1. Money and Money Market Money The Quantity Theory of Money
Monetary Aggregates
The Deposit and Money Multipliers
The Money Market

2. Money
Money is anything that serves as a commonly accepted medium of exchange or means of payment.
The earliest kind of money were commodities, but over time money evolved into paper currencies, bank money.

3. Money’s Function There are the three basic money’s function:
Medium of exchange
Unit of account
Store of value

4. The Quantity Theory of Money
Economists use to express the quantity theory of money as the equation:
M . V = P . Q
M: money supply
V: velocity of circulation of money
P: the average price level
Q: the total output

5. The Quantity Theory of Money
The key assumption is that the velocity of money is relatively stable and predictable.
The original equation can be rewritten:
P = M . V/Q
If transaction patterns are stable and real output grows smoothly (at potential output level) then the prices move proportionally with the supply of money.

6. The Quantity Theory of Money
Cambridge version of the quantity theory of money: M = k . P . Q
k is the the fraction of income that people seek to hold in the form of cash and demand deposits.
M is money demand

7. J.M.Keynes and The Quantity Theory of Money
There a two major differences between Keynesian and classical view of the role of money in the economy:
Economy is not operating at potential level of output.
Velocity of circulation of money is not stable.

8. Liquidity Preference
According to Keynes, demand for liquidity is determined by three motives. One of them is speculative motive:
speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

9. Monetarism and The Quantity Theory of Money
According to monetary economists, the reason for stability of the velocity of money is that velocity mainly reflects underlying patterns in timing of income and spending. The velocity of money is closely related to the demand for money.

10. Monetarism and The Quantity Theory of Money
The monetary rule: Optimal monetary policy sets the growth of the money supply at a fixed rate (e.g. at 3 % annually in case of 3 % GDP growth).
Monetarists believe that a fixed growth rate of money would eliminate the source of instability in a modern economy.

11. Monetary Aggregates
Monetary aggregates are the quantitative measures of the supply of money.
The money supply in an economy encompasses all the assets that serve the functions of money.

12. The Liquidity of Assets
Liquidity is an ability to quickly and easily convert an asset into spendable money at a price near its maximum market value.

13. Monetary Aggregates
Narrow definitions of money include items that can be spend directly (cash, current accounts).
Broad definitions of money include items that cannot be spent directly but can be readily converted into cash.

14. Monetary Aggregates The M1 money supply includes:
Assets that serve as media of exchange – currency, checking accounts (deposits regarded as money, you can write checks on it).
M 2 includes all M1 +
Saving deposits and small time deposits
Assets that act as media of exchange and other very liquid assets that can be converted into media of exchange very easily at little cost.

15. Monetary Aggregates M 3 includes all of M 2 +
Large –denomination time deposits
Other less liquid savings instruments (money market funds, shares, debt securities)
L is a broad measure of liquid assets, which includes M 3 +:
Short-term treasury securities
Commercial papers near money
Other liquid assets

16. Monetary Aggregates D includes all forms of credit money:
Any future monetary claim that can be used to buy goods and services. There are many forms of credit money, such as mortgage loans, bonds and money market accounts.

17. Balance sheet of the central bank
Assets
Liabilities
Loans granted to commercial banks
Currency in circulation
Securities
Commercial banks reserves
Reserves
Deposits
Other assets
Securities issued
Other liabilities

18. Balance sheet of the commercial bank
Assets
Liabilities
Bank reserves
Liabilities to central bank
Bank credits
Deposits of households and firms
Other assets
Other liabilities

19. The Deposit Multiplier
All commercial banks are required by law and the CB regulations to keep a fraction of their deposits as reserve.
The ratio of new deposits to the increase in reserves is called the money supply multiplier: 1/r

20. .............. Required reserves r = 10 % Deposit Loans and Investment
9 000,-
Deposit
Reserves
Bank I
Deposits €
Loans and
Investment
8 100,-
Reserves
+ 900
Bank II
Deposits
Deposit
9 000,-
Deposit
8 100,-

21. Balance sheet of the Commercial bank I.
Assets
Liabilities
Bank reserves
Liabilities to central bank
Bank credits
Deposits of households
and firms
Other assets
Other liabilities
Total
Total

22. Balance sheet of the Commercial bank II.
Assets
Liabilities
Bank reserves
Liabilities to central bank
Bank credits
Deposits of households
and firms
Other assets
Other liabilities
Total
Total

23. The Deposit Multiplier
Deposits: Loans:
Bank I:
Bank II:
Bank III: :
Total
Total reserves:

24. The Deposit Multiplier
The banking system transforms deposits into a much larger amount of bank money:

25. The Money Multiplier
The money multiplier (m) is the number you multiply the monetary base by to get the money supply:

26. The Money Multiplier
The supply of money (M) is currency (CU) plus deposit (D): M = CU + D
Although currency and deposits are both part of money supply, they have different characteristics. In order to determine the amount of currency versus deposits in the economy as a whole, we assume that people want to hold currency equal to a certain fraction of their deposits: CU = k . D
k is the currency to deposit ratio.

27. The Money Multiplier
The supply of money (M) is currency (CU) plus deposit (D):
M = CU + D
M = k.D + D
M = D(k + 1)

28. The Money Multiplier
The sum of currency and bank reserves (BR) is called the monetary base (MB):
MB = CU + BR
Bank reserves (BR) represent the reserves that commercial banks hold at the central bank. Then the relationship between reserves and deposits can be written using symbols as: BR = r . D

29. The Money Multiplier
The sum of currency and bank reserves (BR) is called the monetary base (MB):
MB = CU + BR
MB = k . D + r . D
MB = D (k +r)

30. The Money Multiplier
The link between the monetary base (MB) and the money supply (M) can be derived and used by the central bank to control the money supply:
M = D (k+1)
MB = D (k + r)

31. The Demand for Money
The demand for money refers to the desire to hold money:
The transaction motive: people and firms use money as a medium of exchange. The transaction demand for money responds to changes in income and prices. If all prices and incomes increase then the transaction demand for money increases.
The precautionary motive: unforeseen circumstances can arise, thus individuals and firms often hold some additional money as a precaution.
The speculative or assets motive

32. The Demand for Money
The transaction and precautionary demand for money is determined by the national income, frequency of payments, and interest rate.
There are three major determinants of the speculative demand for money:
The rate of interest
Expectations of changes in the prices of securities and other assets
The expectation about changes in the exchange rate.

33. The Demand for Money
The demand for money is sensitive to the cost of holding money: other things equal, as interest rates rise, the quantity of money demanded declines.
The major impact of interest rates on the quantity demanded of money comes in the business sector.

34. The Demand for Money i
MDMD1 the demand for money increases because of:
Rising prices
Rising incomes
MD1 MD M

35. The Supply of Money
The supply of money is determined by the private banking system and the nation’s central bank.
The central bank through different instruments provides reserves to the banking system.
Commercial banks create deposits out of the central bank reserves.
By manipulating reserves, the central bank can determine the money supply.

36. The Money Market i The money market is affected by a combination of :
The public’s desires to hold money (MD)
The CB monetary policy (MS)
The intersection of the supply and demand curves determines the market interest rate MS E iE MD ME M

37. Tight Money i MS1 MS The lower MS produces an excess
demand for money shown by the gap
AE. As people attempt to attain
the desired money stock, interest rates
rise (i1) to the new equilibrium at E1. E1 i1 iE E A MD M M1 ME

38. Money-Demand Shift i The demand for money has
increased because of higher
price level.
The higher demand for money
forces market interest rates
upward. MS E1 i1 E iE
MD1 MD ME M