Lecture 4 - The Role of Money in the Economy v2

8/12/2019 Lecture 4 - The Role of Money in the Economy v2

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What is Money? Anything that is used and accepted as a medium of

any transaction in an economy


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Functions of Money

Functions of Money Medium of Exchange Facilitate buying and selling transactions

Store of Value

Transporting purchasing power over time Even if you decide to defer consumption today,provided that things/ policies are constant, you can stillconsume that good in the future at the same rate


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Functions of Money

Functions of Money Unit of Account Standard unit for quoting prices

Unit for Deferred Payment

Compensated for opportunity costs Payment in the future interests


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Ways of Creating Money Commercial Banking System

Central Bank and numerous commercial banks Central Bank: manages the amount of money circulating

around the economy and plays the role of an observer andwatchdog of commercial banks

Commercial Banks: are monetary institutions that are givenpermission by the central bank to accept deposits fromhouseholds and firms and use these deposits for lending invarious sectors and instruments


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Ways of Creating Money Deposits, Borrowing, Required Reserves and

Increasing Money Sanrios Companys Initial Deposit of P100,000 to BDO and

created the succeeding deposits and money:

Deposit of Sanrio Company P 100,000

Deposit of Fish and Company P 75,000

Deposit of Trumpets Company P56,250

Deposit of ..... P42,187.50

Deposit of ..... P31,640.63

..... ...Total Money and Money Generated P400,000


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Ways of Creating Money Deposits, Borrowing, Required Reserves and

Increasing Money The process can also be demonstrated using the formula:

Total Deposits and Money Generated =

Initial Deposit x Deposit Multiplier

where Deposit Multiplier = 1 / Required Reserve Rate

P100,000 x 1/0.25 = P400,000


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Money Market the interaction between demand for money and the

supply of money (the size of the money stock) asset by the Central Bank working through the bankingsystem


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Money Demand: Different Views Classical Theory in the Demand for Money

Quantity Theory of Money (QTM) Money demand is based on its use as a medium of

exchange

MV = PY

where M is the volume of moneyV is the velocity of money

(number that indicates how many times a unitof money is used in different transactions in aspan of one year)

P is the level of overall price Y is the real national income


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Quantity Theory of Money (QTM) MV = PY

ExampleY = 500 billion units; P = P4.00 per unit; V = 10;

M = ?

M (10) = (4)(500Bn)M (10) = 2 TrnM = Php 200Bn

So there is a need for P200Bn of money to financethe P2 Trn national income


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Assumes that the velocity of money is constant The demand for money is a propotrion of the

monetary value of national income or nominalnational income

M = (1/V) PY

where PY is the national income

When PY increases, M increasesWhen PY decreases, M decreases


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Assumes that the economy is in full emloymentwherein production is in its maximum capacity, realincome (Y) is constant

Any increase in the volume of money will only resultto increase in prices

Increase in money supply inflation


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Money Demand: Different Views Keynesian Perspective

Transactions Demand/Motive Used for buying and selling Function of Income (Y)

If Y increases, transaction demand increases If Y decreases, transaction demand decreases


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Precautionary Demand/ Motive Money demand for unexpected contingencies Function of Income (Y)

If Y increases, precautionary demand increases If Y decreases, precautionary demand decreases


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Speculative Demand/ Motive Cash used for speculation Function of interest rate (r)

If r increases, speculative demand decreases If r decreases, speculative demand increases (looking for other

alternatives)


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Money Demand: Different Views Theory of Portfolio Balance

An individual can hold various kinds of wealth such asmoney, land, stocks and bonds

Portfolio: design and distribution of various kinds of wealth Money demand: Holding a lot of money (liquidity) VS

Holding noncash wealth Money demand is based on national income and interestrate

Higher national income, more transactions, higher moneydemand

Change in interest rate (opportunity cost of holding money) Interest rate increases, money demand decreases, holdingfinancial instruments is profitable


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Money Demand: Different Views Theory of Portfolio Balance

Speculative Demand (Keynes) VS Theory ofPortfolio Balance

Speculative Demand the inverse relationshipbetween money demand and interest rate is due toexpected change in the interest rate

Theory of Portfolio Choice the inverserelationship between money demand and interestrate is due to the opportunity cost of holding money


