Monetary economics - University of London · Monetary economics Y. Aksoy EC3 115 2015 Undergraduate study in Economics, Management, Finance and the Social Sciences This …

Monetary economicsY. AksoyEC3115

2015

Undergraduate study in Economics, Management, Finance and the Social Sciences

This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE).

For more information, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by:

Dr Y. Aksoy, Reader in Economics, Department of Economics, Mathematics and Statistics, Birkbeck, University of London.

Some of the material in this subject guide has been adapted from the previous edition, written by:

Ryan Love, formerly of the London School of Economics and Political Science.

This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

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Contents

Contents

1 Introduction to the subject guide 7

1.1 The structure of the guide . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.2 The subject guide and the syllabus . . . . . . . . . . . . . . . . . . . . . 7

1.3 Specifics of the syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.4 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.5 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.6 Subject chapters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.7 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.8 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1.10 Online study resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1.11 How to use this subject guide . . . . . . . . . . . . . . . . . . . . . . . . 14

1.12 The examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

1.13 Use of mathematics and statistics . . . . . . . . . . . . . . . . . . . . . . 16

2 The nature of money 17

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17


2.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17


2.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.7 What is money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.8 The functions of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.9 Why do we have money? . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

2.10 Types of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.11 Properties of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.12 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . . 26

2.13 Sample examination questions . . . . . . . . . . . . . . . . . . . . . . . . 27

2.14 Feedback to Sample examination questions . . . . . . . . . . . . . . . . . 27

1

Contents

3 The demand for money 29

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

3.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29


3.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30


3.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

3.7 Microeconomic determinants of the demand for money . . . . . . . . . . 31

3.8 Baumol–Tobin transactions demand for money . . . . . . . . . . . . . . . 33

3.9 Tobin’s model of portfolio selection . . . . . . . . . . . . . . . . . . . . . 35

3.10 Macroeconomic determinants of money demand . . . . . . . . . . . . . . 36

3.11 The stability of the money demand function . . . . . . . . . . . . . . . . 38

3.12 Reasons for the breakdown of the money demand functions . . . . . . . . 39



3.15 Feedback to Activity 3.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . 41


4 The supply of money 43

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

4.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43


4.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44


4.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4.7 Financial intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

4.8 The money multiplier and base money . . . . . . . . . . . . . . . . . . . 46

4.9 A simple model of the banking sector . . . . . . . . . . . . . . . . . . . . 47





5 Classical theory 57

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

5.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

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Contents


5.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57


5.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

5.7 The quantity theory of money . . . . . . . . . . . . . . . . . . . . . . . . 58

5.8 A simple general equilibrium framework . . . . . . . . . . . . . . . . . . 63




6 Stylised facts 69

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

6.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69


6.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70


6.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

6.7 Trends and business cycles . . . . . . . . . . . . . . . . . . . . . . . . . . 71

6.8 Moments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

6.9 Cross country business cycle evidence . . . . . . . . . . . . . . . . . . . . 78

6.10 Key macroeconomic relationships . . . . . . . . . . . . . . . . . . . . . . 79

6.10.1 Relationship between monetary aggregates and inflation . . . . . 79

6.11 Relationship between monetary instruments and macroeconomy . . . . . 80

6.12 Price level stickiness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82




7 Money, inflation and welfare 85

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

7.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85


7.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86


7.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

7.7 Inflation as taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

3

Contents





8 Classical models and monetary policy 101

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

8.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101


8.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102


8.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

8.7 The classical model revisited . . . . . . . . . . . . . . . . . . . . . . . . . 103

8.8 The effect of monetary policy . . . . . . . . . . . . . . . . . . . . . . . . 103

8.9 Real business cycle theory . . . . . . . . . . . . . . . . . . . . . . . . . . 106

8.10 Business cycle facts and RBC theory . . . . . . . . . . . . . . . . . . . . 106

8.11 Classical models with real effects of money . . . . . . . . . . . . . . . . . 107




8.15 Appendix to Chapter 8: a ‘simple’ RBC model . . . . . . . . . . . . . . . 111

9 Keynesian models with money supply as a policy instrument 119

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

9.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119


9.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120


9.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

9.7 Keynesian aggregate supply function . . . . . . . . . . . . . . . . . . . . 121

9.8 Predictable and unpredictable components of the money supply . . . . . 130




10 New Keynesian models of monetary policy 137

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

4

Contents

10.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137


10.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138


10.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

10.7 IS-PC-MR model of new Keynesian economics . . . . . . . . . . . . . . . 139

10.8 Analysing demand shocks . . . . . . . . . . . . . . . . . . . . . . . . . . 141

10.9 Analysing supply shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

10.10 Financial accelerator models . . . . . . . . . . . . . . . . . . . . . . . . 145

10.11 Simple monetary policy rules . . . . . . . . . . . . . . . . . . . . . . . . 147

10.12 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . 149

10.13 Sample examination questions . . . . . . . . . . . . . . . . . . . . . . . 150

10.14 Feedback to Sample examination questions . . . . . . . . . . . . . . . . 150

11 Time inconsistency and inflation bias 151

11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

11.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151


11.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152


11.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

11.7 Time inconsistency and inflation bias . . . . . . . . . . . . . . . . . . . . 153

11.8 Inflation aversion, steepness of the Phillips curve and interest rates . . . 155

11.9 Ways inflation bias can be reduced . . . . . . . . . . . . . . . . . . . . . 156

11.9.1 Delegation of monetary policy to a conservative central bank: centralbank independence . . . . . . . . . . . . . . . . . . . . . . . . . . 156

11.9.2 Inflation contract for the central bank . . . . . . . . . . . . . . . . 156

11.9.3 Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157




12 Monetary policy and data/parameter uncertainties 161

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

12.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162


12.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

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Contents


12.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

12.7 Data uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

12.8 Parameter (or multiplicative) uncertainty . . . . . . . . . . . . . . . . . . 165

12.8.1 The New Keynesian model and parameter uncertainty . . . . . . 167

12.8.2 Graphical exposition . . . . . . . . . . . . . . . . . . . . . . . . . 170

12.9 Interest rate smoothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171




13 The term structure of interest rates 175

13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

13.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175


13.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176


13.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

13.7 The yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

13.8 Why is the yield curve of importance to policy-makers? . . . . . . . . . . 177

13.9 Bond prices and the rate of return . . . . . . . . . . . . . . . . . . . . . . 178

13.10 Empirical regularities of the term structure . . . . . . . . . . . . . . . . 179

13.11 The expectations hypothesis . . . . . . . . . . . . . . . . . . . . . . . . 179

13.12 The segmentation hypothesis . . . . . . . . . . . . . . . . . . . . . . . . 180

13.13 Preferred habitat theory . . . . . . . . . . . . . . . . . . . . . . . . . . 181




A Sample examination paper 185

B Examiners’ commentary to Sample examination paper 189

6

Chapter 1

Introduction to the subject guide

1.1 The structure of the guide

The subject guide broadly mirrors the syllabus, which is split into three sections.

The first section of the guide (Chapters 2–5) introduces the concept of money;what it is, why we use it and how it is created. The role of banks and the bankingsector will be analysed in this section only, leaving the rest of the guide to focus onpolicy issues.

The second section (Chapters 6–10) examines monetary policy in a closed economy,considering a number of models that allow real effects of monetary policy, rangingfrom new-Classical to new-Keynesian. Specific models will be introduced andsolved, allowing you to see exactly how these models work and what differentiatesone from another.

The third section of the guide considers important issues in the design of monetarypolicymaking. Topics include i) time inconsistency in monetary policy design, ii)monetary policy in an uncertain environment such as data and parameteruncertainties that monetary policy makers face and how policy makers canalleviate problems associated with these uncertainties and iii) term structure ofinterest rates.

Please see the syllabus at the end of this ‘Introduction’.

1.2 The subject guide and the syllabus

The aim of the guide is to enable you to interpret fully the published syllabus for theEC3115 Monetary economics course. It does so by identifying what you areexpected to know within each area of the syllabus, and suggesting the reading that willbe most helpful in acquiring an understanding of the material concerned. It cannot beemphasised strongly enough that the guide is not a substitute for reading textbooks andother references.

1.3 Specifics of the syllabus

Important: the information given in the following section is based on the syllabus atthe time this guide was written. However, you should refer to the Programme handbookfor the latest version of the syllabus and any additional information.

7

1. Introduction to the subject guide

Section 1: Introduction to money and monetary economics

The nature of money:

What constitutes money. Why people hold money; introduction to cash in advance(CIA) and money in the utility (MIU) functions.

Money demand and supply:

Microeconomic determinants of the demand for money and macroeconomic moneydemand functions. Financial intermediaries, banks and money creation.

The Classical school, neutrality of money and the quantity theory:

The Classical dichotomy, Walras’ and Say’s laws, introduction to money in ageneral equilibrium setting.

Section 2: Monetary policy

Stylised facts and monetary policy:

Trends and business cycles. Means, volatility, cyclicality and persistence inmacroeconomic time series. Money and macroeconomic variables in the short andlong-run. Empirical evidence for Phillips curves.

The welfare effects of inflation and monetary policy:

Neutrality and superneutrality of money, welfare costs, seigniorage and theinflation tax.

The Classical model, flexible price economies and monetary policy:

Rational expectations, representative agents and real business cycle theory. MIU,CIA, Lucas supply functions and the effects of monetary policy.

The Keynesian approach to monetary policy – nominal rigidities:

Multi-period pricing and the persistence of monetary policy shocks. The Lucascritique.

The new Keynesian approach to monetary policy – nominal rigidities:

New Keynesian Phillips curve, IS Curve, Taylor rules, financial accelerator models.

Section 3: Topics in monetary economics

Time inconsistency in monetary policy:

Inflation bias, the central bank independence. Monetary policy rules: interest ratetargeting and monetary targeting. (rules versus discretion).

8

1.4. Aims

Uncertainties in the monetary policy design:

News versus noise in data revisions. Brainard conservatism, certainty equivalence,interest rate smoothing.

Term structure of interest rates:

Explanation of the yield curve: expectations hypothesis and the segmentationhypothesis.

1.4 Aims

The aims of the course are to:

develop understanding of the theories that relate to the existence of money,explaining why it is demanded by individuals and used in the trading process

develop an understanding of the monetary transmission mechanism, wherebydecisions made by the monetary authorities concerning money supplies or interestrates can have real effects on the economy

develop a number of macroeconomic models through which monetary policy can beevaluated. Such models will include Classical, Keynesian and new Keynesianschools of thought and will consider why monetary policy matters and whenmonetary policy decisions may be impotent

develop understanding of the uncertainties policy-makers face and how policymakers may deal with these.

1.5 Learning outcomes

At the end of this course and having completed the essential reading and activitiesstudents should be able to:

explain and discuss why people hold money and why it is used in the tradingprocess

solve macroeconomic models and assess the role and efficacy of monetary policy forvarious types of models in both the Classical and Keynesian set-ups

describe and explain the main channels of the monetary transmission mechanism,through which monetary policy can have real effects on the economy

discuss the merits and disadvantages of different monetary policies used by CentralBanks

introduce the concepts of data and parameter uncertainties and discuss policyunder uncertainty.

9


1.6 Subject chapters

A different chapter is devoted to each major section of the syllabus, and the chapterorder follows very closely, though not identically, the order of the topics as they appearin the syllabus. This order will not concur with that in any one of the recommendedtextbooks and the fact that the order varies between the textbooks themselves reflectsthe view that there is no obvious sequence of topics because of the interrelationshipsbetween them. It is most important to appreciate that the ‘topics’ in the syllabus arenot self-contained and mutually exclusive, and neither therefore are the chapters of thisguide. Instead there is considerable overlap between many of the ‘topics’ and betweenthe chapters. For example, the chapter on ‘the demand for money’ explains the linkbetween the level of real money balances an economy wishes to hold and the nominalinterest rate. This is essential for understanding how monetary policy influences the realeconomy in later chapters. Similarly, an understanding of how, and to what extent,changes in the supply of money affect the macroeconomy will require an understandingof the subject matter of several chapters.

