Chapter 15 - The Role of Money in The Economy

Written by: Edmund Quek
CHAPTER 15 THE ROLE OF MONEY IN THE ECONOMY
LECTURE OUTLINE 1 2 2.1 2.2 2.3 3 BARTER TRADE MONEY AND THE MONEY SUPPLY Functions of money Attributes of money Official definitions of money in Singapore MONETARY BASE (M0), MONEY MULTIPLIER EFFECT, DEPOSIT MULTIPLIER AND MONEY MULTIPLIER (optional) DETERMINANTS OF THE MONEY SUPPLY (optional) Monetary base (M0) Money multiplier THEORIES OF INTEREST RATE DETERMINATION Loanable funds theory (Classical Theory) Liquidity preference theory (Keynesian Theory) Interest rates in reality RELATIONSHIP BETWEEN THE MONEY SUPPLY AND THE GENERAL PICE LEVEL (optional) Classical view (Quantity Theory of Money) Monetarist view Keynesian view
4 4.1 4.2 5 5.1 5.2 5.3 6
6.1 6.2 6.3
References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
2011 Economics Cafe All rights reserved.
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BARTER TRADE
Before there was money, there was barter trade. In other words, people exchanged goods directly for other goods. However, barter trade suffers from many disadvantages. Lack of double coincidence of wants A double coincidence of wants occurs when the two parties involved in a barter trade have the goods that each other desires. Such exchange was possible in a primitive society which produced a small range of goods. However, in todays society, it is virtually impossible to carry out a direct exchange of goods and services using barter system since our wants are numerous and diverse. Lack of a common measure of value The value of a good is the quantities of other goods it can command in the market. Therefore, the value of a good is difficult to measure since it has to be stated in terms of the quantities of many other goods. For this reason, it will be difficult for firms to draw up and interpret profit and loss statements. Indivisibility of certain goods Barter trade is undesirable if the goods that are to be exchanged cannot be divided without incurring any loss of value. This is a problem when large goods are to be exchanged for small ones. Inability to specialise In todays society, many people produce only parts of goods. This is a process known as specialisation. However, exchanging parts of goods for other parts of goods is much more difficult than exchanging a whole good for another whole good.
2 2.1
MONEY AND THE MONEY SUPPLY Functions of money
Money is anything that is accepted as a medium of exchange. However, in addition to the function as of a medium of exchange, good money must serve three other functions. Medium of exchange Money is a medium of exchange as it is accepted in payment for goods and services. Therefore, the use of money does away with the need for a double coincidence of wants for a transaction to take place and hence facilitates specialisation and exchange. Store of value Money is a store of value as it allows us to store our purchasing power for future use. Therefore, not every sale is a purchase. A person can be a seller but only become a buyer tomorrow. However, in times of inflation, money becomes a poor store of value.
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Unit of account Money is a unit of account which provides a common measure of value. Therefore, money allows us to make comparison between the values of different goods and services. In addition, money allows firms to draw up and interpret profit and loss statements. Standard of deferred payment Since money is a unit of account, it is also a standard of deferred of payment, or simply a unit of account over time. People often want to agree today the values of some future payments. For instance, some firms sign contracts with their suppliers specifying the prices of raw materials and other supplies. Money provides a convenient means of measuring future payments.
2.2
Attributes of money
To function properly, money must be durable, portable, divisible, difficult to counterfeit and controllable. These attributes combine to give money its key characteristic. That characteristic is acceptability. Historically, different things have been used as money. Forms of money have changed over time and are constantly evolving. The following is an outline of the origin and the historical development of the todays money. First, there was commodity money (e.g. cattle, salt, silver, gold, etc). Next, there was paper money (receipts given by goldsmiths, evolved into banknotes, fractionally backed by gold, inconvertible paper money declared by the government to be legal tender which is also known as fiat money where fiat means 'let there be' in Latin) Finally, there are bank deposits (i.e. demand/sight/current account deposits).
2.3
Official definitions of money in Singapore (Institutions-based approach)
Narrow money (M1) The narrow definition of money measures the immediate purchasing power in the economy. It looks at money primarily as a medium of exchange.
