Lecture 3

MONEY DEMAND AND MONEY SUPPLY

By:
Amsalu B. (MSc.)
Lecturer, Department of Economics

Unity, University
Email: [email protected]

Unity, University
 What is money?
 To an economist, money does not refer to all wealth but only to

one type of it:

 money is the stock of assets that can be readily used to make

transactions.
 The Functions of Money

 As a medium of exchange, money is what we use to buy

goods and services money’s liquidity

 As a store of value, money is a way to transfer purchasing

power from the present to the future.

 Of course, money is an imperfect store of value: if prices are
rising, the amount you can buy with any given quantity of
money is falling
 As a unit of account, money provides the terms in which prices

are quoted and debts are recorded.

 Money is the yardstick with which we measure economic

transactions.
 The Types of Money
 Money that has no intrinsic value[commodity money ]is called

fiat money because it is established as money by government

decree, or fiat
 Commodity money is commodity with some intrinsic value.

 The most widespread example of commodity money is gold

Components of the Money Stock

 There are four main monetary aggregates: currency, M l, M2,

and M3.
 Ml comprises those claims that can be used directly, instantly,

and without restrictions to make payments. Thus they are the

 It corresponds most closely to the traditional definition of

money as the means of transaction

 M2 includes, in addition, claims that are not instantly liquid,

withdrawal of time deposits, for example, may require notice to

the depository institution; money market mutual funds may set
a minimum on the size of checks drawn on an account.

 Finally, in M3 we include items that most people never see, namely,

large negotiable deposits and repurchase agreements

 As we move from M1 to M3, the liquidity of the assets decreases,

while their interest yield increases. Currency earns zero interest

 Components of money Supply
 M1 = currency with the public + demand deposit with the banking
system or deposits in checking account + checks for current
conversion and use (e.g: travelers’ checks).
 M2 = M1 + deposit in saving account + money market mutual
funds.
 M3 = M2 + Time deposits with the banking system (long time
deposits) + financial securities such as treasury bills, bonds and so
on .
 M4 = M3 + Total post office deposits
 Money supply and monetary expansion mechanism

 The quantity of money available is called the money supply

 The policy used to control over the money supply is called

monetary policy

 Narrow money: referred to as M1- normally include coins and

notes in circulation
 M1 = C+D; where C is currency and D demand deposit
 Broad money: refers to M2. It is also known as money and quasi-

money
 It is the sum of M1 and time deposits, money market mutual fund

and foreign currency deposits of resident sectors.

 Who controls the money supply?

 The answer for this question is, besides the central bank, the

behavior of both the public and the banks affects the money supply
The role of banks in money supply
 We referring to in this particular section is the M1 or

narrow money. M = C + D.
 Let’s get introduced to some of the basic terms. These are:

 Reserves(R): the portion of deposits that banks have not lent.

 A bank-liabilities include deposits and a bank assets include

reserves and outstanding loans

 100-percent-reserve banking: a system in which banks hold all

deposits as reserves.
 Fractional-reserve banking: a system in which banks hold a
fraction of their deposits as reserves.
 Scenario1: There are no banks

 With no banks: D =0 and M = C = Birr 1000. Thus, all the money is

found in the form of currency in the hand of the public.

 Scenario 2: 100 Percent Reserve Banking

 Suppose initially a household has $ 1000. Then C = $1000, D = $ 0 and

M = C+D= $ 1000.

 Now suppose households deposit the $ 1000 at First bank. After the

deposit: C = $ 0, D = $ 1000 and M = $1000.

 Now let’s see the balance sheet of the banks.
 100 Percent Reserve Banking has no impact on size of money supply.
 First bank’s balance sheet
Asset Liability

Reserve = $1000 Deposit = $ 1000

 Scenario 3: Fractional-Reserve Banking

 Suppose banks hold 20 Percent of deposits in reserve- making loans with the

rest. First bank will make USD 800 in loans. The money supply now equals $
1800: The depositor still has USD 1000 in demand deposits but now the
borrower holds $ 800 in currency.

Firstbank’s balance sheet

Asset Liability
Reserve = $200 Deposit = $ 1000
Loan =$ 800
 Suppose, with the borrowed money, the second individual either makes a

transaction or pay someone who will deposit in the Second bank. And
suppose banks hold 20 Percent of deposits in reserve- making loans
with the rest. So the second bank will make a loan of $640. Therefore the
borrower will hold $640.