Consequently, you must expect the examination to include questions that require anunderstanding of several different parts of this subject, in other words you cannot ‘pickand choose’ what to study from the guide.

Each chapter begins with a checklist of learning outcomes; what you should know afterhaving completed the chapter and done the essential reading and activities. Thenfollows some reading advice and a list of the most helpful books and articles for thatparticular chapter. Following the main text, each chapter concludes with a list ofSample examination questions. Occasionally these questions will overlap with materialcovered in one or more of the other chapters.

1.7 Reading advice

Unfortunately no single textbook adequately covers the whole of the EC3115Monetary economics syllabus. Indeed, using several different textbooks may still notprove adequate. Sometimes it will be necessary to consult a ‘specialist’ book, or perhapsan article in a journal in order to get a good grasp of the subject matter concerned.Consequently, the reading suggested at the beginning of each chapter might include notonly references to one or more textbooks, but also references for wider reading. In somechapters, it might be useful to study the recommended reading before you move on tothe material presented in the subject guide. Where this is the case, the introductoryparagraph will let you know what you should read before you work through the chapter.For each chapter, the reading list is split into two sections: Essential reading andFurther reading. As the name suggests, Essential reading is required reading in orderfor you to fully understand the concepts introduced in the particular chapter. Again, itmust be stressed that this subject guide is not a substitute for reading textbooks. Theitems listed under Further reading will give you greater insight into the topics coveredin the chapter and will certainly help you understand any areas with which you still feeluncomfortable.

10

1.8. Essential reading

1.8 Essential reading

For Sections 1 and 2, you are encouraged to buy:

either

Lewis, M.K. and P.D. Mizen Monetary Economics. (Oxford; New York: OxfordUniversity Press, 2000) [ISBN 9780198290629]

or

Carlin,W. and D. Soskice Macroeconomics: Imperfections, Institutions and Policies.(Oxford: Oxford University Press, 2006).

For Sections 1 and 2 the Carlin and Soskice and Lewis and Mizen books are veryhelpful. Carlin and Soskice book provides an excellent account of new Keynesian modelsin particular, while Lewis and Mizen is easier to read. For Section 3, there is no singlebook that is adequately covering issues addressed in the guide. We indicate relevantliterature in academic journals.

Throughout this guide, there are references in both the Essential and Further readingsections to articles in The New Palgrave Dictionary of Money and Finance. Thisincludes essays and articles on most aspects of money, contributed by authors who areinternationally recognised authorities on the subject matter of their particular entry. Ineach chapter you will be directed to the relevant entries in this book in either theEssential or Further reading categories. Other books are particularly useful on specifictopics (such as money demand). Where such books (and indeed articles as well) arerecommended, page references or chapter numbers are given.

Detailed reading references in this subject guide refer to the editions of the settextbooks listed above. New editions of one or more of these textbooks may have beenpublished by the time you study this course. You can use a more recent edition of anyof the books; use the detailed chapter and section headings and the index to identifyrelevant readings. Also check the virtual learning environment (VLE) regularly forupdated guidance on readings.

The Essential reading for all chapters in this subject guide is taken from the twotextbooks above but also includes the following:

Books

Cagan, P. ‘The monetary dynamics of hyperinflation’, in Friedman, M. (ed.)Studies in the Quantity Theory of Money. (Chicago: University of Chicago Press,2000) [ISBN 9780226264042].

Gali, J. Monetary Policy, Inflation, and the Business Cycle: An Introduction to theNew Keynesian Framework. (Princeton: Princeton University Press, 2008) [ISBN:9781400829347].

Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan,1989) second edition [ISBN 9780262570756].

11


Gordon, R.J., ‘A century of evidence on wage and price stickiness in the US, theUK and Japan’, in Tobin, J. (ed.) Macroeconomics, Prices and Quantities. (Oxford:Blackwell, 1983) [ISBN 9780815784852].

Jones, C.I. Macroeconomics. (W. W. Norton Company, 2013) third edition [ISBN9780393923902].

Laidler, D.E.W. The Demand for Money: Theories, Evidence and Problems. (NewYork: Harper Collins, 1997) fourth edition [ISBN 9780065010985].

Lucas, R.E. ‘Econometric policy evaluation: a critique’, in Brunner, K. and A.H.Meltzer (eds) The Phillips Curve and Labor Markets. (Amsterdam; Oxford:North-Holland, 1976) [ISBN 9780444110077].

Mankiw, N.G. Macroeconomics. (New York: Worth Publishers, 2012) eighth edition[ISBN 9781429240024].

McCallum, B. Monetary Economics. (New York: Macmillan; London: CollierMacmillan, 1989) [ISBN 9780023784712].

Mishkin, F.S. The Economics of Money, Banking and Financial Markets. (Boston,Mass.; London: Prentice Hall, 2012) tenth edition [ISBN 9780132770248].

Newman, P., M. Milgate and J. Eatwell (eds) The New Palgrave Dictionary ofMoney and Finance. (London: Macmillan, 1994) [ISBN 9780333527221].

Williamson, S. Macroeconomics. (New Jersey: Prentice Hall, 2013) fifth edition[ISBN 978-0132991339].

Journal articles

Aksoy, Y. and T. Piskorski, ‘US domestic money, inflation and output’, Journal ofMonetary Economics, 53, 2006, pp.183–197.

Bernanke, B. , Gertler, M., and S. Gilchrist (1999) ‘The financial accelerator in aquantitative business cycle framework’, Chapter 21, in Handbook ofMacroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford, Elsevier.Brainard, W., ‘Uncertainty and effectiveness of policy’, American Economic Review(papers and proceedings), 57 (2), 1967, pp.411–425.

Carlin, W. and D. Soskice ‘The 3-equation New Keynesian model – A graphicalexposition’, BE Journals in Macroeconomics: Contributions, 5(1) 2005, pp.1–38.

Clarida, R., Gal, J. and Gertler, M., ‘The science of monetary policy: a newKeynesian perspective’, Journal of Economic Literature, 37(4), 1999, pp.1661–1707.

Kydland, F.E. and E.C. Prescott, ‘Rules rather than discretion: the inconsistencyof optimal plans’, Journal of Political Economy 85(3), 1977, pp.473–492.

Long, J. and C. Plosser, ‘Real business cycles’, Journal of Political Economy 91(1),1983, pp.39–69.

12

1.9. Further reading

Lucas, R., ‘Some international evidence on output-inflation trade-offs’, AmericanEconomic Review, 63, 1973, pp.326–334.

Plosser, C., ‘Understanding real business cycles’, Journal of Economic Perspectives3(3) 1989, pp.51–77.

Taylor, J.B., ‘An historical analysis of monetary policy rules’, NBER workingpaper, w6768, (1998).

1.9 Further reading

Please note that as long as you read the Essential reading you are then free to readaround the subject area in any text, paper or online resource. You will need to supportyour learning by reading as widely as possible and by thinking about how theseprinciples apply in the real world. To help you read extensively, you have free access tothe VLE and University of London Online Library (see below).

1.10 Online study resources

In addition to the subject guide and the Essential reading, it is crucial that you takeadvantage of the study resources that are available online for this course, including theVLE and the Online Library.

You can access the VLE, the Online Library and your University of London emailaccount via the Student Portal at: http://my.londoninternational.ac.uk

You should have received your login details for the Student Portal with your officialoffer, which was emailed to the address that you gave on your application form. Youhave probably already logged in to the Student Portal in order to register! As soon asyou registered, you will automatically have been granted access to the VLE, OnlineLibrary and your fully functional University of London email account.

If you forget your login details, please click on the ‘Forgotten your password’ link on thelogin page.

The VLE

The VLE, which complements this subject guide, has been designed to enhance yourlearning experience, providing additional support and a sense of community. It forms animportant part of your study experience with the University of London and you shouldaccess it regularly.

The VLE provides a range of resources for EMFSS courses:

Self-testing activities: Doing these allows you to test your own understanding ofsubject material.

Electronic study materials: The printed materials that you receive from theUniversity of London are available to download, including updated reading listsand references.

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Past examination papers and Examiners’ commentaries : These provide advice onhow each examination question might best be answered.

A student discussion forum: This is an open space for you to discuss interests andexperiences, seek support from your peers, work collaboratively to solve problemsand discuss subject material.

Videos: There are recorded academic introductions to the subject, interviews anddebates and, for some courses, audio-visual tutorials and conclusions.

Recorded lectures: For some courses, where appropriate, the sessions from previousyears’ Study Weekends have been recorded and made available.

Study skills: Expert advice on preparing for examinations and developing yourdigital literacy skills.

Feedback forms.

Some of these resources are available for certain courses only, but we are expanding ourprovision all the time and you should check the VLE regularly for updates.

Making use of the Online Library

The Online Library contains a huge array of journal articles and other resources to helpyou read widely and extensively.

To access the majority of resources via the Online Library you will either need to useyour University of London Student Portal login details, or you will be required toregister and use an Athens login: http://tinyurl.com/ollathens

The easiest way to locate relevant content and journal articles in the Online Library isto use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try removing anypunctuation from the title, such as single quotation marks, question marks and colons.

For further advice, please see the online help pages:www.external.shl.lon.ac.uk/summon/about.php

1.11 How to use this subject guide

At the start of most chapters you are advised on how to approach the material andwhich readings to consult as well as when to consult them. In general though, for eachtopic in the syllabus you should read through the whole of the chapter in the guide soas to get an overview of the material to be covered. Then try to read as much of thesuggested reading as you can. This is important as you will often find that things youhave difficulty understanding in one book are made perfectly clear in another. Athorough understanding of the material covered in recommended passages is essential ifyou are to maximise the benefits you derive from this subject.

Use the checklist and Sample questions as a way of testing your understanding of thematerial covered. The textbooks will also include exercises and questions, and youwould be well advised to attempt as many of these as you can. The real test of whether

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1.12. The examination

you understand something is not whether you have followed the explanation, butwhether you can apply that understanding to answering questions.

A number of chapters include a substantial activity. This is a longer question, whichyou should be able to work through after having consulted the relevant readings.Although an outline of the solution is included at the end of the chapter, you arestrongly encouraged to use this only to check your answers or to get hints as to how tostart your answer.

You should allocate approximately two weeks to study each chapter. Chapters 1 and 2contain relatively little mathematical material, therefore can easily be dealt with in oneweek.

1.12 The examination

Important: the information and advice given here are based on the examinationstructure used at the time this guide was written. Please note that subject guides maybe used for several years. Because of this we strongly advise you to always check boththe current Regulations for relevant information about the examination, and the VLEwhere you should be advised of any forthcoming changes. You should also carefullycheck the rubric/instructions on the paper you actually sit and follow those instructions.

Examination questions will require short essays, demonstrating understanding of thesubject material and critical ability.

The three-hour unseen examination consists of two sections:

Section A (40 marks) contains eight statements, which are true, false or uncertain.You will be asked to answer all of these, also explaining your answer in a shortparagraph. A typical ‘true, false or uncertain’ question will appear at the end ofeach chapter and in the first half of the guide a suggested answer is also included,in order to give you an idea as to how detailed the explanation should be.

Section B is worth 60 marks. You must answer three out of five questions. Thesewill typically involve discussing and solving some of the models covered in theguide. These may also involve interpretation of data in the light of specifiedmacro-monetary theories.

To give you an idea as to how the examination will be structured, an example isincluded in the Appendix. In addition to the Sample examination paper, the questionsat the end of each chapter will also give you an insight into the examination. The ‘true,false or uncertain’ question in each chapter is representative of the questions you will beasked in Section A and the remaining questions are similar to those found in Section B.The longer activities, found in a number of chapters, are exactly the type of questionyou should expect to find in Section B of the examination.

