You are on page 1of 51

4.

Money

4.1 What is money?


4.2 Quantity theory: income and price
4.3 Interest rate and money demand
4.4 Commercial banks
4.1 What is money?
What is money?
a particular form of wealth (or asset)
that is universally accepted in exchange
other forms of wealth are not, e.g., real
property, specific goods, or other forms of
financial wealth)
without money, trade would be barter
problem: double-coincidence of wants
Some forms of wealth
real wealth
stocks of goods (e.g., jewelry, CD collection)
real property (e.g., land, buildings)
financial wealth
shares/stocks in corporations
bonds (e.g., corporate debt, T-bills)
money (cash, savings deposits, time-
deposits)
Three functions of money
store of value
transfers purchasing power from the present to the
future
storability is imperfect owing to inflation
unit of account
common term in which prices are quoted and debts
recorded
medium of exchange
universal acceptability as a means of payment
quality of liquidity (other assets must be liquidated)
Types of money
commodity money
goods with intrinsic value (precious metals, shells,
salt, etc.)
commodity-standard
paper money (notes) redeemable in some commodity
(e.g., a gold-standard)
used in Europe for most of the 18th C.
fiat money (let it be done, Latin)
money by decree
no intrinsic value (e.g., paper notes, cheques)
Evolution of fiat money
portability
standardisation of weights and measures and
purity (hence standard minting)
transition to commodity-standard (notes
redeemable in the commodity)
reliability of supply
erratic supplies of gold and silver lead to
shortages or gluts of money in the economy
e.g., Spains discovery of gold in America
Evolution of fiat money
commodity-standard becomes expedient
legal claims on the stock of the commodity suffice
instead of actual possession of the commodity itself
commodity-backing becomes irrelevant
because no one bothers to redeem the notes in
exchange for the commodity, transactions can be
completed using the notes themselves
fiat money comes into its own
notes ultimately function as money, even without a
direct connection with stocks of the commodity
4.2 Quantity theory of money

Income and prices


Quantity theory of money
money is desired to support transactions
(exchanges)
amount of money desired is related to the
number and value of transactions made
M VT = P T
M = money stock
P = price level; T = number of transactions
P T = value of transactions
Quantity theory of money
VT = PT/M = velocity of money
Example:
PT = (P20 per kilo of rice)(100 kilos of
rice)
= P2,000 (value of rice transactions)
If M = P200, then it must circulate 10 times
in a period to discharge P2,000 in
transactions:
VT = 10.
Quantity theory of money
Assertion: The demand for money will
depend on transactions, but transactions
depend on output or income.
value of total transactions may be greater
than current output (e.g., latter excludes
sales of used goods)
MV=PY
where Y = output and V = income-velocity.
Money-demand function
Answers the question: how much money
people are willing to hold.
Depends on the transactions they wish to
discharge (or output they wish to buy and
sell)
MV = PY
M/P = (1/k)Y
where k = 1/V.
Quantity theory of money
Presumes society will voluntarily hold real
cash balances proportional to the value of
output or of income.
(M/P) = kY M = MS Y = YF
Upon substitution:
MS = kPYF
Full employment and exogenous money
supply will determine the price level P.
Quantity theory of money
Conclusion:
An increase in money supply will cause an
increase in prices. In the long run, money
is a veil that affects only prices but not
employment and output.
If real output is to grow without inflation,
the money supply should grow at a rate
equal to the growth of real output.
QTM hypothesis on inflation
The simple QTM implies that inflation is a
monetary phenomenon
MS = kPYF
DMS/MS = Dk/k + DP/P + DYF/YF
But since Dk/k = 0, then:
DMS/MS = DP/P + DYF/YF
m =p+g
where g = DYF/YF . So,
p = m g.
So p = 0 only if m = g. Hence the conclusion.
Controlling the quantity of money
quantity of commodity-money is
determined by supplies of the commodity
quantity of fiat money is determined by the
monetary authorities:
printing notes (traditional but direct way)
open-market operations
modern version of the same thing
involves buying and selling government bonds
When the Central Bank buys
bonds from the public
BSP
BSPLIABILITIES
ASSETS

Currency
Bonds 150
100
+ 50 + 50
Foreign assets 50

Total
Total 150
150
200 200
but Its liabilities also
its assets increase by rise because of the new
the value of the bonds currency it must issue to
it acquires pay for them.
Open-market operations
When the central bank buys bonds from the
public, it issues new currency to pay for
them. Both its assets and liabilities
(currency) rise. Money supply expands.
When the central bank sells bonds to the
public, it takes in their money as payment.
It reduces its liabilities (currency) as well
as its assets. Money supply contracts.
Suppose exporters and OFWs
exchange their dollars for pesos
BSP
BSPLIABILITIES
ASSETS

