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E co money

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E co money

1. 1. Demand for and supply of money
2. 2. What is money?     Money is anything that is generally acceptable as a means of payment in the settlement of all transactions General acceptability – unique feature of money Money is what money does Purchasing power
3. 3. Functions of money  Medium of exchange  Measure of value /unit of account  Standard of deferred payments  Store of value
4. 4. Kinds of money   Fiat money (legal tender)  Coins  Currency notes Fiduciary (credit) money  Deposits  Bank deposits – Demand and time deposits  Post office deposits
5. 5. Measures of money supply  M1 = C + DD + OD  M2 = M1 + savings deposits with post office savings banks  M3 (AMR) = M1+ net time deposits of banks  M4 = M3 + total deposits with post office savings organization
6. 6. Quantity theory of money   Variations in quantity of money impacts prices, money and real income, rate of interest Two approaches    Quantity theory of money Keynesian theory Quantity theory   Irving Fisher’s transactions version Cambridge cash balances approach
7. 7. Fisher’s QTM  M*V = P*T       M – stock of money – depends on monetary system V – velocity of circulation – average number of times a unit of money changes hands in a given period P – average price of market transactions T – physical volume of transactions Assuming V and T constant, direct relation between M and P Ms = Md
8. 8. Cash balances approach  Marshall and Pigou Md = K P y  K – behavioural constant – ratio of money income people like to hold in the form of money – measured in time units – 0<K<1  P – average price level  y – real income In equilibrium, Md = Ms    K is reciprocal of V (turnover per time period)
9. 9. Money market      Money as an asset Money market Demand – consumers – general public Supply – producers of money – government, monetary authority and banking system Equilibrium in money market
10. 10. Demand for money      Sum total of all the money demanded by general public including households and firms Demand for money is demand for real balances i.e. purchasing power of money Why do people demand money? or What are the determinants of people’s demand for money? Neoclassical theory – cash balances approach Keynesian theory
11. 11. Keynesian theory of Md    Why do people demand money when there are other non-money financial assets that earn income for holders? Money demand due to two characteristics – general acceptability as means of payment and perfect liquidity Motives for demanding money    Transactions motive Precautionary motive Speculative motive
12. 12. Contd….  Md = f (Y, r)     Y – income r – rate of interest Transactions & precautionary demand depends on Y – similar to Cambridge approach Speculative demand – most important contribution of Keynesian analysis to monetary theory – depends on r – Tobin’s argument – demand for money depends on expected yields and riskiness of the yields of other assets
13. 13. Contd….     Downward sloping aggregate demand for money w.r.t. rate of interest Liquidity trap – a situation in which at a certain low rate of interest, demand for money becomes perfectly elastic People not willing to hold money in bonds and convert to cash Increase in money supply gets trapped as people hoard money
14. 14. Contd….    Demand for and supply of money affect economic activity through r and changes in real investment depending on r Determination of rate of interest – intersection of demand for and supply of money Ms – determined exogenously by the monetary authority
15. 15. Supply of money      Ordinary money (M) and high-powered money (H) M=C+D H=C+R Relation between M and H H is the monetary base that consists of currency and banks’ reserve deposits with central bank
16. 16. Contd….       H theory of money supply Hs is policy determined i.e. given exogenously to public and banks Hd = Cd + Rd Cd = c . D, where c is the currency deposit ratio, a behavioural ratio that expresses people’s preferences between currency and deposits Rd – required reserves and excess reserves Rd = r. D, where r is the reserve deposit ratio, ratio of reserves to total deposits of banks
17. 17. Money multiplier  Hd = Cd + Rd  Hd = c. D + r. D = (c + r) D  M = C + D = (1 + c) D In equilibrium, Hs = Hd         Money multiplier = mm = M / H mm = (1 + c ) / (c + r) M = {(1 + c ) / (c + r)}. H mm depends on currency deposit ratio, c and reserve deposit ratio, r mm > 1 mm is larger the smaller is r mm is larger the smaller is c