To give you an idea as to how you should structure your answers in the examination,feedback to some of the Sample examination questions is given at the end of eachchapter. However, as is the case for the feedback to the longer activities, you shouldonly use this to check your answers, or to get hints as to how to start.

15


Remember, it is important to check the VLE for:

up-to-date information on examination and assessment arrangements for this course

where available, past examination papers and Examiners’ commentaries for thecourse which give advice on how each question might best be answered.

1.13 Use of mathematics and statistics

Economics is becoming an increasingly technical subject and, as such, in this subjectyou will be required to employ mathematics in order to solve simple optimisationproblems. However, what is most important is the intuition behind the models, whichcan often be demonstrated easily using diagrams. Any mathematics that is used in thissubject is limited to simple calculus (differentiation), algebra and basic statistics (thedefinition and calculation of means and variances). The most technically demandingchapters are from Chapter 7 to Chapter 12 but in order to help you work through this,the mathematics is presented so as to allow you to see how the models are solved,step-by-step. Some of the passages in some of the recommended books and articles docontain more complicated or lengthy mathematics/statistics but almost invariably itsmeaning is clarified in the written text.

Model-based approach of the guide

This subject guide follows a more model-based approach to monetary economics thanthe previous guide. Each chapter introduces one or more models that, when solved, willshow you the linkages between monetary variables (money supply or interest rates, forexample) and other variables such as output. As such, for the examination you will beexpected to solve and work through mathematical models but these will be no morecomplicated than what is presented in this subject guide. However, what is just asimportant is that you demonstrate that you understand what is going on. To do this,you must explain your answer using words, and possibly also diagrams. Even though allyou need to know to succeed in your study of monetary economics is presented in theessential and further reading sections of each chapter, for those of you who require morehelp with this model-based approach, you can consult Walsh, C. Monetary Theory andPolicy (2010) third edition and Gali, J. Monetary Policy, Inflation and the BusinessCycle (2008). It should be stressed, however, that you should read the items in therecommended reading sections first, before you consider reading these moreadvanced/technical textbooks. Hopefully you will find your study of monetaryeconomics interesting and enjoyable.

Good luck.

Dr. Yunus Aksoy (Birkbeck, University of London)

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Chapter 2

The nature of money

2.1 Introduction

Fiat money is indispensable in modern economic systems, although it has been part ofdaily life as far back as 9000 BC, when grain and cattle were used in Anatolia andMesopotamia for exchange purposes. While we take the usage of some form of money asgranted, we need to understand why it exists, its functions and properties. In particular,we need to solve the double coincidence of wants problem associated with barter and toresolve the lack of trust between the payer and the payee in a transaction.

2.2 Aims

The aim of the chapter is to introduce the main ingredients of a monetary economy. Wewill introduce money for exchange purposes of goods and services. We will describe itsfunctions, why money is useful in trade, its types and properties.


By the end of this chapter, and having completed the Essential reading and activities,you should be able to:

discuss the nature and shortcomings of a barter economy

list and describe the general functions performed by money

describe the Wicksell problem and demonstrate how indirect barter can lead to theemergence of a commodity money

describe the differences between transactions using credit cards and bank debitcards

list and describe what the different types of money are.

2.4 Reading advice

You will certainly find it easiest, and probably most useful, to read the appropriatesections on the nature of money in one or more of the basic textbooks before you move

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2. The nature of money

on to the material in this chapter.1 All textbooks on money and banking will have asection covering the material here. However the best, although most difficult, is that ofGoodhart (1989a) Chapter 2 – see below under ‘Essential reading’. You may find ithelpful to read Goodhart (1989b) first – see below under ‘Further reading’.


Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989a)Chapter 2.

Lewis, M.K. and P.D. Mizen Monetary Economics. (Oxford; New York: OxfordUniversity Press, 2000) Chapters 1 and 2.

2.6 Further reading

Clower, R.W. ‘Introduction’ in Clower, R.W. (ed.) Monetary Theory: Selected readings.(Harmondsworth: Penguin, 1969).

Goodhart, C.A.E. ‘The Development of Monetary Theory’ in Llewellyn, D.T. (ed.)Reflections on Money. (Basingstoke: Macmillan, 1989b).

Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapter 1.

Kiyotaki, N. and J.H. Moore ‘Evil is the Root of all Money’. Clarendon Lecture series,Lecture 1 (2001).

Kiyotaki, N. and R. Wright ‘Acceptability, Means of Payment, and Media of Exchange’,Federal Reserve Bank of Minneapolis Quarterly Review, Summer 1992. Also in Newman,P., M. Milgate and J. Eatwell (eds) The New Palgrave Dictionary of Money andFinance. (London: Macmillan, 1994).

McCallum, B. Monetary Economics. (New York; Macmillan; London: CollierMacmillan, 1989).

Newlyn, W.T. and R.P. Bootle Theory of Money. (Oxford: Clarendon Press, 1978)Chapter 1.

2.7 What is money?

Money is defined by its function rather than the form in which it takes. In this sense,money is defined as ‘anything which is in general use, and generally accepted, as ameans of payment.’ In the past, money has taken the form of corn, rice, cattle, shells,various precious metals and more recently, pieces of paper issued by governments. In allcases though, money was and is used as a means of payment in exchange. The payer ina transaction (he or she who is purchasing a good or service) hands over money to thevalue of the item bought and at this point the payee (the seller of the good or service)

1See for example, Harris, and Newlyn and Bootle.

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2.8. The functions of money

accepts that the payment is complete. The payee neither holds any further claims onthe payer, nor on any third party who may have produced or issued the money.

In this chapter we will discuss and explain the important functions, properties anddifferent types of money. We will also explain why we use money and compare thealternative trading strategies, both with and without money.

2.8 The functions of money

Below, we will discuss the three main functions of money, although, arguably, someauthors will expand these into four.2

Money as a means of payment

As suggested above, the most important function of money is its use as a means ofpayment – money being used to pay for items purchased or to settle any debts. Arelated role of money is that as a medium of exchange, which Wicksell defined as anobject which is taken in exchange, not on its own account. . . not to be consumed by thereceiver or to be employed in technical production, but to be exchanged for somethingelse within a longer or shorter period of time.’3 In this sense, a means of payment canalso be a medium of exchange. A gold coin for example, used to buy a piece of land, willbe a means of payment (the seller of the land will not hold a claim on the payee whohas just handed over the gold) but it will also be a medium of exchange. The receiver ofthe gold coin will not use it for decorative purposes or to ‘make’ any other goods orservices, but will use it as a medium of exchange when he or she wishes to purchase agood or service some time in the future.

However, the converse is not necessarily true.4 That which may act as a medium ofexchange may not act simultaneously as a means of payment. For example, if I wish topay for a television set using a credit card, the seller may accept this as a medium ofexchange.

Although the television shop’s account may be credited effectively immediately, it maynot be a means of payment since I, the payer, still have a debt outstanding, namely thatto the credit card company. I have merely replaced a debt to the television shop with adebt to the credit card issuer. The purchase of the television set with the credit card isthen not a means of payment. For this reason we will not include credit cards, tradecredit between firms, or any other line of credit such as unused overdraft facilities, inour definition of money.

2The fourth function of money commonly quoted, is that of a standard for deferred payment. Thissimply means that if something is bought today although payment for it does not have to be made untilsome later date, then the amount due for deferred payment can be measured in terms of money.

3Wicksell, 1906, quoted by Kiyotaki and Wright, (1992).4For an excellent analysis of the differences between ‘means of payment’ and ‘medium of exchange’

see Goodhart (1989a) Chapter 2, Section 4.

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Money as a unit of account

This function is also described as money acting as a measure of exchange value, moneyacting as a standard of value, or money as a numeraire. The essential point about thisfunction is that money is acting as a common denominator, in terms of which the valuein exchange of all goods and services can be expressed. Money is simply acting as a unitof measurement in the same way that metres measure length and kilograms measureweight. Money in this sense is being used to measure the value of goods, services andassets relative to other goods, services and assets. If it is convenient to trade allcommodities in exchange for a single commodity, so it is convenient to measure theprices of all commodities in terms of a single unit, rather than record the relative priceof every good in terms of every other good. If there is to be a single unit of account, it isagain clearly convenient (though not necessary) that the unit of account be the mediumof exchange, given that goods actually exchange against the medium of exchange.

A clear advantage of having a single unit of account is that it greatly reduces thenumber of exchange ratios between goods and services. With four goods (A, B, C andD), in order to facilitate exchange, exchange ratios of each good in terms of all theothers must be available (i.e. the six ratios A:B, A:C, A:D, B:C, B:D and C:D must beavailable). In fact with n goods, there are n(n− 1) = 2 relative prices. However, if weintroduce a fifth good, ‘money’ that acts as a unit of account then there only need to befour prices. With n goods and money being the n+ 1-th commodity acting as a unit ofaccount, we only need n prices. For example, with 1,000 goods and no unit of account,the economy needs 499,500 relative prices of one good in terms of another. Introducingmoney as a unit of account dramatically reduces this to only 1,000. Thus, having moneyas a unit of account can encourage trade by making it easier for individuals to knowhow much one good is worth in terms of another.

Money as a store of value

The exchange attributes of money, in particular that it is durable and can readily beused in the purchase of goods, also mean that people may wish to hold it as an asset,that is as part of their stock of wealth. In this sense, money serves as a store of value: itis permitting the separation in time of the act of sale from the act of purchase. Theexistence of a means of payment enables a person to sell a good without simultaneouslyhaving to buy another good in exchange. Receiving a means of payment in exchange forthe good sold allows the seller to hold on to it until such time as it is needed to beexchanged for the goods and services he or she requires.

Money is not unique as a store of value: any asset, such as equities, bonds, real estate,antiques and works of art can all act as stores of value. Money itself is sometimes a poorstore of value. This will occur when the relative price of money falls as a result of themoney prices of other goods and services rising, that is, during periods of inflation.

2.9 Why do we have money?

The use of money helps facilitate trade since in the absence of money, trade has toproceed through barter, that is the direct exchange of one good for another.

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2.9. Why do we have money?

Barter

Barter tends to be associated with primitive economies in which individual householdsoperate in an isolated manner, and in particular have no sophisticated informationsystems concerning what is going on in the rest of the economy. For various reasonshouseholds may wish to consume a different bundle of goods from those they produce,so that there are gains from trade. The problem is how to achieve these potential gains,given that trade is a voluntary activity and can proceed only when it is to the benefit ofboth parties.

In barter, there has to be what is known as a ‘double coincidence of wants’. If I growcorn but want to consume apples, not only do I have to find someone willing to tradeapples but they must also want what I have to offer, namely corn. In other words fortrade to be mutually beneficial, it is necessary not only that trader A has what trader Bwants but also that trader B has something to offer in exchange which trader A wants.It is quite possible that no trade will occur, especially in cases where the goods desiredare so specialised that the probability of a double coincidence of wants occurring is solow that the cost of finding a match (for example in terms of advertising, transport, andso on) becomes very large and outweighs the increased utility derived from trade. Evenif the goods offered for trade are readily available, it may still be the case that no tradeoccurs. This is the subject of the Wicksell problem in which it is impossible to securegains from trade through bilateral exchange.

The Wicksell problem

Consider the situation in Table 2.1 and shown in Figure 2.1. There are three individualswho each only produce one good but derive more utility from the consumption ofanother. Avinash produces bread but wants wine, Nicole produces wine but wantsapples and Edwin has apples but wants bread. In this situation, no bilateral exchangewill result. Edwin will not trade with Nicole since he derives more utility fromconsuming his own apples than he does from Nicole’s wine. The utility maximisingsituation is shown in Figure 2.1 but under the assumption of no commitment, this willnever arise. Avinash will not want to give his bread to Edwin, hoping to receive winefrom Nicole since after receiving bread, Edwin has no incentive to give apples to Nicolewho in turn will have no incentive to hand over her wine to Avinash. The system willcollapse to autarky (in which all individuals become self-sufficient).