Currency
Bonds 150
100
+ 25
Foreign assets 50
+ 25
Total
Total 150
150
175 175
but Its liabilities also
CB assets increase by rise because of the new
the peso-value of the currency it must issue in
dollars it acquires exchange.
Exports and loans
When earners of foreign exchange (e.g.,
exporters) or borrowers of foreign loans
exchange their dollar proceeds for pesos, the
Central Bank effectively expands the currency:
foreign assets rise, liabilities increase.
When demanders of foreign-exchange buyers
exchange their pesos for dollars, the Central
Bank accepts reduces its foreign assets and
also reduces its liabilities. Money supply
contracts.
4.3 Interest rates and
money demand
Interest rates and bonds
Controlling the money supply will depend on
whether the Central Bank can persuade
the public to hold more or fewer bonds
(i.e., more or less currency) in their
portfolio.
This will depend on the rate of interest.
Interest rates and bonds
The interest rate i is the return on different forms of financial
wealth other than money.
E.g. debt (IOUs) issued by the government (T-bills) or by private corporations promise a
percentage annual return.
Hence i can also be defined as the cost of holding money
instead of these other assets.
Holding P100 in cash rather than a bond that promises
P110 a year from now means foregoing 10% per annum.
James, Inc.

James, Inc. promises to pay the bearer


the amount of
one hundred thousand pesos only
redeemable one year
from the date indicated below
1 January 2013

Signed: Henry James


Interest rates and bonds
A bond is a promise to pay a certain amount at some future date
The interest rate is implied in the ratio of the face value (FV) of
a bond to the price (P) at which it is sold:
FV P = (1 + i)
If a bond with P100,000 face value is sold for P90,000, then:
1 + i = 100,000 90,000
= 1.11
i = 0.11.
For a fixed face value, the higher is the price of the bond, the
lower is the interest rate (i.e., the more funds the firm can
obtain, the less the bond-buyer gains).
Interest rates and bonds
In order to persuade bond-holders to sell their bonds,
the Central Bank must offer a higher price for these.
But this amounts to saying the interest rate on bonds is
reduced.
Firms wishing to issue new bonds will then find they
can get a good price for these effectively being able
to borrow from the public at a lower interest rate.
Essentially, therefore, the expansion of money supply
through open-market operations lowers interest rates
for all.
Conversely, contracting money supply will raise interest
rates.
Inflation and interest rates
QTM says a 1-percent increase in money supply
causes a 1-percent increase in the inflation rate.
In turn the Fisher Equation says a 1-percent increase
in inflation will cause a 1-percent increase in the
nominal rate of interest.
i =r+m
Hence in the long run, the nominal interest rate
reflects the growth of money supply.
Choosing between assets
Bonds
yield an interest rate, i = r + p
but not a medium of exchange
Money
the medium of exchange
but has a zero or negative yield ( p )
The interest rate is the cost of holding money.
Choosing between assets
People will hold their wealth in different forms
(Dont put your eggs in one basket.)
They want the convenience of transacting, but
also want their assets to grow and earn.
So they will demand both money and bonds and
hold some wealth in each form.
Choosing between assets
If the interest rate rises, the cost of holding
money increases.
People will want to shift their portfolio to hold
more bonds and less money.
As the interest rate rises, the demand for bonds
increases and the demand for money falls .
Demand for money
Originally, the QTM showed only real income as influencing
real-money demand:
M/P = L(Y) , e.g., M/P = kY
Now, two influences: real income and the interest rate
M/P = L(i, Y).
,+
This also implies money-velocity is not constant.
People will demand more money as their income increases,
But they will economise on money balances when interest
rates are higher.
Money in the long run
Y = F(K, L) full employment
S(Y) = I(r) investment-saving
M/P = L(r ,Y) money demand-supply
(N.B. Assume p = 0, so that i = r)
Full employment of factors determines output and income.
Full-employment saving determines the interest rate and
investment.
Interest rate and output determine the demand for real
balances.
Demand for real balances and given money supply
determine the price level.
Some long-run results
1. If Y increases, S rises, r falls, money demand
rises, P falls.
Story: An economy with rising income will save more
and face lower real interest rates. If the monetary
authorities keep money supply constant, prices
will be stable or even decline.
Some long-run results
2. If M increases, only P is affected (it rises) [In the
long run, money is only a veil.]
Story: In the long run, the levels of the factors of
production (and the rate of saving) determine the
level of income. Managing the money supply
affects only the price level.
Some long-run results
3. Higher G (or lower T) lowers S and raises r ; money
demand falls, P rises.
Story: In the long run, higher government spending merely
reduces saving (and investment) and therefore reduces
the prospects of future growth. Interest rates rise and flee
from money towards bonds. Money supply is excessive
relative to income so prices rise. So, pursued long
enough, government deficits will raise prices and reduce
growth.
Some long-run results
4. If I increases, r rises, money demand falls, P rises.
Story: If the investment motive increases exogenously
with saving fixed, interest rates are bid up. People
shift from money to bonds; excess money supply
causes prices to rise. So, unless saving
increases, higher investment will cause higher
prices (though also raise growth prospects).
Commercial banks
In practice, the BSP deals not mainly with the public but
with commercial banks, or KBs.
KBs can borrow from and lend to the BSP, as well as
borrow from and lend to the public.
KB liabilities take the form of current accounts (CA),
savings accounts (SA), and time deposits (TDs),
among others.
Examples of KB assets are cash, government and
corporate bonds, various loans, and reserves with the
central bank.
4.4 Commercial banks
Commercial banks
Rather than directly hold liabilities (e.g., bonds and
loans) of the government and corporations, the
public can hold the liabilities of KBs instead
(CAs, SAs, TDs). Two advantages to the public
of doing this:
(1) KB liabilities are less risky (KBs are less likely
to default than corporations).
(2) KBsliabilities (CAs and SAs) can be used as
means of payment, i.e., they are also money.
Commercial banks
KBs earn profits through the principle of fractional-reserve
banking.
(1) People entrust their cash with the KB in exchange for
current accounts or savings- or time-deposits.
(2) But KBs need to keep ready only a fraction h of the
cash in reserve, since people do not need all of their
cash at once. This is called the required-reserve ratio.
(3) Therefore, the proportion (1 h) can be lent out by
the bank.
(4) Profit arises from the difference between the interest
paid to depositors and that charged to borrowers.
When the public deposits P50 with a KB
KB
KBLIABILITIES
ASSETS

