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Money. Money Supply and Money Demand

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  1. Money. Money Supply and Money Demand Frederick University 2014

  2. Money & the Payments System • meaning of money • functions of money • forms of money • measuring money

  3. without money • barter for stuff -- need “double coincidence of wants” -- inefficient: more time shopping, less time producing

  4. example • I have exam 2, want to trade it for soda

  5. You have to want the exam & be willing to give up soda AND I have to want the soda & be willing to give up exam

  6. double coincidence of wants

  7. The Meaning of Money • anything commonly accepted in exchange for goods/services • many objects throughout history

  8. examples • livestock • shells • metals • cigarettes

  9. to act as money, must be • measurable • divisible • widely accepted • durable

  10. Forms of Money • commodity money has its own value as a good -- gold & silver coins

  11. Paper money - a substitute for the commodity money - freely convertible

  12. credit money (fiat money) -- no value other than fact that it’s accepted in exchange for goods and services

  13. Our money is fiat money! • NOT backed by gold • coins do not contain silver or gold

  14. fiat money is more efficient • commodity money has opportunity cost: you could use it for something else

  15. debit or credit cards? • NOT money • payment mechanisms

  16. money, income, & wealth • money • what is accepted as payment • income • earnings during time period (year) • wealth • accumulated assets at a point in time

  17. money, wealth are STOCKS • amount at a point in time • income is a FLOW • amount during a time period

  18. examples • I own € 2 million in diamonds. • I am wealthy • I have no money

  19. I win € 25 million in lottery • I put it under my bed • I quit my job • I am wealthy • I have a lot of money • my income is zero

  20. software engineer • earnings € 100,000/yr • blows it all, every paycheck • high income • no wealth

  21. Functions of Money • money is a means of payments • (medium of exchange) -- accepted as payment for goods and services -- main function of money

  22. money is a unit of account -- money is used to measure value

  23. if something costs €5, not that valuable • if something costs € 500, that’s valuable

  24. money is a store of value -- use money to save, accumulate wealth, buy stuff later -- money is liquid asset

  25. money is NOT always a good store of value -- political instability -- poor economy -- high inflation

  26. example Historically, the U.S. dollar has been a good store of value • but when the $ started falling in value, this changed…

  27. Measuring Money How much money do we need? The quantity of money (money supply) depends on the value of goods and services that will be bought … = P x Q

  28. Measuring Money and on the velocity of money circulation = the number of transactions, served by the same money asset (V)

  29. example • I buy from George coffee with a €2 coin • George buys from Maria a newspaper with the same €2 coin • Maria buys from Sofia a sandwich with the same €2 euro coin • One and the same €2 coin serves 3 transactions • Therefore, for these transactions we do not need €6 but only €2 • The velocity of circulation (V) is 3 • The greater the velocity, the smaller the quantity of money needed.

  30. The quantity of money M = (P x Q) : V or MV = PQ

  31. Measuring Money • Money aggregates • amount of cash (coins and banknotes) BUT • other forms of money too (quasi - money

  32. M1 (high power money) = currency in circulation (cash) + demand deposits + checkable deposits + traveler’s checks

  33. M2 = M1 + savings deposits + small time deposits

  34. Comparing measures • get larger • M1 < M2 • add less liquid assets to larger measures

  35. Which measure is best? • move together in general • BUT behavior can vary in short-term • M2 most watched

  36. Money Demand • Money demand – the quantity of liquidity that the public would like to hold at every level of the interest rate, ceteris paribus

  37. Motives for money demand • Transactionary to pay purchases

  38. Precautionary because of the possible lack of synchronization of payments

  39. Speculative (liquidity preference) • because holding money has an opportunity cost • money has time value – it may bring interest • on the one hand, people are motivated to have liquidity, • on the other hand, they want extra income (interest) • … when the interest rates fall, people will be willing to convert part of their interest bearing assets into liquidity • … when the interest rates increase, the liquidity preference diminishes.

  40. Equilibrium on the Money Market i MS MD M/P

  41. Factors, Determining Money Demand • Nominal GDP • Current transactions • Expectations • Frequency of payments • Synchronization of payments • Wealth

  42. Financial Institutions • Banking institutions: • The Central bank • Commercial Banks • Nonbanking: • Insurance funds • Pension funds • Investment funds • Mortgage funds • Brokering houses • Mutual funds

  43. Commercial Banks The Balance sheet of a commercial bank liabilities assets loans deposits reserves

  44. The Money Tree Deposit Multiplier – Maximum increase in money supply as a result of the increase in the reserves of the banking system

  45. The Deposit Multiplier €1000 new reservesenter Commercial Bank “А” Reserves (safety) 1000 + 800 + 640 + 512 + … 200 Loans (income) 800 DM = ΔD/ ΔR 160 640 128 512

  46. The Central Bank Functions: • Control on money supply • Supervision of Commercial Banks • Banker of the government • Providing cash • Lender of last resort • Monetary policy • Control on reserves • Foreign currency policies and external payments

  47. Central Bank Liabilities: Coins and notes Deposits of the CBs Assets: Foreign currency Government bonds Loans to the Treasury and to CBs The Central Bank