However, models of this type can lead to the emergence of indirect barter. In indirectbarter a trader accepts a good not because she or he wants to consume it but because ofthe possibility that it may result in a future trade. In the above example, Avinash maytrade his bread for apples, not because he wants to consume the apples but in theknowledge that when meeting Nicole, she will be willing to trade her wine for thosegoods. This may seem an obvious solution at first glance but if we assume traders meetat random (or do not know how long it will be before they meet a prospective trader)then considerable risk may be taken on in this transaction. The goods Avinash acceptsin exchange for his bread may deteriorate before he meets Nicole, in which case Nicolewill not want to trade.

Let us assume that the apples do not perish. The situation of indirect barter is shown in

21


Table 2.1:

Figure 2.1:

Figure 2.2.

If apples are used in both stages of the trading process then each trader will gain. Inindirect barter, commodities are acquired not for consumption but for the purposes ofmaking future exchanges. They should therefore have appropriate physical attributes; inparticular they should be durable, portable and homogeneous (or at least easily valued).In primitive societies money emerged from the process of indirect barter, and took theform initially of staple foodstuffs like corn or rice. With the development oftechnologies, which allowed the separation of metals, money increasingly took the formof precious metals, especially gold.

Money and trust

The solution of indirect barter in the Wicksell problem arises almost entirely from thelack of trust between traders. As shown in Figure 2.1, each trader could maximiseutility by giving his or her goods to the next person in the triangle. However, Avinashcould not trust Edwin to hand over his apples to Nicole once he gave him his bread andneither could he trust Nicole to hand over her wine once (or if) she received Edwin’s

22

2.9. Why do we have money?

Figure 2.2:

apples.

Let us consider another situation. Suppose I visit my dentist and I pay for his servicesusing a bank debit card.5 The bank will debit my account and credit that of the dentist.I have effectively given an IOU6 to the bank and the bank has given the dentist one ofits IOUs. But why did I not just hand over one of my IOUs directly to the dentist?Perhaps it may be that my dentist does not trust me to repay once he tries to redeemmy IOU. More realistically, he cannot use my IOU to make purchases with anyone elseand the likelihood that he will ever want to redeem the IOU from me, by receiving aneconomics lesson, may be so small that he would never have agreed to spend his timefixing my teeth. If the dentist went to the grocers the following day trying to buyprovisions with an IOU from an economics teacher, of whom the grocer had neverheard, it is highly unlikely that the trade would be completed. On the other hand, if hetried to pay using the bank’s IOU, the grocer should happily agree to the sale, purelybecause everyone knows and trusts the bank.

The difference between my IOU and that of the bank is that the bank’s IOU is liquid

5This example is taken directly from ‘Evil is the Root of all Money’ by Kiyotaki and Moore (2001).The model presented in this paper is not necessary for this subject but the ideas discussed therein willgreatly improve the reader’s intuition as to what is money and why we hold it.

6‘IOU’ is short for ‘I owe you’ and is merely a written statement acknowledging that a debt has beencreated, to be repaid sometime in the future.

23


and functionally equivalent to cash. My IOU, on the other hand, is not liquid andcannot flow around the economy facilitating trades. As we will discuss later in thischapter, it is ‘credit’ money but serves the same purpose as the commodity moneyderived in the indirect barter problem, without having to use or lock up any goods inthe payment process.

Activity 2.1 Consider the problem in Figure 2.1. How could you introduce a bankand a system of IOUs to resolve the problem without having to use any commodityto act as a medium of exchange?

The idea of trust and uncertainty are important ones when explaining the existence ofmoney.7 If you do not know, or have any way of obtaining information as to thecreditworthiness of, a prospective customer, there is a high risk that he or she maydefault on that debt. The risk is, however, minimised if the payer hands over an item ofworth, such as commodity money or another store of value, or an IOU redeemable froma third party on which the payee has sufficient information, such as a bank. In this wayit may be essential to hold money beforehand in order to make purchases. This is thewhole idea behind ‘cash in advance’ (CIA) models that we will consider in a moremacroeconomic setting in later chapters. People have to hold money in order toalleviate the problem of trust (or lack of trust) when transactions are made.

2.10 Types of money

Up to now we have considered only two types of money: commodity money in thesolution to the Wicksell problem, and credit money as the solution to the lack of trust inthe issuance of private IOUs. Traditionally, however, money is divided into three types:

commodity money

fiat money

credit money.

Commodity money

Commodity money derives from the use of commodities as exchange intermediaries inindirect barter. Commodity money has taken many forms, such as cattle, corn, seashellsand suchlike, but in most societies, it has evolved towards the precious metals, copper,silver and, above all, gold. Such commodities are accepted in exchange because of theirintrinsic value, even though the trader intends to use them in further exchange ratherthan for their own consumption. Commodity money is inefficient, in part because thecommodities being used may not have ideal properties as exchange intermediaries butmore fundamentally because it is unnecessary to use goods which have intrinsic valuefor a purpose which does not make use of that value. For example, using gold as acommodity money does not make use of the fact that gold does have some alternativeutility-yielding use and could be used in more satisfying ways, such as through jewelleryor ornaments.

7On this issue, see Goodhart (1989a), Chapter 2, Section 2.

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2.10. Types of money

Fiat money

Fiat money, whose archetype is the government-issued bank note or metal coin, ismoney that has physical substance but no intrinsic value. It is used because its use isestablished by custom and practice. People accept fiat money that they know to beintrinsically worthless because they know others will accept it in payment for goods andservices. The value of fiat money is reinforced in society by the attribute of being ‘legaltender’, that is making it illegal for anyone to refuse payment in fiat money insettlement of a debt. In fact it is this legal ‘stamp’ and recognised power of the issuer,usually governments, which gives fiat money its unquestionable acceptance as a meansof payment.

Since fiat money is essentially worthless, there is a difference between the value of thegoods such money can purchase and the smaller cost of printing this money. Thedifference is known as seigniorage and is effectively the profit made by the issuingauthority when it produces currency.

Credit money

Whereas fiat money is not a claim on any commodity or individual, credit money is; itis the debt of a private person or institution. In the dentist example above, I gave anIOU to the bank, which in turn hands this debt over to the dentist. If he can pass thisclaim on to another individual, the grocer, in exchange for goods, then this debt isbeing used as a means of payment and so constitutes money. However, the asset thatthe grocer now has, the claim on the bank, is matched one-for-one with the bank’sclaim on me. What the bank owes to the grocer (the bank’s liability) must be matchedby what I owe the bank (the bank’s asset) in order for the bank’s balance sheet tobalance. The limitation of credit money is that it can only function if both individuals,the dentist and me in the example, have complete confidence in the willingness andability of the intermediary to honour the debt. If the bank fails then both my dentistand I would lose out since the dentist would still have a claim on me and I may nothave the funds to honour that claim if the bank has been forced to close. Since thereexists a private liability perfectly offsetting the asset acting as a means of payment (i.e.the money is generated inside the private system) credit money is also known as ‘insidemoney’. Fiat money, which cannot be matched against private sector claims (and isgenerated outside the private sector) is in a similar fashion, known as ‘outside money’.In the UK today, inside money is quantitatively much larger than outside money. At thetime of writing, the nominal value of inside money is approximately 30 times the valueof outside money, notes and coins.

There may appear to be a contradiction at this point when we compare the definition ofcredit money to the discussion in the section ‘money as a means of payment’ where weargued that all forms of credit should not be included in our definition of money. In theabove example, although I have replaced a debt to my dentist with a debt to my bank,this is commonly accepted as a means of payment since a transfer of credit to a currentaccount has advantages such as safe-keeping and making use of book-keeping services atthe bank. Only when all parties concerned are entirely confident the bank will not fail,will such transfers be a means of payment. Once the bank hears of my purchase at thedentist (via the swiping of the debit card), the bank debits my account and credits that

25


of the payee, the dentist. Nothing further needs to be done since the payment iscomplete. If a purchase is made by credit card, however, a debt is still outstanding andhas to be repaid. Similarly, if I paid by my bank debit card but went overdrawn, a debtwould remain outstanding which I would later have to pay off. For this reason, overdraftfacilities are not a means of payment.

2.11 Properties of money

When discussing the appropriate properties of commodity money, we mentioneddurability, portability and that it should be homogeneous. Other necessary propertiesare divisibility and recognisability. In fact all money should possess these properties:electronic transfers when purchases are made by bank debit card are themselvesdurable, if not in a physical sense, in that $1 credited to your account does notdeteriorate over time. Another property that is just as important is that ofacceptability, the probability that it will be accepted as a means of payment. Kiyotakiand Wright (1992) emphasise this property and argue that acceptability is not aproperty of the money per se. An equilibrium can be reached where one individual usesone money purely because they believe everyone else will use it:

‘When an object is more readily acceptable to other people in the economy, itis more likely that each individual will desire it and accept it as a medium ofexchange. The implication is that the property of acceptability can have aself-reinforcing nature. . . (This) lead(s) to the conclusion that acceptabilitymay not actually be a property of an object as much as it is a property ofsocial convention.’

Kiyotaki and Wright, 1992, p.19.

2.12 A reminder of your learning outcomes


discuss the nature and shortcomings of a barter economy

list and describe the general functions performed by money

describe the Wicksell problem and demonstrate how indirect barter can lead to theemergence of a commodity money

describe the differences between transactions using credit cards and bank debitcards

list and describe what the different types of money are.

26

2.13. Sample examination questions

2.13 Sample examination questions

Section A

Specify whether the following statement is true, false or uncertain. Explain your answerin a short paragraph.

1. ‘The evolution of commodity money from indirect barter, as the solution to theWicksell problem, arises because of a lack of trust between the relevant parties.’

Section B

2. In a monetary economy, money usually performs the three roles of medium ofexchange, unit of account and store of value. Why are these three roles typicallycombined in one entity? Is it possible to conceive of an economy in which they areperformed by three separate entities?

3. What is money and why do we use it? Outline the three different types of moneyand explain what is different between them.

4. ‘Money should essentially be perceived as an instrument that allows an increasinglywidespread and anonymous economic society to deal with the inevitable resultingshortcomings in information and trust of each of the members on the others.’(Goodhart) Explain and discuss.

5. Explain why some economists argue that payment by cheque is the same as givingtrade credit. If this is the case and considering that cheques are drawn on bankcurrent accounts (as are payments by bank debit cards), do cheque payments countas money?

2.14 Feedback to Sample examination questions

Section A


1. The statement is true. Suggested answers may include Figure 2.1 and anexplanation as to why each person cannot trust the others to pass their goodsalong the chain. In the example of Figure 2.1, Avinash could not trust Edwin tohand over his apples to Nicole once he gave him his bread and neither could hetrust Nicole to hand over her wine once (if) she received Edwin’s apples. By using acommodity money, such as wine, the problem can be solved. Edwin trades hisapples for Nicole’s wine, not because he wants to consume the wine, but because hecan trade it with Avinash for his bread. Wine is thus being used as a commoditymoney.

27


Section B

3. Money is anything which is in general use, and generally accepted, as a means ofpayment. Although money has a number of functions, including unit of accountand store of value, it is its use as a means of payment that defines it. The mainreason why money is used is to avoid the problems associated with barter, namelythe double coincidence of wants. You could discuss the origins of a commoditymoney here, from the Wicksell problem, and also explain how money solves thelack of trust problem in a world of largely anonymous individuals. The three typesof money are: commodity money, fiat money and credit money. All these aredescribed near the end of this chapter.