M1 = Currency in Active Circulation + Demand Deposits with Banks

Broad money (M3) The broad definition of money measures the potential purchasing power of money in the economy. It looks at money primarily as store of value. Quasi-money Quasi-money is any asset that is not money but can readily be converted into money. Items commonly regarded as quasi-money are savings deposits, fixed deposits, unit trusts, etc. None of these deposits serves as a medium of exchange and thus they are not included in
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narrow money (M1). However, many banks now allow depositors to transfer savings deposits to demand deposits through phone calls or ATMs and this blurred the distinction between narrow money (M1) and broad money (M3).
M2 = M1 + Quasi-money with Banks (i.e. Fixed Deposits, Savings Deposits, Unit Trust Funds, etc) M3 = M2 + Net Deposits with Non-bank Financial Institutions (i.e. Finance Companies)
Note: In some countries such as the US, the monetary characteristics of instruments approach is used. In economics, unless otherwise stated, the money supply refers to broad money.
MONETARY BASE (M0), MONEY MULTIPLIER EFFECT, DEPOSIT MULTIPLIER AND MONEY MULTIPLIER (optional)
The monetary base (M0) is comprised of currency in active circulation, reserves in banks vaults and banks reserves with the central bank. A change in the monetary base (M0) will lead to a change in the money supply (M). Furthermore, due to the money multiplier effect, the change in the money supply (M) will be larger than the initial change in the monetary base (M0). Suppose that the central bank increases the monetary base (M0) by purchasing a $1000 worth of government securities (treasury bond or treasury bill). Further suppose that the reserve ratio (r reserves/deposits) 0.1 and the currency-deposit ratio (c currency/deposits) 0.1. Round 1 2 3 Sum Deposits (D) $1000 $800 $640 $5000 Loans $900 $720 $4500 Reserves $100 $80 $500
In the above table, D 1000 800 640 . Therefore, D 1000 (0.8)(1000) (0.8)2(1000) . Applying geometric progression, D 1000/(1 0.8) $5000 M0 $1000. The deposit multiplier refers the number of times by which deposits (D) change due to a change in the monetary base (M0).
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Since D = M0/(r c), D/M0 1/(r c).
Deposit Multiplier D/M0 = 1/(r c)

The money multiplier refers the number of times by which the money supply (M) changes due to a change in the monetary base (M0). Money (M) Deposits (D) Currency in active circulation (C). Since c C/D, M D cD (1 c)D. Since (1 c) is a constant, M = (1 c)D. Since D/M0 1/(r c), M0 (r c)D. Therefore, M/M0 (1 c)/(r c).
Money Multiplier M/M0 (1 c)/(r c)

4 DETERMINANTS OF THE MONEY SUPPLY (optional)
From the money multiplier, we can see that the money supply (M) is affected if there is a change in the monetary base (M0) or the money multiplier. More precisely, the money supply (M) will rise if there is an increase in the monetary base (M0), the money multiplier, or both.
4.1
Monetary base (M0)
The monetary base will be affected when the central bank conducts open market operations, also known as domestic market operations. If the central bank buys government securities (open market purchase), the monetary base (M0) will increase. The central bank charges banks an interest rate, known as the bank rate, for borrowing. If the central bank lowers the bank rate, banks will increase borrowing from the central bank which will increase the monetary base (M0). If the government finances a public sector deficit by selling government securities to the central bank, the monetary base (M0) will increase. If the government finances a public sector deficit by selling government securities to the non-central-bank sector which comprises banks and the public, the monetary base (M0) will remain unchanged whether the government securities are purchased by banks or the public. However, if the government securities are purchased by the foreign sector, under the fixed exchange rate system or the managed float exchange rate system, the monetary base (M0) will increase. If the economy experiences a balance of payments (BOP) surplus, under the fixed exchange rate system or the managed float exchange rate system, the monetary base (M0) will increase.