Checking deposits 100


Cash in vault 150
+ 50 + 50
Loans 50

Total
Total 150
150
200 200
but Its liabilities also
KB assets increase rise because it owes
by the value the depositor.
of the deposit
When the public deposits P50 with a KB
KB
KBLIABILITIES
ASSETS

Checking deposits 150+50


Cash in vault 100+50
- 40
Loans 50 It only needs to keep a
+ 40 fraction of the original
deposit in its vaults
Total
Total 200200
.. the rest can be lent out
at interest
When the public deposits P50 with a KB
KB
KBLIABILITIES
ASSETS

Checking deposits
Cash in vault 200 110

Loans 90

Total
Total 200
200
The money-multiplier
So, both KB assets and liabilities increase by P50.
But if the required-reserve ratio is 1/5, the bank needs
to keep only 20% of the deposited amount.
So it needs only to keep P10 in the vault and can lend
out P40 by creating a checking account for the
borrower.
Suppose the P40 is deposited with the bank again (or
some other bank); then it need keep only P8 in the
vault and lend out P32, and so on
Initial deposit of Z and
required-reserve ratio of h
LendDeposit
out as CA
Round 1: Z (1 h)Z
Round 2: (1 h) (1Z h)(1 h)Z
Round 3: (1 h)2Z (1 h)3Z
Round N: (1 h)N (1
1
Z Zh)NZ

..
The money-multiplier
Let (1 h) = v. What is the total amount of current accounts
created from an original deposit of Z?
The answer is:
Z + vZ + v2Z + v3Z + = ZV,
where V = (1 + v + v2 + ) = (1 + v( 1 + v + v2 + ))
V = (1 + vV), or (1 v)V = 1
V = 1/(1 v) = 1/(1 1 + h) = 1/h.
So, ZV = Z/h; the initial cash deposit can support current
accounts equal to a multiple 1/h of itself.
The money-multiplier
Example: If the public deposits an original P100, and the
required-reserve ratio is 12%, the commercial banking
system can create checking accounts equal to a
maximum of
P100 0.12 = P100 8.33 = P833,
or credit equal to P733.
Obviously, if the BSP reduces the required-reserve ratio,
KBs could create even more credit and money supply.
So raising or lowering the required-reserve ratio is
another tool of monetary policy.
Another tool of the BSP
Sometimes it is inevitable that KBs run short of cash for their
depositors.
They can then borrow from the BSP at some interest rate,
called the rediscount rate, to pay off their depositors. This
reduces liabilities to depositors but increases liabilities to
the BSP. (So total liabilities remain the same.)
By doing this, KBs dont have to call in the loans they made to
borrowers.
But if the rediscount rate is high, KBs might find it better to call
in loans (or to be more conservative in lending). So a higher
rediscount rate reduces money supply.
Monetary tools of the BSP
To summarise, the tools the central bank can
use to control the money supply are:
1. open-market orperations;
2. changing the reserve-requirement of KBs;
3. changing the rediscount rate, or other rates at
which the KBs can borrow or lend money with
the BSP.
End of chapter

You might also like