28

Chapter 3

The demand for money

3.1 Introduction

In Chapter 2 we saw why there was a need for money:

to solve the double coincidence of wants problem associated with barter

to obviate the lack of trust between the payer and the payee in a transaction.

However, what determines the quantity of money that individuals and economiesdemand is a separate question. It is the aim of this chapter to explain what determinesthe quantity of money we demand and also to present a number of models (or theories)of the demand for money. The chapter is split into two main sections. The first partconsiders the demand for money from individuals or institutions/firms themicroeconomic determinants of money demand. The second part examines the demandfor money at the macroeconomic level gives a brief history of money demand, focusingon the breakdown of the macroeconomic demand for money function.

3.2 Aims

The aim of the chapter is to study the money demand as one of the building blocks ofthe money market equilibrium.



explain why it is important to study the demand for money

describe the four main microeconomic determinants of money demand

outline the inventory theoretic model of Baumol–Tobin and the portfolio selectionmodel of Tobin

discuss why Tobin’s model solves the ‘plunger’ problem of the demand for moneymodel of Keynes

describe the general set-up of macroeconomic money demand equations

29

3. The demand for money

discuss empirical evidence on money demand functions, especially on income andinterest elasticities

describe what happened and what is meant by ‘the case of the missing money’ andgive reasons for the breakdown of the estimated money demand equations.

3.4 Reading advice

Before embarking on this chapter, and before consulting any of the recommendedreading, you should review your understanding of ‘the demand for money’ from yourstudies in EC2065 Macroeconomics. A very useful text on the demand for money isLaidler (1993), which is both readable and comprehensive, and should be consulted oneverything covered in this chapter. Goodhart (1989) is also essential reading and shouldbe read while you work through the chapter.


Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989)Chapters 3 and 4.

Laidler, D.E.W. The demand for money: Theories, evidence and problems. (New York:Harper Collins, 1993) Section II.

Lewis, M.K. and P.D. Mizen Monetary Economics. (Oxford; New York: OxfordUniversity Press, 2000) Chapters 5, 6, 11 and 12.

3.6 Further reading

Books

Friedman, M. ‘The quantity theory of money: a restatement’, in Friedman, M. (ed.)Studies in the quantity theory of money. (University of Chicago Press, 1956).

Goldfeld, S.M. ‘Demand for money: empirical studies’, in Newman, P., M. Milgate andJ. Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London:Macmillan, 1994).

Goldfeld, S.M. and D.E. Sichel ‘The demand for money’, in Friedman, B. and F. Hahn(eds) Handbook of monetary economics. (Amsterdam: North-Holland, 1990).

Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapters 9 and10.

Journal articles

Baumol, W. ‘The transactions demand for cash: an inventory theoretic approach’,Journal of Econometrics (1952) 66, November, pp.545–56.

30

3.7. Microeconomic determinants of the demand for money

Judd, J. and J. Scadding ‘The search for a stable money demand function: a survey ofthe post-1973 literature’, Journal of Economic Literature 20(2) 1982, pp.993–1023.

Miller, M. and D. Orr ‘A model of the demand for money by firms’, Quarterly Journalof Economics 80(3) 1966, pp.413–35.

Sprenkle, C. ‘The uselessness of transactions demand models’, Journal of Finance 24(5)1969, pp.835–47.

Tobin, J. ‘The interest elasticity of transactions demand for cash’, The Review ofEconomics and Statistics 38(3) 1956, pp.241–47.

Tobin, J. ‘Liquidity preference as behaviour towards risk’, Review of Economic Studies25(1) 1958, pp.65–86.

3.7 Microeconomic determinants of the demand formoney

There are essentially four main determinants of money demand at the individual level.These are

1. interest differentials: the difference between the yield on money, commonlyassumed in the literature to be zero,1 and the rate of return on other assets. Thegreater the rate of return on assets other than money, the greater the opportunitycost of holding money, and so the fewer money balances will be demanded.

2. cost of transfers: the costs associated with transferring between higher interestearning assets and money, needed to purchase goods and services. If the cost oftransfers, known as brokerage fees, are high then it is unlikely that we will put ourwealth into the higher interest earning assets as to do so will involve substantialcosts. Demand for money will then be a positive function of these transfer costs.

3. price uncertainty of assets: there is inevitably risk involved in holding assets.Even though there exists a risk in holding money as a store of value, since we donot know for certain how many goods a given quantity of money can buy in thefuture due to inflation, the risk associated with holding other, interest earning,assets is generally considered to be greater. If the price of assets is likely to varyover time then, by the time we want to sell those assets in order to obtain moneyto undertake transactions, we may face considerable capital loss. If we arerisk-averse then our demand for money will therefore be a positive function of theriskiness or price uncertainty of alternative assets.

4. the expected pattern of expenditures and receipts: if individuals were paidtheir wages in lump sums weekly then average cash balances would be less than ifwages were paid monthly. If the pattern of payments and receipts was uncertainthen cash balances would be likely to be higher; it may be unwise to face thebrokerage fees and transfer cash to bonds if there is a possibility that you will needto make a large cash payment in the near future.

1In practice the interest paid on sight deposit accounts is positive.

31


These determinants are also related to Keynes’ description of money demand motives.Keynes (1936) broke down the demand for money into three types: transactions,precautionary and speculative motives:

The transaction demand for money is essentially that needed to buy goods andservices where money is needed as a medium of exchange.

Precautionary money balances are simply holdings of money kept in case ofemergencies (an unexpectedly large tax bill or hospital treatment for example).

Finally, the speculative demand for money considers money as an alternative tointerest earning assets. Due to the capital loss involved with holding bonds whenthe interest rate increases2 if an individual expects the interest rate to rise, then hewill expect to experience a capital loss on his bond holdings. Knowing that thebond price will fall, he will want to hold a larger quantity of money.

In fact, Keynes originally assumed that individuals held their expectations of interestrate movements with certainty. When the interest rate was below what they expected inthe long run, R∗ in Figure 3.1, then they would put all of their financial wealth in theform of money to avoid the capital loss associated with holding bonds. When theinterest rate was above what was expected, then the expected interest rate fall would beassociated with a capital gain from holding bonds. The individual would then hold aslittle money as possible, only covering the transactions and precautionary motives (Trepresenting minimum cash required to conduct transactions). The individual’s demandfor money, as a function of the interest rate, would then be a step function, shown inFigure 3.1 below.

Figure 3.1:

2This is due to the negative relationship between the price of a bond and the yield the bond earns.This is considered in more detail in Chapter 9.

32

3.8. Baumol–Tobin transactions demand for money

It has become standard to model each component of the demand for money separately.3

The transaction demand for money is typically modelled by allowing money to be afunction of determinants 1, 2 and 4 above (i.e. ignoring asset price uncertainty). Byallowing more flexible assumptions on the expected pattern of expenditures andreceipts, similar analysis can incorporate a precautionary motive for money holdings.4

Analysis of the speculative demand for money, however, concentrates on determinant 3,asset price uncertainty, while dropping one or more of the other factors for tractability.

3.8 Baumol–Tobin transactions demand for money

The two papers by Baumol (1952) and Tobin (1956) explicitly model the transactionsdemand for money in an inventory theoretic approach. Each assumes that a cashmanager (individual or firm) has to manage an inventory of cash and otherinterest-earning assets. In the original Baumol model, the cash manager is paid in bondsand spends money (or makes transactions) at a constant, known rate. The objective isto choose the number of times she transfers between the stock of bonds and cash thatmaximises profits, or equivalently minimises costs. These costs come in two forms:brokerage fees and the interest foregone by holding money. By making a large number oftransfers out of bonds and into cash, she will be able to earn more interest on the bondsthat are kept for longer. However, such a strategy will involve large brokerage fees. Onthe other hand, by making only a few transfers, she will avoid paying frequent brokeragefees but will miss out on the interest the wealth could earn if kept in the form of bonds.

Let T equal the value of the cash manager’s expenditures, equal in this case to herincome: i is the interest rate earned on bonds, b is the fixed cost of making a transferbetween bonds and cash and Z is the value of money transferred each time, equal to theamount of bonds sold each time. If the money is spent at a constant, known rate thenthe average money balances will be equal to M = Z/2. The cost minimisation problemcan be written as:

minZC =

bT

Z+iZ

2. (3.1)

Costs, C, are made up of brokerage costs, equal to the cost per transfer, b, multiplied bythe number of transfers, T/Z, plus the interest foregone by (opportunity cost from)holding money. The interest rate foregone will equal the interest rate, i, multiplied bythe average money holdings, Z/2. Differentiating the cost with respect to the choicevariable, Z, the amount we transfer each time, gives:

dC

dZ= −bT

Z2+i

2. (3.2)

Setting this equal to zero and solving for M = Z/2, gives:

M =Z

2=

√bT

2i. (3.3)

The average money demand, M , is then a positive function of both the brokerage cost,b, determinant number 2, and income/receipts, T , determinant number 4. It is also a

3See Goodhart (1989) Chapter 3, Sections 1 and 2 for a more complete discussion of the modellingtechniques.

4See Miller and Orr (1966).

33


negative function of the interest rate earned on alternative assets, i, determinantnumber 1. One can also show that the interest and income elasticities of money demandare −1/2 and 1/2, respectively. This is left as an exercise. So average money demandwill increase by 1/2% if income increases by 1% and decreases by the same amount ifthe interest rate earned on alternative assets increases by 1%. The model generates a‘saw tooth’ pattern of money holdings as shown in Figure 3.2 below. For simplicity,assume that interest payments are made at the end and do not accrue during the period.

The diagram shows a situation where the optimal number of times to transfer betweenbonds and money is 4. At time t0, the cash manager receives T in bonds and transfersZ to cash immediately in order to buy goods and services. The amount of bonds left istherefore B1 (the difference between T and B1 being Z). Money balances and hencefinancial wealth decline gradually as the cash is spent. At time t1, another transfer ismade that reduces bond holding by a further Z to B2. The process continues until allwealth is spent and a new income is received. Money holdings are therefore shown bythe saw-tooth pattern, financial wealth is shown by the straight line from T and thelevel of bond holdings is shown by the dashed step function.

Figure 3.2:

Activity 3.1 A taxi driver takes £15,000 net over the course of a year, at anapproximately constant daily rate. He spends 80% of his takings on consumptiongoods, also at an approximately constant daily rate, but saves the remainder to payfor a world cruise at the end of the year. He can hold his savings in a depositaccount in a bank paying 4% per annum, with costless deposits and withdrawals, orhe can purchase bonds paying a known yield of 7%. The brokerage fee in purchasingor selling bonds is £5 per transaction. Assume the taxi driver manages his finances

34

3.9. Tobin’s model of portfolio selection

optimally by making n transactions, n− 1 of these being purchases of bonds spacedequally through the year, and the n-th transaction being the sale of bonds at theend of the year to pay for the world cruise.

(a) Draw the time profile of the taxi driver’s holdings of deposits and bonds.

(b) What is the optimal value of n? (Note that n must be a whole number.)

(c) What is the taxi driver’s ‘demand for money’, or average deposit balance?

(For Feedback, see the end of this chapter.)

Criticisms of the inventory theoretic model

Despite the intellectual appeal and simplicity of the inventory theoretic model, it faces anumber of criticisms. One argument made against such models is that they make theassumption that the pattern of expenditure and receipts is known perfectly. This isclearly not true in reality. Adding uncertainty to these processes is exactly what Millerand Orr (1966) do but, even then, these inventory theoretic models face a huge uphillstruggle when faced with empirical evidence. At the micro level, the percentage ofactual cash balances held by firms that is explained by the Baumol model is tiny.

3.9 Tobin’s model of portfolio selection

One problem with Keynes’ original ideas of the micro level demand for money was thatindividuals held expectations of interest rate movements with certainty. This resulted ina step demand function given in Figure 3.1 where individuals either held no money andall long term bonds (or as little money as possible to cover transactions) or held allmoney and no bonds. Individuals were ‘plungers’ – all or nothing. This did not explainthe empirical regularity that people held their financial wealth in both forms of assetsand could only provide a downward sloping aggregate money demand function byassuming that every individual had a different expectation of the equilibrium interestrate, also assuming that each of these expectations were held with certainty. Thisclearly is too strong an assumption.