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4.2
Money multiplier
If the central bank raises the required/minimum reserve ratio (if one is in force), banks will raise their reserve ratios which will decrease the money multiplier. If the central bank induces banks to reduce loans and hence raise their reserve ratios by issuing directives or through moral suasion, the money multiplier will decrease. If the central bank increases banks reserve ratios by demanding them to place with it special deposits, the money multiplier will decrease. If the public holds more currency, the money multiplier will decrease. If banks hold more excess reserves, the money multiplier will decrease. 5 5.1 THEORIES OF INTEREST RATE DETERMINATION Loanable funds theory (Classical Theory)
Interest is the cost of borrowing and the reward for lending. According to the loanable funds theory, interest rates are determined in the loanable funds market, more commonly known as the capital market in everyday English.
In the above diagram, the equilibrium interest rate r0 is determined by the intersection of the demand and the supply curves of loanable funds. The demand curve for loanable funds is downward-sloping. In other words, the demand for loanable funds is negatively related to interest rates. The higher the interest rates, the lower the demand for loanable funds. The demand for loanable funds consists of the borrowings of households, firms and the government.
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Households borrow to consume at the expense of lower future consumption. A rise in interest rates will mean that a larger amount of future consumption will be forgone for any given amount of borrowing. Therefore, the higher the interest rates, the lower the demand for loanable funds by households Firms borrow to invest. A rise in interest rates will lead to higher costs of borrowing and hence less profitable planned investments. Therefore, the higher the interest rates, the lower the demand for loanable funds by firms. The government borrows to finance a budget deficit. This is done through issuing securities such as bonds and bills. For the determinants of the demand for loanable funds, refer to the notes on THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION, sections 4.2.1 (consumption expenditure) and 4.2.2 (planned investment expenditure). The supply curve of loanable funds is upward-sloping. In other words, the supply of loanable funds is positively related to interest rates. The higher the interest rates, the higher the supply of loanable funds. The supply of loanable funds consists of the savings of households and firms. Households save to increase their future consumption. A rise in interest rates will mean that a larger amount of future consumption will be made available for any given amount of savings. Therefore, the higher the interest rates, the higher the supply of loanable funds by households. Firms save when they retain a part of the profits that they make. However, this does not depend so much on interest rates. Rather, firms make decisions regarding retained profits based on factors such as the economic outlook, investment opportunities, etc. For the determinants of the supply of loanable funds, refer to the notes on THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION, section 4.2.1 (consumption expenditure). Note: Loanable funds can be defined as funds available for loan in the form of bank loans or funds available for loan in general. I use the second definition.
5.2
Liquidity preference theory (Keynesian Theory)
According to the liquidity theory, interest rates are determined in the money market.
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In the above diagram, the equilibrium interest rate r0 is determined by the intersection of the demand and the supply curves of money. In the General Theory, Keynes divides the demand for money (liquidity preference) into three components: the transactions demand for money, the precautionary demand for money and the speculative demand for money. The transactions demand for money (Active balances) The transactions demand for money is the amount of money people demand to carry out normal day-to-day transactions owing to the time lag between the receipt of factor income and the payment of expenditure outlays. The transactions demand for money depends positively on the level of nominal national income. According to Keynes, the higher the level of nominal national income, either due to a rise in the general price level or a rise in the level of real national income, the higher the transactions demand for money. The precautionary demand for money (Active balances) The precautionary demand for money is the amount of money people demand over and above their expected transactions needs owing to the existence of uncertainty. Some expenditure outlays such as medical bills are unpredictable and rational people will therefore demand an amount of money over and above their expected transactions needs to deal with such contingencies. The precautionary demand for money depends positively on the level of nominal national income. According to Keynes, the higher the level of nominal national income, either due to a rise in the general price level or a rise in the level of real national income, the higher the precautionary demand for money. The speculative demand for money (Idle balances) The speculative demand for money is the amount of money people demand for speculative financial transactions if market conditions appear favourable. According to Keynes, the speculative demand for money is negatively related to the interest rate.
