Monetary Economics:

The Role of Money 1

To appreciation the subject

the following should be
performed:
 1.Historical Zimbabwean
financial structure 1980-2015
In tabular form show the historical
structure in Zimbabwean financial
institutions:
1980 1.Cenral Bank (CB)/Reserve
Bank(RB) and its functions.
2.Commercial Banks and their functions.
3. Merchant Banks and functions.
4.Discount houses and their functions.
5.Other financial institutions and their role
in the economy.
 2.Comment on topics to be
covered in the course
1 Introduction to money and monetary
economics.
2.Concept of money
3. The demand for money
4. The supply of money
5. Financial intermediation and regulation
6. Monetary policy
7. International monetary relations
8. The stock exchange
3.What is monetary economics-
Suggestions:
discuss
A branch of economics which analyses money in its
function as MEDIUM OF EXCHANGE, STORE OF
VALUE AND UNIT OF ACCOUNT.
Monetary economics also considers how money is
accepted as public good because of convenience.
Monetary economics considers monetary instruments that
can be used to get financial institutions bring about
intended changes in level of economic performance.
Appropriate monetary instruments can be used to obtain
a required exchange rate level in international economic
trade relations so as to maintain a favourable balance of
trade.
Monetary economics is a branch of macro-economics.
 4.Role of Financial
Markets/Institutions
Bringing together of buyers and sellers of
financial securities to establish prices
Provides a mechanism for those with
excess funds (savers) to lend to those
who need funds (borrowers)
Includes banks, savings and loans, credit
unions, investment banks and brokers,
mutual funds, stock and bond markets
 Money
Currency – bills(notes) and coin
Includes demand deposits (checking
accounts) issued by banks
Through financial institutions and financial
markets, money plays a key role in
influencing the performance of the
economy as a whole.
 Monetary Economy
Facilitates transactions within the
economy
Principal mechanism through which
central banks attempt to influence
aggregate economic activity
– Economic Growth
– Employment
– Inflation
 Banking
Place where savers can invest their funds
to earn interest with a minimum of risk.
Make loans to individuals and small
businesses
 Banks
Banks serve as the principal caretaker of
the economy’s money supply, and along
with other financial intermediaries, provide
important source of funds.
Banks are intimately involved in how the
central bank influences overall economic
activity
 Monetary Policy
The central bank directly influences the
lending and deposit creation activities of
banks
Flow of funds from lenders to
borrowers
What is the proper amount of
money for the economy?
Sir William Petty (1623–87) wrote in 1651
“To which I say that there is a certain
measure and proportion of money requisite
to drive the trade of a nation, more or less
than which would prejudice the same”
– Too much money will lead to inflation
– Too little money will result in an inefficient economy
(Deflation)
 Functions of Money
Standard of value (unit of account)
– or unit of account for all the goods and services we
might wish to trade.
Medium of exchange
– it is the only financial asset that virtually every
business, household, and unit of government will
accept in payment of goods and services.
Store of value
– reserve of future purchasing power.
 Liquid Asset

