This document discusses the role of money in the economy, including: 1) Money creation and different monetary systems like fractional reserve banking. 2) The demand for money which includes transactions, precautionary, and speculative motives. 3) How governments control money supply and demand through monetary policy tools like interest rates. 4) The classical view that only real factors like output affect wealth, while money is neutral, versus Keynesian views of uncertainty. 5) How the real sectors of output and financial markets interact with the monetary sector through the quantity theory relationship of MV=PY.

1. Lecture 2
Role of money in the economy cont.
[Chetty et al chapter 14 and Dennis chapter 3 available on
Blackboard ]
Money creation and money supply
Money creation and money destruction
Money creation in a monopolistic banking system
• Hundred percent reserve system – result
gold standard
• Fractional reserve system under the:
gold exchange standard
bank-money standard 1

2. The demand for money
• Transaction
• Precautionary
• Speculative
2

3. The control of money supply and money demand by government
Monetary policy in South Africa
Inflation targeting
Monetary independence:
• Operational
• Instrumental
Interest rate and inflation target
• MPC
• Repo-rate
• Accommodation policy
• Lags
Open market operations and liquidity reserve requirement
3

4. The classical school of thought
(Only the real sector matters in the creation of
economic wealth)
Topic Pages
The real sector in the economy:
The real market and real prices including interest rate (demand for
and the supply of goods and services or real exchange)
Dennis
43-46
The money sector in the economy:
The money market and nominal prices and interest rate (demand for
and the supply of money or money exchange and the interest rate
Dennis
47-54
The transmission of the money influence in the economy:
A change in the supply of money
A change in the demand of money
The Classical dichotomy and the neutrality of money in the economy
Dennis
54-60
4

5. Opposing schools
• Classical
Specific assumption: Certainty or risk on the variables and structures
of these variables due to incomplete information on the determination
of the supply and the demand of goods, services and money
• Keynesian
Specific assumption: Uncertainty on the variables and structures of
these variables in the determination of the supply and the demand of
goods, services and money
5

6. General assumptions:
• About money in the economy
• Money = medium of exchange only – reason – institution and
instrument develop inside by economic forces – scarce factor – only
introduced when can increase in economic wealth – the economic
theory contradicts the social theory of money of Keynes
• Money supply exogenous – value fixed by implication
• The need of money for transactions is stable
Assumptions needed to be able to proof money is neutral (therefore
money does not change relative prices but only aggregate nominal price)
and does not change real factors like investment and production and
therefore economic wealth (utility).
Thus only act as oil for the economic machine – not the fuel as in
Keynesian theory
• About goods and services in the economy
• Economic wealth (utility) is determined by real factors (variables) only 6

7. The functioning of different sectors and
markets
Real sector – PY
Connection between the real and monetary
sectors
Link described by the Quantity theory:
MVPY
• Output and labour market (determines wages and YF)
• Output and the capital market (determines interest rate)
i) THE LABOUR MARKET
7

8. • Demand for labour
• demand – marginal
productivity of capital =
marginal production – law
of decreasing demand –
demand=f(-w/p)
• Supply of labour
Derived supply – increase
in wage have to
compensate the increase
inloss of leisure
supply=f(w/p)
• Production function
• Law of diminishing returns
• Capital kept constant
• change in labour does not
change production –
optimal use of labour –
implies full employment
point
N
N
W/P
Y
YF
NF
SL
DL
8

9. Importance of wage flexibility
• W=50, P=5, W/P=10
• If P falls to P=2
• W/P rises to 50/2=25
• DL down and SL up
• = Unemployment
• If W is flexible, then it will
fall to W=20 immediately
• So that W/P=20/2=10
• Back to real wage where
there is no unemployment
N
W/P
SL
DL
10
25
Jobs
offered
Jobs
wanted
9

10. ii) Capital market
• Saving
• r is opportunity cost of present
consumption – increase in
savings implies increase in rent
to compensate increase in
future consumption
• Savings = f(r)
• Investment
• r determines profitability of
investment
• Real rate (𝑟𝑛) = natural interest
rate
• Investment = f(-r)
• Capital market in equilibrium –
implies also full employment
and optimal production – why?
K
r
S
I
rn
10

11. Monetary sector - MV
Connection between the real and monetary
sectors
Quantity theory: MVPY
• Assume:
• Money only for transactions
• Money supply exogenously determined by
variables outside the economy
• V the need for money, is stable (structure and
variables which impact on V)
11

12. i) Money and financial markets
Money market
• DM = f(I; y)
• SM = exogenously determined
• SM = DM
Equilibrium money rate of
interest
Financial market
• Bonds
• DB
• SB
• Inverse relationship between i
and PB
Real funds
Money
rate (i)
DM
Bonds
1/Price of
bonds
DB
SB
12
SM

13. Real, money and financial rates equalise
• Investment rises
• Real rate rises
• Need financing
• Demand for loanable
funds increases
Capital
r S
I1
rn
Real funds
i
DM (I)
i2
Bonds
1/PB
DB (S)
SM (S)
SB (I)
• Money and real rates
equalise
• Satisfy demand by selling
financial assets
• Supply of bonds rises and PB
falls
rn
2
SB
DM
i1
I2
13

14. The transmission channel of a money
influence on wealth in the economy:
• Money rate (i)
• Financial market in equilibrium
• Nominal i = r + p
• p is the demand inflation rate
• Real i - p = r
• With no intervention in money market no demand
inflation : p=0
• money interest rate i = r
14