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To simplify the analysis conceptually, Keynes assumes the existence of only two financial assets: non-interest-bearing cash and interest-bearing non-redeemable government bonds, also known as consols or perpetuities. The prices of bonds are negatively related to the market interest rate. Suppose the government issues a non-redeemable bond for $100 which pays an interest rate of 5% (i.e. a coupon of $5). The fact that the government is able to sell such a bond indicates that the market interest rate is in the order of 5%. Further suppose that the market interest rate rises to 10% some time later. In this case, the holder of the bond will be able to obtain only $50 from the sale of the bond, since $50 is all that is required to earn an interest income of $5. Therefore, the prices of bonds are negatively related to the market interest rate. The speculative demand for money is negatively related to the market interest rate for two reasons. First, the cost of keeping money idle in the form of speculative demand for money is the interest forgone. Therefore, the higher the market interest rate, the higher the cost of the speculative demand for money and hence the lower the speculative demand for money. Second and more important, is the part played by the expectation of capital gains or losses. Keynes defines the normal interest rate as the interest rate that an individual expects the market interest rate to ultimately converge to. If the normal interest rate is higher than the market interest rate, the individual will expect the latter to rise and hence the prices of bonds to fall. In such a situation, he will move out of bonds and hold cash to avoid a capital loss. If the normal interest rate is lower than the market interest rate, the individual will expect the latter to fall and hence the prices of bonds to rise. In such a situation, he will move out of cash and hold bonds to make a capital gain. However, individuals have different normal interest rates and in the aggregate, will be holding a combination of cash and bonds. The higher the market interest rate, the larger the number of individuals with normal interest rates lower than the market interest rate. Since more people will entertain the belief that the market interest rate will fall and hence the prices of bonds will rise, the speculative demand for money will be lower. Conversely, the lower the market interest rate, the larger the number of individuals with normal interest rates higher than the market interest rate. Since more people will entertain the belief that the market interest rate will rise and hence the prices of bonds will fall, the speculative demand for money will be higher. The supply of money is often assumed to be independent of the market interest rate which is the assumption we make in this course. More complex models, however, explain why higher interest rates will lead to higher levels of money supply (refer to Economics by John Sloman). The main determinant of the supply of money is the central banks money market operations.
Note: According to the Classical economists, the only determinant of the demand for money is the level of nominal national income. Therefore, the Classical money demand function, also known as the Cambridge cash-balance equation, can be expressed mathematically as Md = kPY, where k is a constant.
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5.3
Interest rates in reality
In reality, interest rates are determined in both the loanable funds market and the money market. Example (Loanable funds market) Interest rates in developing economies are typically higher than those in developed economies. This is because households in developing economies are generally poor and hence do not have high savings. Therefore, banks in developing economies have little money to lend which leads to a low supply of loanable funds and hence high interest rates. This leads to a problem commonly known as the poverty trap or poverty cycle. High interest rates discourage investment. When investment expenditure is low, economic growth will be low. Therefore, developing economies are trapped in poverty. Example (Money market) When the economy moves into a recession, the central bank will normally increase the money supply. When this happens, interest rates will fall. The objective of this policy, which is commonly known as monetary policy, is to boost consumption expenditure and investment expenditure to steer the economy back onto the path of expansion. However, in reality, the mechanism of an increase in the money supply resulting in a fall in interest rates is different from the Keynesian mechanism. The interbank overnight rate is the interest rate charged on overnight loans between banks. It is determined by the demand and the supply of reserves in the banking system. Interest rates vary directly with the interbank overnight rate. For instance, when the central bank increases the money supply, the supply of reserves in the banking system will rise. When this happens, the interbank overnight rate will fall which will lead to a fall in interest rates.
