the fractionary reserve

banking system creates money by issuing loans.

Fractionary reserve banking system

Banks use the money they receive from primary deposits to lend to borrowers at a

higher interest rate. Persons use the money to buy cars etc. eventually the money is

deposited in the bank by the car dealers resulting in a second deposit (assuming only

one commercial bank for simplicity). This second deposit is called derivative deposit

or secondary deposit. The central bank working on behalf of the government insists

that only a portion of the deposits can be lent out and the rest kept as cash called

reserves ration/liquidity ratio. Eg the government may request 20% cash ratio. If the

bank has $1000 and it lends $800 which will return to the bank then $640 will be lent

out etc. until there is no more to lend.

Depositor Deposits Loans Reserves

($) (80%) (20%)

Primary Deposit 1st 1000 800 200

Derivative deposits 2nd 800 640 160

Derivative deposits 3rd 640 512 128

Derivative deposits 4th 512 410 102

Derivative deposits 5th

Derivative deposits

Derivative deposits

Derivative deposits

Totals 5000 4000 1000

The money Multiplier

A number which indicates the amount by which the MS would increase if commercial

banks reserves or deposits increase by $1.

Formula

1/RR x initial deposit RR is the reserve ratio – now based on the exercise above

1/20 x $1000 = 5

Overall/total bank deposits = initial deposits x multiplier

$1000 x 5 = $5 000

1/20 is reserved ie 1/20 x $5000 = $1000

Loan = Total deposits - Primary/initial deposits $5000 - $1000 = $4 000

The nature of currency substitution and hoarding

Currency substitution – using foreign currency for transactions purposes instead of

the domestic currency. The foreign currency is therefore the medium of exchange.

Countries using flexible exchange rates can experience problems if there is a high rate

of currency substitution because they can no longer control all currency types through

monetary policy (Jamaica). The higher the rate of currency substitution, the greater

the likelihood of monetary instability caused by changes in the foreign currency. The

usefulness of the domestic currency as a store of value is compromised. Inflation

erodes the purchasing power of the local currency ad so people may find other means

of storing wealth hence currency substitution.

Money Hoarding

Accumulating/storing money as it increases in value. People tend to hoard the money

that is of greater value as in Jamaica’s case the US dollars which cause a shortage in

the US currency and a further reduction in the value of the JA dollar.

Quantity theory of money – was already done

Tight monetary policy

These are meant to restrict the amount of spending in an economy. These policies

control the level of inflation and include increasing IR which reduces borrowing,

investment and AD.

Easy monetary policy

Designed to stimulate the economy. They are generally accompanied by low interest

rate that encourages investment, employment and AD.

Balance of Payment – expansionary and contractionary policies

Expansionary policies – results in interest rate falling. If the price of bonds were to rise

causing them to be less attractive as returns fall investors will invest abroad in more

financially attractive assets. Therefore the capital section of the B.O.P will decline. There

will be an increase in demand for foreign currency causing the exchange rate to decline

and the local currency to lose value. Exports become cheaper and imports become

relatively more expensive causing the current account to improve.

Curve

Interest rate falls – price of local bonds increases - demand for local bonds fall – demand

for foreign currency increases – local currency looses value – exports become cheaper –

imports more expensive. Therefore X>M resulting in a favourable BOP.

Contractionary Policy

Curve

Interest rate increased –price of bonds falls – greater demand for local bonds- demand for

local currency increases- local currency value increases – imports are cheaper – X<M.

BOP will be unfavourable.

How monetary policy affects national income

Curve

Expansionary easy policy – MS increases – IR falls – investment increases – AD

increases – national income increases.

Contractionary tight policy – MS decreases – IR increases – investment decreases –

AD decreases – national income decreases.

Limitations of monetary policy

1. permissive (accommodating), not compelling and only creates the environment

2. difficult to control the money supply of foreign-owned commercial banks

3. difficult to eliminate lags in monetary policy

4. weakened by fiscal indiscipline