1. Chapter 5 Money is for Lunatics Demanders and Suppliers of Money

2. LEARNING OBJECTIVES Functions of money Four forms of money Money creation by the Bank of Canada and chartered banks Relate bond prices and interest rates and explain how money and bond markets determine the interest rate Differentiate the Yes and No camps positions on the monetary transmission mechanism

3. IS IT SMART TO NOT WANT MONEY? DEMAND FOR MONEY People demand money for its liquidity as a medium of exchange, unit of account, store of value. People willingly give up interest on bonds to hold wealth as money.

4. DEMAND FOR MONEY Money anything acceptable as means of payment; money has three functions a) medium of exchange acceptability solves barter problem of double coincidence of wants b) unit of account standard unit for measuring, comparing prices c) store of value time machine for moving purchasing power from present to future; earn now, spend later

5. Bond financial asset where borrower promises to repay original value, and make fixed interest payments

6. Why hold wealth as money which pays no interest, rather than as bonds which pay interest? money provides liquidity assets easily convert into medium of exchange money is most liquid asset acceptable by sellers as means of payment money pays no interest, but has liquidity; bonds pay interest, but do not have liquidity

7. Why hold money as a store of value? Yes camp hold more wealth as interest-paying bonds, since savings safely invested in loanable funds (bonds) No camp hold more wealth as money because fundamental uncertainty about future makes bond investments risky

8. Interest rate price of holding money; what you give up by not holding bonds determined by demand and supply in both money and bond markets Law of demand for money as the price of money interest rate rises, quantity demanded of money decreases

9. Fig. 5.1 Macroeconomic Demand for Money Price (interest rate) Quantity Demanded (billions of dollars) 2%100 4%90 6%80 8%70 10%60

10. Changes in real GDP or average prices cause change in demand for money increase in real GDP increases demand for money; decrease in real GDP decreases demand increase in prices increases demand for money; decrease in prices decreases demand

11. Fig. 5.2: Macroeconomic Demand for Money Before and After Real GDP Increases Price (interest rate) Quantity Demanded (Q D ) billions of dollars) Q D after Real GDP Increases (billions of dollars) 2%100200 4%90180 6%80160 8%70140 10%60120

12. SUPPLY OF MONEY Forms of money a) commodity money saleable product with alternative uses b) convertible paper money paper money converted into gold on demand c) fiat money currency (government-issued paper bills and coins) with no alternative uses, valuable simply by government decree d) deposit money demand deposits balances in bank accounts depositors withdraw on demand using debit card or cheque

13. CURRENCY IN CIRCULATION M2 OTHER DEPOSITS DEMAND DEPOSITS M1 $465 b BILLIONS OF $ $951 b Supply of money is currency and deposit money M1 = currency in circulation and demand deposits M2 = M1 plus all other less liquid deposits continued… Fig. 5.3 The Money Supply

14. Bank of Canada is Canadas central bank government institution responsible for supervising chartered banks and financial institutions and for regulating the supply of money

15. Bank of Canada roles issuing currency banker to chartered banks chartered banks pay each other with deposits at Bank of Canada lender of last resort making loans to banks to preserve stability of financial system banker to government managing government accounts, foreign currency reserves, national debt conducting monetary policy changing money supply and interest rates

16. Chartered banks create money (demand deposits) because of fractional reserve banking banks hold a fraction of deposits as reserves Banks face a tradeoff between profits and prudence –smaller fraction of reserves, more loans, and higher-risk loans may yield more profits Supply of money determined by Bank of Canada and chartered banks –quantity of money supplied is a fixed amount at a moment in time –supply of money does not change when interest rate changes continued…

17. $ billion (August 2009) Percentage of deposits Total Funds1925.3169.0 Sources Deposits1139.1100.0 Borrowing and own capital786.269.0 Uses Reserves6.20.5 Liquid assets319.428.0 Securities and other assets169.814.9 Loans1429.9125.5 Fig. 5.4 Chartered Banks: Sources and Uses of Funds

18. Fig. 5.5 Supply of Money Price (interest rate) Quantity Supplied (billions of dollars) 2%80 4%80 6%80 8%80 10%80

19. WHAT IS THE PRICE OF MONEY? INTEREST RATES, MONEY, AND BONDS Bond prices and interest rates are inversely related and determined together in money and bond markets.

20. MONEY AND BONDS a) Interest rate is the price of money –opportunity cost of holding money –cost of borrowing money b) Bonds promise to pay back original value plus fixed dollar amount of money –bonds do not promise fixed interest percent –when interest rates rise, market price of bond falls, vis-à-vis – holding a bond until maturity, you receive fixed dollar payments plus original value

21. Fig. 5.6 Macroeconomic Demand and Supply for Money Price (interest rate) Quantity of Money Demanded (billions of dollars) Quantity of Money Supplied (billions of dollars) 2%10080 4%9080 6%80 8%7080 10%6080

22. Interest rate determined by demand and supply in money and bond markets at market-clearing interest rate, quantity of money demanded equals quantity of money supplied when interest rate below market-clearing rate, excess demand for money; people sell bonds to get money; increased supply of bonds causes bond prices to fall, interest rate to rise Many different interest rates on financial assets, but most interest rates rise and fall together continued…

23. J.B. SAY AND J.M. KEYNES AS FACEBOOK FRIENDS? MONEY, INTEREST RATES, INVESTMENT, & REAL GDP Yes and No camps disagree about moneys effect on the frequency of business cycles and on how quickly markets adjust.

24. MONEY AND BUSINESS CYCLES Does money affect key macroeconomic outcomes of real GDP per person, unemployment, inflation? –money can affect inflation, according to quantity theory of money –money does not directly increase aggregate supply or economic growth continued…

25. Money indirectly affects real GDP and unemployment through monetary transmission mechanism how impact of money transmitted to real GDP – demand & supply of money determine interest rate – when interest rate falls, interest-sensitive purchases become cheaper so consumer spending (C) and business investment spending (I) increase – increases in C and I increase aggregate demand continued…

26. Fig. 5.7 Transmission Mechanism from Money Demand and Supply to Real GDP

27. lower interest rates are positive demand shock, increasing aggregate demand, increasing real GDP, decreasing unemployment, causing inflation higher interest rates are negative demand shock, decreasing aggregate demand, decreasing real GDP, increasing unemployment, causing deflation continued…

28. Economists disagree on the question How much does money change the economy when economy is not in equilibrium? Say and Yes, markets quickly self-adjust camp answer not much. o money does not affect external supply shocks that are main source of business-cycles o money allows savings to flow easily through loanable funds market for business borrowing, for investment spending o money helps quick adjustments to equilibrium continued…

29. Keynes and No, markets fail to adjust camp answer a lot o money gives people a way to save, creating possibility of financial crises and new internal demand shocks for business cycles o money gives people a way not to spend, blocking transmission mechanism so loanable funds market does not match spending to savings o money slows market adjustments to equilibrium

30. Fig. 5.8 How Much Does Money Matter for Business Cycles? Camp Compared to a barter economy, how does money affect: Yes Left Alone, Markets Quickly Self- Adjust (Say) No Left Alone, Markets Fail to Adjust (Keynes) How Often Business Cycles Happen Money has no effect. Money does not affect external supply shocks that are main source of business cycles. Money creates new shocks. Money gives people a way not to spend, adding new internal demand shocks. How Quickly Markets Adjust Money helps loanable funds market quickly adjust to equilibrium. Money blocks transmission mechanism, slowing adjustment to equilibrium.