RELATIONSHIP BETWEEN THE MONEY SUPPLY AND THE GENERAL PRICE LEVEL (optional) Classical view (Quantity Theory of Money)
6.1
Classical economists believe that an increase in the money supply will not have any effect on the level of real national output. Therefore, using the equation of exchange, they argue that an increase in the money supply will only lead to an increase in the general price level. The equation of exchange is MV = PY, where M = the money supply, V = the velocity of circulation, which is the average number of times a unit of currency changes hand during a year, P = the general price level and Y = the level of real national output. Classical economists believe that an increase in the money supply will not affect V and Y. They believe that V is stable since it is determined by the frequency with which people get paid and Y is solely determined by supply factors since the economy is always tending towards to the full-employment national output. With V and Y as constants with respect
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to M, Classical economists argue that an increase in M will only lead to an increase in P. This theory is commonly referred to as the quantity theory of money. Note: The original version of the equation of exchange developed by Irving Fisher is MV = PT, where T stands for the number of transactions. However, economists prefer to use the version MV = PY. The equation of exchange is also known as the Fisher equation.
6.2
Monetarist view
Monetarists believe that inflation is always and everywhere a monetary phenomenon. By this, they mean that inflation can only be produced by a more rapid increase in the money supply than in real national output. This view is an outgrowth of the study of the historical relationship between the money supply and prices done by the leader of the Monetarist school of thought, Milton Friedman. His study indicated a strong positive relationship between the money supply and prices. Direct (Monetarist) transmission mechanism. Monetarists believe that people do not just hold their wealth in the form of money and financial assets such as bonds, but also physical assets such as cars, televisions and other consumer goods. If the money supply increases, people will find themselves holding more money than they want. Some of this money will be used to purchase financial assets and some will be used to purchase physical assets which will increase aggregate demand. An increase in aggregate demand will increase nominal national output. Initially, the change will appear primarily in real national output. However, after a few months, prices will rise and real national output will fall back. Therefore, an increase in the money supply will only lead to higher prices in the long run. The Monetarist view on the quantity theory of money The Monetarist view on the quantity theory of money is similar to but differs from the Classical view in several ways. First, according to Monetarists, V is not only determined by the frequency with which people get paid but also by the demand for money and since the demand for money is stable, V is also stable. Second, the economy may be at a below-full-employment equilibrium or an above-full-employment equilibrium. Third and most important, Monetarists believe that Y is not independent of M. Initially, an increase in M will lead to an increase in Y. However, after a few months, P will rise and Y will fall back. Therefore, in increase in M will only lead to a higher P in the long run.
Note: At your level, you do not need to know why prices will rise after a few months. This has to do with some advanced economic model known as The imperfect information model.
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6.3
Keynesian view
Keynesians believe that an increase in the money supply will lead to a rise in the general price level. Indirect (Keynesian) transmission mechanism If the central bank increases the money supply, interest rates will fall which will lead to an increase in aggregate demand due to three reasons. First, lower interest rates will lead to more profitable planned investment projects which will result in an increase in investment expenditure. Second, lower interest rates will decrease the incentive to save which will result in an increase in consumption expenditure. Third, lower interest rates will lead to a decrease in capital inflows and an increase in capital outflows. The resultant fall in the exchange rate of domestic currency will make domestic goods and services relatively cheaper than foreign goods and services which will result in an increase in net exports. The increase in consumption expenditure, investment expenditure and net exports will lead to an increase in aggregate demand resulting in a rise in the general price level. The effect of an increase in aggregate demand on the general price level depends on the amount of slack in the economy. An increase in aggregate demand will lead to a small rise in the general price level if there is a large amount of slack in the economy. However, if there is no or only a small amount of slack in the economy, an increase in aggregate demand will lead to a huge rise in the general price level. The Keynesian view on the quantity theory of money Keynesians believe that V is not independent of M. An increase in M will lead to a fall in interest rates and hence an increase in the speculative demand for money. Since these idle balances have zero velocity of circulation, the average V in the economy will fall. Accordingly, Keynesian believe that an increase in M will lead to an increase in both P and Y, but the effect is partially offset by a fall in V.
Note: The Keynesian view that has just been discussed is mainstream economics. Traditional Keynesians believe that an increase in the money supply has little effect on the level of real national income and the general price level. In terms of the Fisher equation, an increase in M will mainly lead to a fall in V, leaving P and Y little affected.
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Written by: Edmund Quek