To overcome this problem, Tobin (1958) considered the problem of how much money tohold as one where individuals maximise utility by choosing between assets in aportfolio. Money is assumed to have a zero rate of return and is considered riskless. Thevariance of the return on money is then also zero. Bonds, however, pay a positive rate ofreturn, µ, but are risky due to the possibility of capital gains or losses if the bond issold before maturity. Let the variance of the return on bonds be σ2.

Let B be the proportion of your financial wealth held in bonds. 1−B is therefore theproportion held in the form of money if we assume a two-asset world. The distributionof money and bonds are given below:

Money ∼ (0, 0) (3.4)

Bonds ∼ (µ, σ2). (3.5)

35


A portfolio containing a share B of bonds and 1−B of money therefore has adistribution:

Portfolio ∼ (0 · (1−B) + µ ·B, 0 · (1−B)2 + σ2B2) = (µB, σ2B2). (3.6)

Let the mean return of this portfolio be µp and the variance be σ2p.

µp = µB (3.7)

σ2p = σ2B2. (3.8)

Writing B in terms of σ and σp from (3.8) and substituting into (3.7) gives a budgetconstraint relating the maximum return on a portfolio to the standard deviation, whichwe assume is a proxy for risk.

µp =µσpσ. (3.9)

Assuming that agents are risk-averse, the indifference curves will be convex and upwardsloping, as shown in Figure 3.3.

The top part of the figure shows the budget constraint and indifference curves of theagent. Note that there is an upper bound on the return and risk of the portfolio, µ′p andσ′p, respectively, where the individual has put all of their financial wealth in bonds;B = 1. At this point it is impossible to increase the return or risk of the portfolio bysubstituting between money and bonds. The bottom part of the figure simply shows theshare of the portfolio held in bonds and the corresponding risk of the portfolio.

As can be seen in the figure, the individual maximises utility by being at the pointwhere the indifference curve is tangential to the portfolio budget constraint, point E.The share of wealth held in bonds is B∗ and the share held in money is 1−B∗. Byusing portfolio analysis, Tobin showed how individuals can diversify their wealth intomore than just one asset. By changing the return earned on bonds, µ, this will shift thelines in the figure, resulting in a new equilibrium and different bond/money allocation(see ‘Feedback to the Activity’ at the end of this chapter).

3.10 Macroeconomic determinants of money demand

As seen in the previous section and the models referenced there, money demand at themicro level is modelled as a function of a number of variables: interest differentials, costof transfers, asset price uncertainty and the pattern of expenditures and receipts. At themacro level, however, the demand for money is modelled under, arguably, a simplerframework. That is not to say that the analysis is simpler or there are fewercomplications to overcome. Indeed, the econometric techniques used to model theaggregate demand for money are complex and have needed to be after the breakdown ofthe demand for money functions starting in the 1970s.

The demand for money is one of the most thoroughly researched topics in the field ofeconomics but why has it attracted so much attention? We study the demand forsomething in order to be able to predict the consequences of changes in its supply, andthis is as true of money as of anything else. Changes in the supply of any good, serviceor asset will alter at least one of the variables upon which the demand for that good,

36

3.10. Macroeconomic determinants of money demand

Figure 3.3:

service or asset depends. For example, assume that the demand for apples dependsprimarily on the following:

1. their price

2. the price of pears

3. the incomes of consumers, and

4. the tastes and preferences of consumers.

Then a change in the supply of apples will be expected to alter one of these factorsinfluencing demand. In this case most probably the price of apples. In a similar fashion,changes in the supply of money can be expected to bring about a change in the value ofone or more of the determinants of the demand for money. The possibility that thesedeterminants may include interest rates, real income and the general level of prices –themselves important macroeconomic variables – gives the study of the demand formoney a particular importance.

A particular aggregate money demand function takes the form:

Md = f(Y,Ri,W ). (3.10)

Md is the demand for nominal money balances, Y is nominal income and Ri is the rateof return on asset i. Since the rate of return on a number of assets will determine thedemand for money, including that on money itself, i can represent a number of assets.The Ris represent the opportunity cost of holding money and Y acts as a proxy for thelevel of transactions undertaken. Wealth (W ) is included as it forms the budgetconstraint on which the choice of money holdings depends but since wealth iscapitalised current and future income, it is not independent of Y . For this reason, and

37


also because data on wealth levels of nations are very difficult to obtain, W is oftendropped from the analysis. If money demand is homogenous of degree one in prices (i.e.a doubling of the price level leads to a doubling of the demand for nominal moneybalances), (3.10) can be re-written as:(

M

P

)d= g(y,Ri) (3.11)

where y is real income. A common log linear form of this equation is:

mt − pt = ayt − bRt (3.12)

where mt, pt and yt are log values of the nominal money supply, price level and incomeat time t respectively and Rt is ‘the’ nominal interest rate at time t. Two importantparameters of the money demand function are the elasticities with respect to incomeand the interest rate. For a summary of the empirical evidence on these estimates, seeLewis and Mizen, especially Chapter 11. This chapter also explains in detail themethods used to estimate such money demand functions.5 The interest elasticity ofmoney demand is important in the debate over whether monetary or fiscal policy ismore powerful. A low value of b implies a relatively steep LM curve and, other thingsbeing equal, monetary policy has a larger effect on output than fiscal policy. Keynesianson the other hand argue the opposite: a high value of b and therefore a relativelyshallow LM curve, implying a greater role for fiscal policy.

Of equal importance is whether or not the money demand equation is stable. If themonetary authorities decide to target the money supply then an unstable moneydemand function can lead to unexpected and adverse changes in nominal and possiblyreal factors in the economy. The stability of money demand can only be determined bystatistical analysis of the relevant data – hence the enormous number of empiricalstudies relating to the demand for money.

3.11 The stability of the money demand function

Relatively simple functional forms of money demand were estimated until the early1970s and these appeared to work reasonably well at explaining the demand for money.One such specification was used by Goldfeld (1973) and is similar to (3.12).

ln

(M

P

)t

= b0 + b1yt + b2Rt + b3 ln

(M

P

)t−1

+ ut (3.13)

where ut is a random error term and a lagged dependent variable, ln(M/P )t−1, is alsoincluded. Goldfeld himself suggested:

‘Perhaps most interesting is the apparent sturdiness of a quite conventionalformulation of the money demand function, however scrutinised. . . (T)heconventional equation exhibits no marked instabilities, in either the short runor the long run.’6

5For a more technical review, see also Goldfeld and Sichel listed in the ‘Further reading’ section.6Goldfeld, 1973, quoted by Goodhart, 1989.

38

3.12. Reasons for the breakdown of the money demand functions

However, from 1974 Goldfeld’s equation overpredicted real money balances, M1, in theUS. This was known as ‘the case of the missing money’ (Goldfeld, 1976). Basically, forany given level of real income and interest rates, the above equation suggested that thereshould be more money in circulation than there actually was.7 Such demand for moneyfunctions were breaking down, not only in the US but also elsewhere, such as the UK –see Hacche (1974) who examined a broader measure of money, M3. Whereas Goldfeld’sequation overpredicted the amount of money in the US, money demand equations forthe broader M3 aggregate in the UK were underpredicting the amount of money.

3.12 Reasons for the breakdown of the moneydemand functions

A common reason quoted for why the money demand equations broke down in the 1970swas greater financial innovation. The oil shocks of the mid-1970s and the resulting highinflation caused interest rates to increase substantially. This meant that the opportunitycost of holding money increased and was eventually so large that it became worthwhilefor cash managers to find more efficient ways of holding cash balances, allowing morewealth to be put into interest-earning assets. Hence for any level of income and interestrate, the demand for money would be reduced, explaining the ‘missing money.’

Another possible explanation for the negative results of the 1970s is the fact that asingle equation money demand function may be misspecified. An equation relating realmoney balances, income and interest rates may not represent a true money demandequation, but a reduced form equation; a mixture of both money demand and supplyequations, especially if the money supply set by the authorities is dependent onconditions in the economy such as inflation and output. A changing policy stance by theauthorities, as was the case from 1979 to 1982 in the US,8 will cause the reduced formrelationship to alter, explaining the breakdown of the estimated ‘demand’ function.Overly simplified econometrics was also used up until the last couple of decades. Issuesincluding stationarity, spurious regressions and co-integration need to be addressedbefore any meaningful interpretation can be taken from empirical results. See Lewis andMizen (2000), Chapter 11.



explain why it is important to study the demand for money

describe the four main microeconomic determinants of money demand

outline the inventory theoretic model of Baumol–Tobin and the portfolio selectionmodel of Tobin

7For a review of the stability of the demand for money function, see Judd and Scadding (1982).8See Goodhart (1989), Chapter 10.

39


discuss why Tobin’s model solves the ‘plunger’ problem of the demand for moneymodel of Keynes

describe the general set-up of macroeconomic money demand equations

discuss empirical evidence on money demand functions, especially on the incomeand interest elasticities

describe what happened and what is meant by ‘the case of the missing money’ andgive reasons for the breakdown of the estimated money demand equations.


Section A


1. ‘Tobin’s portfolio model implies that the demand for money will always fall whenthe interest rate rises.’

Section B

2. According to some economists, Tobin’s portfolio selection model suffers from thefollowing deficiencies: (a) it explains the allocation of wealth between assets, but itdoes not explain the demand for money; (b) it implies that investors viewinvestment in long-term assets as more risky than investment in short-term assets:this, however, is false. Discuss these shortcomings.

3. Somebody suggested that instead of introducing the Euro, the European CentralBank should have introduced a debit card that could be used for any kind oftransaction; a ‘Eurocard’. If this suggestion had been followed by the ECB, whatwould be the transaction demand for cash in the euro-area economy?

4. At the micro-level, the transactions elasticity of money demand has been found tobe close to unity and the interest elasticity has been found to be close to zero. Howdo these estimates compare to those of the Baumol–Tobin model? Explain whythey differ.

5. By definition, wealth forms the budget constraint that people face when decidinghow much money to hold. Why then is wealth not present in many macroeconomicmoney demand functions?

6. Many economists have produced empirical, econometric studies purporting to haveestablished a stable money demand function, which subsequently broke down.What went wrong?

40

3.15. Feedback to Activity 3.1

3.15 Feedback to Activity 3.1

If 80% of the taxi driver’s income is spent, that implies non-spent income increasesgradually from zero at the start of the year to £3,000 at the end of the year. As in theexample, the problem amounts to minimising the costs of holding inventory associatedwith making transfers, buying and selling bonds, and the opportunity cost of notholding the higher interest-earning asset. This time, however, the problem involveschoosing the number of times to make transfers. The time profile of deposits and bondsfor an arbitrary number of transfers, n, is shown in Figure 3.2.

With n transfers in the year, the amount transferred each time from money/deposits tobonds is 3000/n and so the average deposit balance, M , is 3000/2n. Average bondholdings, B, is then the difference between average non-spent income, £1,500, and M :

B = 1500− 3000

2n.

The problem then is to maximise profits, i.e.:

maxn

0.07

(1500− 3000

2n

)+ 0.04

(3000

2n

)− 5n.

The first term is the interest earned on bonds (7% = 0.07) multiplied by average bondholdings. The second term is the interest earned on deposits, 4%, multiplied by theaverage deposit balance, and the last term is the cost per transfer, £5, times thenumber of transfers. Simplifying the expression leads to:

maxn

105− 45

n− 5n.

Differentiating with respect to n and setting equal to zero gives an optimal number oftransfers, n, equal to 3, and the average deposit balance, M , is given by:

M =3000

2n= 500.