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Money Supply Money Supply

M1 or Narrow Money = currency in circulation (coins andbills) + demand deposits + travellers checks + negotiableorder of withdrawal (NOW)


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M2 or Broad Money = M1 + Savings Deposits + TimeDeposits


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M3 or Total Domestic Liquidity = M2 + Deposit Substitutes(debt instruments)


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MB or Monetary Base = Currency in Circulation + AvailableReserves

Types of Reserves Available Reserves

Loanable funds

Required ReservesReserve requirement: % of deposits kept in vault or as deposits withthe Central Bank

Excess ReservesLiquidity needed to service heavy withdrawals


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MB

M1

M2

M3

* Expansion in MB expands M1,M2 and M3


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Interaction of Money Demand and Supply

Increase in money supply (MS) can decreaseinterest rate Excess money supply, excess demand for noncash wealth

(bonds, stocks) Law of Demand and Supply: Price of bonds will increase

and interest rate will decrease Decrease in interest rate, increase in money demand


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Decrease in money supply (MS) can increaseinterest rate Lack of money supply, lack of demand in noncash wealth Law of Demand and Supply: Price of bonds will decrease

and interest rate will increase

Increase in interest rate, decrease in money demand


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Money Demand increases due to increase innational income Increase in National Income, Increase in Money

Demand (Transactions Motive) Demand for noncash wealth (stocks, bonds)

decreases, excess supply of bonds Law of Demand and Supply: Prices of bonds will

decrease and interest rates will increase Eventually, demand for money will decrease in order

to eliminate the excess money demand


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Money Demand decreases due to decrease innational income Decrease in National Income, Decrease in Money

Demand (Transactions Motive) Demand for noncash wealth (stocks, bonds)

increases, lack supply of bonds Law of Demand and Supply: Prices of bonds will

increase and interest rates will decrease Eventually, demand for money will increase in order to

eliminate the excess demand for noncash wealth


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Monetary Policy Bangko Sentral ng Pilipinas (BSP) Goals

Price Stability Sole issuer of currency Maintaining the value of the currency Protect the value of the currency

Creating conditions that will promote economic growth Exchange Rate Stability


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Monetary Policy Bangko Sentral ng Pilipinas (BSP) Goals

Creating conditions that will promote economic growth Exchange Rate Stability

Manage international reserves Encourages more trade

Minimize currency speculation Prevents hurting the import and export sectors


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Monetary Policy The Financial Services System

FINANCIALINSTITUTIONS

MobilizeSavings

Fund/Investments

BANKS NON -BANKS


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Monetary Policy Financial Institutions

Serve as financial intermediaries when BSP implementsmonetary policies

Non-Banks Mutual Fund Institutions Investment Banks Insurance Companies Finance Companies Pension Fund Institutions


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Monetary Policy Monetary Policies

Expansionary Monetary Policy increase money supply;interest rates will decrease

Contractionary Monetary Policy decrease money supply;interest rates will increase


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Monetary Policy Instruments of Monetary Policy

Open Market Operations (OMO) Central Bank buys and sells bonds


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REDISCOUNT RATE Rate at which commercial banks borrow from the Central

Bank


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MORAL SUASION Use of influence to manipulate money in circulation


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PRINTING MONEY


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Monetary Policy Strict Monetary Policy (Contractionary)

BSP tightens the accelerated increase of money Growth rate of money supply < Increase of Planned

Production Lower money supply, high interest rate, no incentive to

borrow money to fund planned production UNEMPLOYMENT


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Monetary Policy Loose Monetary Policy (Expansionary)

BSP increases money supply Growth rate of money supply > Increase in the Productive

Sector of the economy Higher money supply, lower interest rate, incentive to

expand production capacity Purchasing power is higher, more demand for goods and

services INFLATION


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Monetary Policy Effects of Monetary Policy

Short-run The effects of increasing money due to loose monetary policy

are the decrease in interest rate and increase in investments,and increase in the general price level

Long-run It is said that monetary policy has no effect in changing

national demand and income, investments and interest rates The only effect of the increase in money supply is to increase

the overall price level (neutrality of money) The initial demand in money supply will be matched by an

increase of money demand

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Lecture 4 - The Role of Money in the Economy v2