Second bank’s balance sheet

Asset Liability
Reserve = $160 Deposit = $ 800
Loan =$ 640
 Thus in a fractional-reserve banking system- banks create money

 Finding the total amount of money:

 Original deposit = USD1000

+ Firstbank lending = $ 800

+ Secondbank lending = $ 640

+ Thirdbank lending = $ 512

+ Other lending…

 Total money supply = (1/rr) $ 1000. Where rr = ratio of reserves to

deposits. In our example, rr = 0.2, so M = $ 5000

 Note that a fractional reserve banking system creates money, but it
doesn’t create wealth.
 A model of the money supply
 According to the model there are three exogenous variables which
determine the money supply.
 The monetary base, B = C + R. It is controlled by the central bank
 The reserve-deposit ratio, rr= R/D. depends on regulations & bank
policies
 The currency-deposit ratio, cr = C/D. depends on households’ preferences
M=C+D and B=C+R
 Divide M by B:
M/B=(C+D)/(C+R)
M/B=(C/D+D/D)/(C/D+R/D)
M/B=(cr+1)/(cr+rr)
M=[(cr+1)/(cr+rr)]B=m*B
 If rr<1, then m>1. If monetary base changes by ∆B, then ∆M=m* ∆B. m is
called the money multiplier.
 The lower the reserve-deposit ratio, the more loans banks make and the higher
is the money multiplier.
 The lower the currency deposit ratio, the fewer dollars of the monetary base
the public holds as currency and the lower is the money multiplier.

 Instruments of monetary policy

 There are three monetary policy tools

 Open market operations: It is the purchase or sale of government bonds by

the Central bank.
 If Central Bank buys bonds from the public, it pays with new Currency, increasing
monetary base (B) and therefore the money supply (M).
 Reserve requirements: It is the Central Bank regulations that require

banks to hold a minimum reserve-deposit ratio.

 If Central Bank reduces reserve requirements, then banks can make more

loans and “create” more money from each deposit

 The discount rate: it is the interest rate that the Fed charges on loans

it makes to banks.
 When banks borrow from the Central Bank, their reserves increase,

allowing them to make more loans and “create” more money

 Open market operations: Most frequently used

 Example: B = Birr 500 billion, cr = 0.6 and rr = 0.1: Find the
money suply?
m=(0.6+1)/(06+0.1)=2.3
M=2.3*500=Birr1150
 Money Demand

 The demand for money is the desire/motive for holding of

financial assets in the form of money: that is, cash or bank
deposits.
 note about is that the demand for money is a demand for real
balances. In other words, people hold money for its purchasing
power, for the amount of goods they can buy with it. Two
implications follow:
 The theories we are going to discuss are the following.

 Portfolio theories, which stress on the demand for arising from the need to

hold money as part optimum portfolio. It also arises from uncertainties

 Transactions theories. which is the demand for money arising from the use

of money in making regular payments

1. A Simple Portfolio Theory

 Stress the store of value function of money

 Money demand depends on risk/return of money & alternative assets

 People hold money as part of their portfolio of assets

 The key insight is that money offers a different combination of risk and

return than other assets

 In particular, money offers a safe (nominal) return, whereas the prices of

stocks and bonds may rise or fall

 For example, we might write the money demand function as

 Portfolio theories are more plausible as theories of money demand if we

adopt a broad measure of money

A transactions theory of money demand
 Emphasize the role of money as a medium of exchange.

 People hold money, unlike other assets, to make purchases

 Explain why people hold narrow measures of money

The Baumol-Tobin Model of Cash Management

 It analyzes the costs and benefits of holding money

 The benefit of holding money is convenience

 The cost of this convenience is the forgone interest they would have
received had they left the money deposited in a savings account that
paid interest
 The Cost of Holding Money
 In general, average money holdings =Y/2N
 Foregone interest = i×(Y/2N)
 Cost of N trips to bank = F×N
Total Cost= i×(Y/2N)+ F×N

 Given Y, i, and F, consumer chooses N to minimize total cost

 What is the optimum number of trip (N) minimizes cost?
Total Cost= i×(Y/2N)+ F×N
 Take the derivative of total cost with respect to N, and then set it equal
to zero:

 Solve for the cost-minimizing N*

 Now let’s obtain the Money Demand Function is

 To obtain the money demand function, plug into the expression for
average money holdings:
 Average Money Holdings=
 Therefore, the money demand depends positively on Y and F, and
negatively on i.
 The Baumol-Tobin money demand function is
THAKS!!!

END!!!

THAKS!!! 23