Section A

1. The statement is false. Suggested answers may include Figure 3.3 and will explainwhat happens after an increase in the interest rate, namely an anticlockwisemovement of the budget constraint. The new point of tangency can lie either to theleft or right of point E, in which case the share of wealth held in money can behigher or lower than before. This is due to the offsetting income and substitutioneffects (to be shown in the diagram).

Section B

2. The suggested answer should show the cost minimisation problem in theBaumol–Tobin model and also show that the average money demand, M , is given

41


as in (3.3). The elasticities of money demand, with respect to T and i, denoted MT

and Mi, respectively, are given by

MT =∂M

∂T· TM

and Mi =∂M

∂i· iM

MT =1

2· T 1/2

√b

2i· TM

=1

2

and Mi can be shown to equal −1/2. The Baumol–Tobin model therefore suggeststransactions and interest elasticities of money demand to be 1/2 and −1/2respectively. These are different to the empirical estimates of 1 and 0. The mainreason for the difference is that many people cannot afford to enter the bondmarkets due to the large brokerage fees. When income increases, agents increasetheir money holdings one-for-one. If the interest rate increases, agents do notconvert any wealth to bonds since the high brokerage fees outweigh the benefit ofhigher interest received on bonds.

42

Chapter 4

The supply of money

4.1 Introduction

In Chapter 2 we discussed what constitutes money and in Chapter 3 we analysed thefactors that determine how much money individuals, and economies as a whole, demand.In this chapter we will discuss how money, credit money in particular, is created andwhat determines the supply of money. As we shall see in later chapters, the supply ofmoney is hugely important since a change in the money supply can lead to changes inthe price level and inflation but also to changes in real variables such as output andunemployment. By affecting the money supply, the monetary authorities can ‘control’or at least help limit the fluctuations of these variables. Later in this chapter we will seehow the authorities can implement monetary policy to help control the money supply.

4.2 Aims

The aim of the chapter is to study the money supply as one of the building blocks ofthe money market equilibrium, the role of financial intermediaries in the credit supplyprocess and how monetary policy makers can control money supply.



describe and discuss the different roles of financial intermediaries

describe why maturity transformation is so important in financial markets

define on which side of a bank’s balance sheet deposits and loans appear andexplain why the balance sheet must indeed balance

explain how the monetary authorities can influence the total money supply bychanging the monetary base or by introducing mandatory reserve ratios or otherregulation.

43

4. The supply of money

4.4 Reading advice

Any monetary economics textbook will have a section on the supply of money but thebook followed most closely in this chapter is Goodhart (1989). Chapter 5 covers the roleof and need for financial intermediaries and Chapter 6 covers the ideas of the moneymultiplier and high-powered money. Unfortunately there is no good reference for themodel of the banking sector at the end of the chapter so you are advised to workcarefully through this section and through the Activities.1


Artis, M.J. and M.K. Lewis Money in Britain: Monetary policy, innovation and Europe.(New York; London: Philip Allan, 1991).

Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989)Chapters 5, 6 and 10.

4.6 Further reading

Books

Brunner, K. ‘High-powered money and the monetary base’, in Newman, P., M. Milgateand J. Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London:Macmillan, 1994).

Goodhart, C.A.E. ‘The monetary base’, in Newman, P., M. Milgate and J. Eatwell (eds)The New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).

Laidler, D.E.W. Taking money seriously and other essays. (New York; London: PhilipAllan, 1990) Chapters 4 and 5.

McCallum, B. Monetary Economics. (New York; Macmillan; London: CollierMacmillan, 1989).

Papademos, L. and F. Modigliani ‘The supply of money and the control of nominalincome’, in Friedman, B. and F. Hahn (eds) Handbook of monetary economics.(Amsterdam: North-Holland, 1990).

Journal articles

Goodhart, C.A.E. ‘What should Central Banks do? What should be theirmacroeconomic objectives and operations?’, Economic Journal 104(427) 1994,pp.1424–36.

1The survey article of Papademos and Modigliani is good but difficult. You should, however, be ableto read and understand the basics of Section 3 of this article.

44

4.7. Financial intermediaries

4.7 Financial intermediaries

Financial intermediaries, such as banks, are hugely important in activities such as thefinancing of investment projects and in the safekeeping of savings. At any point in time,there are agents who spend less than they earn, and so wish to save, and there areagents who spend more than they earn, and so need to borrow. The main service that abank provides is the collection of funds from those who wish to save and the lending outof funds to those who wish to borrow. The reward for providing such services comesfrom the difference between the rate of interest paid on savings and that charged onloans. By charging a higher rate of interest rate on the funds they lend to firms andhouseholds than on the funds they accept from depositors, banks can make profits. Thisis also called credit spreads.

If there are agents who want to save and others who want to borrow, why do those withfunds to spare not just lend directly to those who want to borrow (i.e. why do we needa bank or financial institution at all)? There are a number of reasons to explain theexistence of financial intermediaries, which include:

1. Economies of scale in transactions and information. In order to have asufficiently diversified portfolio, agents with funds to save should hold a largenumber of different assets. If each agent only had limited funds available, this couldonly be done by ‘clubbing’ together. This is exactly the type of service unit trustsand pension funds provide. Also, if an agent wanted to borrow a large sum ofmoney, to buy a house or factory for example, it is unlikely that they would find asingle other agent willing to lend such a large sum. If a large number of agentsdeposited small quantities of savings at a bank, the bank could then lend a largeamount to a single borrower. The financial intermediary may also be able to obtainbetter information about the creditworthiness of a prospective borrower than anindividual agent can; and the intermediary may be more likely to retrieve assetsfrom a borrower who defaulted on the loan after being made redundant.

2. Insurance. Agents are, in general, risk-averse. If there are two states of the world,one where an agent received a high income and another where (s)he received a lowincome, the average of the utilities from both high and low incomes will be lessthan the utility of the average income. As such, the agent would be willing to pay afraction of their income in order to smooth their income receipts and hence theirconsumption. This is exactly the service insurance firms provide. In a similarfashion, banks provide insurance services by guaranteeing a rate of return todepositors even if loans made to borrowers turn bad. Without the bank, the defaultrisk would be faced entirely by the individual/depositor. By paying the bank,depositors accept a lower deposit rate than that they have to pay on loans,depositors can protect themselves from the default risk and obtain a higher utility.2

3. Maturity transformation. Arguably the most important service provided bybanks is that of issuing one form of debt that is illiquid (of long maturity), whiletaking on another which is of short maturity. Individual lenders generally want tolend (to the bank) while still having quick access to their money, in order to maketransactions or for precautionary motives. The liabilities of the bank (the deposits

2Unless, however, the bank fails as a result of too many borrowers defaulting, for example!

45


of savers) are then liquid and the bank will promise to convert the depositors’assets on demand. The banks assets, on the other hand, will tend to be illiquidsince private borrowers tend to want to hold long maturity liabilities (theloans/assets of the bank). For example, if a firm wanted to borrow money to builda factory, they would want to borrow long term. This would allow the steadyincome earned from the investment to gradually pay off the loan.

Activity 4.1 If you had $1,000 in cash and you deposited this at a bank, on whatside of the bank’s balance sheet would this appear? On what side of your ownbalance sheet would it appear? What could and should the bank do with this cash?

Since banks hold short maturity liabilities, which they promise to pay to the depositorson demand, and hold long maturity assets in the form of loans to borrowers, aparamount concern of banks is therefore to ensure that they can honour demands forwithdrawals by customers. To do this they must always hold an adequate supply ofliquid assets. The problem is that the most profitable assets of a bank are those thatpossess least liquidity. Indeed, if the banks held only the most liquid assets in theirportfolios they would not even cover their operating costs! The highest profits areearned on long-term loans and investments but these are comparatively illiquid assets ina bank’s balance sheet. Banks are therefore obliged to balance liquidity on the one handagainst profitability on the other.

Activity 4.2 Why are liquidity and profitability sometimes referred to asconflicting objectives?

4.8 The money multiplier and base money

Base money, also known as high-powered money is the monetary liabilities of theCentral Bank. This consists of notes and coins, and the deposits and reserves of bankswith the Central Bank. If the monetary authorities increased the monetary base byprinting money and giving it to private individuals, those individuals will, more likelythan not, deposit a fraction of it with their bank. The bank will not want to keep all ofthese deposits in the form of liquid assets, as this strategy will not earn the bank themost money. Remember that liquid assets earn the lowest interest. Instead it will keep afraction of it in liquid form but lend out the rest in order to earn a higher return. Thefunds given out as loans will be spent and subsequently deposited at the bank ofwhoever sold the goods to the initial borrower. Again the bank will lend out a fractionof these new deposits and the process continues. In equilibrium the total increase in themoney stock, the liabilities of the government (notes and coins) and the liabilities ofbanks (deposits) will be a multiple of the increase in the high-powered money. Thismultiple will depend on the fraction of the money individuals wish to deposit with theirbank, the currency-deposit ratio, and the fraction of the deposits the bank wishes tokeep in cash reserves and not lend out, the reserve-deposit ratio. If these ratios arestable through time then by controlling the base money, the monetary authorities cancontrol the total money supply in the economy.3 Let the total money supply in the

3Controlling the money supply is not as simple as it sounds, however. See Goodhart (1989).

46

4.9. A simple model of the banking sector

economy, M , be made up of deposits, D, and the liabilities of the government, notesand coins, C. Therefore:

M = D + C. (4.1)

Also, let high-powered money, H, be made up of the notes and coins in the generalpublic, C, and the remainder of the government’s liabilities held by banks in the form ofreserves, R:

H = C +R. (4.2)

Dividing (4.1) and (4.2) by D and then dividing one by the other, we can write:

M = H

(1 + (C/D)

(C/D) + (R/D)

). (4.3)

The bracketed term is the money multiplier: the factor which, when multiplied by thebase money, gives the total money supply in the economy. As can be seen, it is afunction of the currency-deposit ratio (C/D), and the reserve-deposit ratio (R/D). Themonetary authorities should be able to directly control the stock of high-poweredmoney, H, but the determination of the total stock of money, M , ultimately depends onthe banking sector and the preferences of private individuals. It is the workings of thebanking sector to which we now turn.

4.9 A simple model of the banking sector

Assume a banking industry whose market is described by:

D = d0 − d1(i− iD) (4.4)

L = d0 + l1(i− iL) (4.5)

where L is the (demand for) bank loans, D is the (supply of) bank deposits, iL the ratecharged on loans, iD the interest paid on deposits and i the ‘market’ interest rate. Notethat the supply of deposits is a positive function of the interest rate paid on depositsand a negative function of the market interest rate – the interest rate one could earnelsewhere. If iD was large relative to i, that would encourage individuals to depositmore funds with the bank. Equivalently, the demand for loans is a negative function ofthe interest rate charged on loans. If the interest rate you had to pay on a loan was highrelative to the market rate, you would borrow, not from the bank, but from elsewhere.Assume the banks have no operating costs and have no other assets or liabilities.Finally, d0 captures an arbitrary banking relationship constant. It represents theminimum an individual would deposit to the bank and the minimum a firm receivesfrom the bank to hold a bank relationship.

Competitive equilibrium

The profits made by the bank will equal the quantity of loans, L, multiplied by theinterest earned on those loans, iL (which is the bank’s revenues)4 minus the costs faced

4Assume there are no borrowers defaulting on their debts.

47


by the bank. Costs will equal the interest paid to depositors in order to encourage themto hand over their funds to the bank. Costs then equal the quantity of deposits, D,times the interest rate paid on deposits, iD. Denoting bank profits by Π and noting thatin a competitive equilibrium, profits equal zero:

Π = L · iL −D · iD (4.6)

Π = 0 (competitive equilibrium). (4.7)

When making the additional assumption that the bank holds no reserves, in order forthe bank’s balance sheet to balance, loans (assets) must equal deposits (liabilities),L = D. Substituting into (4.6) and using (4.7) implies that in equilibrium:

iD = iL. (4.8)

Substituting into (4.5) and equating L with D gives:

d0 − d1(i− iD) = d0 + l1(i− iL). (4.9)

Solving for the interest rate on deposits, which equals the interest rate charged on loansfrom (4.8), gives:

iD = iL = i. (4.10)

This implies total deposits, D, which equals total loans, L, equals d0 from either (4.4)or (4.5). This is shown in Figure 4.1 below.

In equilibrium, the interest rate paid on deposits equals the interest rate charged onloans, which equals the market interest rate, i. The level of deposits, which in thismodel is equal to the level of the money stock, equals the amount of loans.

Figure 4.1:

48


Government regulation of the deposit rate

One way that the government could reduce or control the money supply is by setting alimit on the interest rate paid on deposits. If the maximum interest rate banks can payon deposits is less than i in the above example, then the amount of funds savers arewilling to deposit with the bank will fall, resulting in a lower money supply. Note thatthis will also be associated with a lower quantity of loans that, despite the lower moneysupply, may be harmful to the economy if it means some investment opportunities arenot undertaken.

Consider the case where the government sets the interest rate on deposits equal to zero.From (4.4), the quantity of deposits is fixed at D = d0 − d1i. Diagrammatically, this isshown in Figure 4.2.

Figure 4.2:

The level of deposits, and hence of the money supply, has fallen from d0 to d0 − d1ibecause of the government regulation. Since deposits must equal loans in order for thebank’s balance sheet to balance, the lower level of deposits means a lower level of loans,which is associated with a higher interest rate charged, iL > i. Also, since there is adifference between the interest rate charged on loans and that paid on deposits (whichhas been set at zero), the government regulation has allowed the banks to make positiveprofits.

Activity 4.3

1. By equating deposits with loans, and noting that iD = 0, find an expression foriL in terms of the market interest rate, i.

2. Using (4.6) find an expression for the profits made by the banks in terms of themarket interest rate.

49


Reserves

As discussed above, banks will try to keep a fraction of their assets in liquid form inorder to meet the day-to-day needs of depositors who withdraw their funds. Assumethat the government introduces a mandatory reserve ratio, r∗ (i.e. total reserves of thebank, R, equals r∗ ×D). The bank’s assets now comprise loans, as before, but nowinclude these reserves. Its liabilities are just the deposits of its customers.

Assets = Liabilities

⇒ r∗ ·D + L = D

⇒ L = (1− r∗)D. (4.11)

Substituting (4.11) into the zero profit condition, (4.6) and (4.7), and rearranging willgive the interest rate charged on loans to be:

iL =iD

1− r∗> iD. (4.12)

The interest rate charged on loans is now higher than the interest rate paid on deposits.This is in order to compensate the banks for holding reserves, on which it earns nointerest. Total loans are now less than total deposits so each dollar lent out must earn ahigher return than that paid on each dollar deposited with the bank. iL then needs tobe greater than iD.

Activity 4.4 Substitute out L and D from (4.4) and (4.5) into (4.11). Thensubstituting out iL from (4.12), show that the rate of interest paid on deposits isequal to:

iD =

(1− l1r

∗

l1 + d1(1− r∗)2

)i+

r∗(1− r∗)d0l1 + d1(1− r∗)2

. (4.13)

Substitute this out into the supply of deposits equation, (4.4), and show that totaldeposits are given by:

D =l1 + d1(1− r∗)l1 + d1(1− r∗)2

d0 −d1l1r

∗

l1 + d1(1− r∗)2i. (4.14)

Although (4.13) and (4.14) appear complicated, they simply relate the deposit rate andtotal deposits (money supply) to the market interest rate and to the reserve ratio. Bychanging the mandatory reserve ratio, the government can change the total moneysupply through the activities of the banking sector. However, the way in which D varieswith r∗ is uncertain and depends on the parameters of the model. With no reserverequirements we equate L to D in order for the bank’s balance sheet to balance. In thissituation we equate L to (1− r∗)D from (4.11). Therefore the new intersection resultsin a lower value of L but a higher interest rate charged, iL. Total revenues for the bank,L× iL, could then increase or decrease depending on the elasticity of the demand forloans function.

50


If the demand for loans is elastic then, if L falls, revenue will fall. Banks will be forcedto cut the interest paid on deposits, so iD falls, resulting in fewer deposits and hencecausing the money supply to fall.

If the demand for loans is inelastic, a fall in L, caused by the reserve ratio, will increaserevenues. The banks will increase iD and so total deposits will increase.

Monetary base control

As seen above, the government can control the money supply by directly controlling therate of interest paid on deposits and it can also affect it through imposing a mandatoryreserve ratio. However, by forcing the banks to hold a certain level of reserves, not just areserve ratio, it can directly control the monetary base. Note that high-powered moneyequals reserves plus cash held by the general public (see (4.2)) and the governmentdirectly controls the amount of cash in the economy since it is the monopoly supplier.

The government fixes the amount of bank reserves, R, at R∗. Together with the reserveratio, r∗, this explicitly determines the amount of deposits in the economy sinceR∗ = r∗D. Inverting (4.14) will give an expression for the market interest rate in termsof r∗ and R∗.

i =l1 + d1(1− r∗)

d1l1r∗d0 −

l1 + d1(1− r∗)2

d1l1r∗D (4.15)

where:

D =R∗

r∗. (4.16)

This is shown in Figure 4.3.

Figure 4.3:

51


The level of total deposits, and hence the supply of money, is determined by themandatory requirement that the banks hold a fixed level of reserves, R∗, and have afixed reserve ratio, r∗. Changing R∗ will directly affect the money supply, shifting thevertical D = R∗/r∗ schedule left or right. However, doing so will necessitate a change inthe market interest rate in order to achieve equilibrium in the banking sector.

Activity 4.5 Assume an economy in which the demand for bank loans is given by:

L = 1000 + 25(i− iL)

and in which the portfolio preferences of the public generate a supply of bankdeposits given by:

D = 1000− 50(i− iD)

where iL is the interest rate charged on bank loans, iD the interest rate paid on bankdeposits and i the ‘market’ interest rate (and interest rates are measured inpercentage points so that a rate of two per cent is given as 2, not 0.02).

The banks hold no reserves and have no other assets and liabilities and incuroperating costs of £60 a year for every £1,000 of deposits.

1. Assuming the banking system is competitive, solve for the loan rate and thedeposit rate as functions of the market interest rate and determine the stock ofmoney in equilibrium.

2. Imagine that the banks were now to collude and reach an agreement to set loanand deposit rates which maximise the profits of the industry. What loan anddeposit rates will they set, what will be the profits of the industry and what willbe the effects of this cartel on the stock of money?

3. Assume the banking industry is described as in the first part of the question(i.e. competitive and unregulated). The government can influence the ‘market’interest rate through its dealings in the gilt-edged money markets. What is theeffect of a change in the market interest rate on deposit and loan rates and onthe stock of money? Explain. Is monetary policy impotent in this economy?

(For Feedback, see the end of this chapter.)



describe and discuss the different roles of financial intermediaries

describe why maturity transformation is so important in financial markets

define on which side of a bank’s balance sheet deposits and loans appear andexplain why the balance sheet must indeed balance

52

4.11. Sample examination questions

explain how the monetary authorities can control the total money supply bychanging the monetary base or by introducing mandatory reserve ratios or otherregulation.


Section A


1. ‘From the money multiplier analysis, the stock of money is a multiple of thequantity of high-powered money. Since this is set by the monetary authorities, theauthorities can directly set the quantity of money in the economy.’

Section B

2. Why should banks be required to satisfy restrictions placed by the regulatoryauthorities in the form of required reserve ratios?

3. Do banks perform a role in the financial system that is qualitatively different fromthe role of other ‘non-bank’ financial intermediaries (NBFIs)? Should all financialinstitutions be regulated by the authorities in the same way?

4. It is sometimes argued that regulation of the banking system (by minimum reserverequirements, for example) acts like a tax on banks, and leads to the growth ofnon-bank financial intermediation, which escapes the regulation. Therefore, it isargued that bank regulation is self-defeating and undesirable. Discuss.

5. What is the effect of an increase in the ‘market’ interest rate on the equilibriumvalue of bank deposits (and hence on the money stock) on the assumptions that:

(a) the banking system is competitive and unregulated, but the banks require forcommercial reasons to hold some proportion of their deposits in the form ofcash

(b) the banking system is regulated by a rule preventing banks from payinginterest on deposits?

Is the effect bigger under assumption (a) or (b)? Explain.

4.12 Feedback to Activity 4.5

1. With no reserves, it must be the case that loans equal deposits, as in the first partof the example in Chapter 3 ((4.4) onwards). The profits of the bank are given byrevenues, L× iL, minus costs. Costs include the interest on deposits, D × iD, but

53


also the operating costs of £60 per £1,000 deposited, i.e. 6% of deposits. Profits, Π,are then given by:

Π = L · iL −D · iD − 6D (4.17)

Π = 0. (4.18)

Noting that L = D, the zero profit condition can be solved to give:

iL = iD + 6. (4.19)

Substituting (4.19) into the loan demand equation and equating this to the supplyof deposits equation gives:

1000 + 25(i− (iD + 6)) = 1000− 50(i− iD). (4.20)

Solving for iD gives:iD = i− 2 (4.21)

which implies:iL = i+ 4. (4.22)

From either the loan demand or supply of deposits equation, we find that the stockof money in equilibrium is:

D = L = 1000 + 25(i− (i+ 4)) = 900. (4.23)

This is shown in Figure 4.4.

2. Equating loans with deposits gives a relationship between iL and iD of:

iL = 3i− 2iD. (4.24)

Using (4.24) and the loan demand and supply of deposits equations we can use(4.17) to obtain an expression for profits.

Π = (1000− 50(i− iD))(3i− 2iD − iD − 6). (4.25)

Differentiating this with respect to iD, the bank’s choice variable, results in anoptimal deposit rate of:

iD = i− 11. (4.26)

Using (4.24) and the supply of deposits equation, this results in:

iL = i+ 22 (4.27)

D = 1000− 50(i− (i− 11)) = 450. (4.28)

3. From ‘1.’, D = 900 (i.e. deposits are a constant in equilibrium and are not afunction of the market interest rate). Changing i will not change D and hence willnot change the stock of money. The government bids for funds by increasing i sobanks have to compete by increasing their own rates. In total, nothing happens to

54

4.13. Feedback to Sample examination questions

D or L since they both only depend on interest differentials. From (4.21) and(4.22), diL/di = diD/di = 1. The effect of changing the market interest rate isshown in Figure 4.4 below.

Even though the money stock has not changed, an increase in the nominal interest ratewill increase the real interest rate if prices (inflation) do not change. Therefore,investment and consumption will be affected (reduced) and so monetary policy may notbe impotent.

Figure 4.4:


Section A

1. The statement is uncertain. The suggested answer should show the relationshipsbetween M (money stock) and H (high-powered money) from (4.1) to (4.3). Themoney multiplier will be shown to be a function of two ratios (currency-deposit andreserve-deposit). Only if these ratios are stable will the monetary authorities beable to control the stock of money directly.

Section B

5. For the first part, where the banking system is competitive and unregulated, theeffects of an increase in the market rate of interest will be to increase deposit andloan rates one-for-one but to leave the money stock unaffected. See the outlineanswer to ‘3.’ of Activity 4.5.

In (b), where banks do not pay interest on deposits, consider Figure 4.2 and (4.4).Deposits are fixed at D = d0 − d1i and therefore an increase in the market rate will

55


cause the money stock to fall. It is therefore likely that the effect of the increase inmarket rates is greater in the second case. The money stock falls and the increasein the market rate can have real effects, as described above.

56

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