Something (AN ASSET) that can be turned into

a generally acceptable medium of exchange,
without loss of value
Liquidity is a continuum from very liquid to
illiquid
Currency (NOTES AND COINS ISSUED BY
THE STATE) and checking accounts (DEMAND
DEPOSITS) of the public (including companies)
in commercial banks are most liquid assets
 Monetary Base
A “base” amount of money that serves as
the foundation for a nation’s monetary
system.
Under a gold standard, the amount of gold
bullion.
In a fiat money system, the sum of
currency in circulation plus reserves (notes
and coins and deposits of Banks at the
Central Bank) of banks and other
depository institutions.
Currency:
The Monetary Base
– Coins and paper money (notes and coins).
Reserves:
– Cash held by depository institutions in their vaults and
deposited with the Central Bank.
Monetary Base = Currency + Reserves or B = Cp + Cb + Db =
Cp + R, Where R = (Cb +Db) = Reserves(non interest
bearing) of commercial banks deposited with the Central Bank.
The CB may require that a fraction of the reserves be put aside
for monetary policy reasons = reserve ratio or required
reserve.
Monetary Base is also known as “High Powered Money ”
Although reserves are non interest bearing, they are important
because the confidence in the banking system depends on the
ability of the system to convert deposits into notes and coin
when requested by beneficiaries.
M = Cp + Dp = Broad money
 The Use Of Coins
Seigniorage:
– The difference between the market value of
money and the cost of its production, which is
gained by the government that produces and
issues the money.
Debasement:
– A reduction in the amount of precious metal in
a coin that the government issues as money.
 Monetary Aggregate
A grouping of assets sufficiently liquid to be
defined as a measure of money.
 What is the money supply?
M1
– Currency + checking accounts
M2
– M1 + savings accounts + small CDs +MMDA
+MMMF
M3
– M2 + large CDs
 Who Determines Our Money
Supply?
The Reserve Bank is responsible for
execution of national monetary policy
– Board of Governors
Who Determines Our Money
Supply?
The Reserve Bank (RB) influences the
total money supply, but not the fraction of
money between currency and demand
deposits which is determined by public
preferences
The Central Bank(CB) implements
monetary policy by altering the money
supply and influencing bank behavior
 Barter
Direct exchange of goods/services for
other goods/services
– Very inefficient and limited economy
– No medium of exchange or unit of account
– Requires double coincidence of wants—”I
have something you want and you have
something I want”
– Items must have approximate equal value
– Need to determine the “exchange rate”
between different goods/services
 Money
Any commodity accepted as medium of
exchange can be used as money
Frees people from need to barter
Makes exchange more efficient
Permits specialization of labor—sell one’s
labor to the market in exchange for money
to purchase goods/services
 Money
Prices, expressed in money terms, permit
comparison of values between different
goods
Must retain its value—the value of money
varies inversely with the price level
(inflation)
If money breaks down as a store of value
(hyperinflation), economy resorts to barter
How Large Should the Money
Supply Be?
Purchase goods/services economy can
produce, at current prices
Generate level of spending on Gross
Domestic Product (GDP) that produces
high employment and stable prices
Monetary Policy is used as a
countercyclical tool—vary the money
supply to influence economic activity
Increases in the Money Supply Alters Public’s
Liquidity and Influences Spending

Direct Impact—excess liquidity is spent on

goods/services
Indirect Impact—purchase financial assets
which lowers interest rates which stimulates
business investment and consumer spending
However, changes in liquidity may alter demand
for money and not influence GDP—people
hoard the additional money
Public’s reaction to changes in liquidity is not
consistent, so CB cannot always judge impact of
a change in money supply
 Velocity
When the CB increases the money supply,
recipients of this additional liquidity
probably will spend some on GDP
Over time there will be a multiple increase
in spending
 Velocity of Money
The number of times the money supply turns
over in a period of time to support spending on
output
The CB has no control over the velocity of
money since this is dependent on behavior of
the public
– It is possible the public will choose to hold onto the
additional liquidity (hoarding of money)
Ultimately, the RB needs to be concerned
whether the additional spending which results
from increased money supply will result in higher
production or higher prices
 Velocity of Money
Velocity is the way in which the quantity of
money is related to economic activity.
The speed with which money is spent.
Velocity = changes in spending/quantity of
money = ΔGDP/ΔM.
If Velocity = 5, then if M increases by $10
billion, GDP will rise by $50 billion.
 Money and Inflation
Inflation—Persistent rise of prices
Hyperinflation—Prices rising at a fast and
furious pace
Deflation—Falling prices, usually during
severe recessions or depressions
Inflation reduces the real purchasing
power of the currency—can buy fewer
goods/services with the same nominal
amount of money
 Money, The Economy, and
Inflation
Economists generally agree that, in the
long-run, inflation is a monetary
phenomenon—can occur only with a
persistent increase in money supply
Increase in money supply is a necessary
condition for persistent inflation, but it is
probably not a sufficient condition
 Examples
Case 1—Economy in a recession.
– Expanding money supply may lead to more
employment and higher output
Case 2—Economy near full employment/output.
– Expanding money supply can lead to higher
output/employment, but also higher prices
Case 3—Economy producing at maximum.
– Expanding money supply will most likely lead to
increasing inflation.
 Money and Inflation
To return to the 1940s, the smallest bill
would be $10 and the smallest coin would
be a dime.
 Hyperinflation Example
GERMANY : Hyperinflation occurred in Germany after
World War I, with inflation rates sometimes exceeding
1000 percent per month. By the end of hyperinflation in
1923, the price level had risen to more than 30 billion
times what it had been just two years before. The
quantity of money needed to purchase even the most
basic items became excessive. Near the end of the
hyperinflation, a wheelbarrow of cash would be required
to pay for a loaf of bread. Money was losing its value so
rapidly that workers were paid and given time off several
times during the day to spend their wages before the
money became worthless. No one wanted to hold on to
money, and so the use of money to carry out
transactions declined and barter became more and more
dominant.
ZIMBABWE HYPER INFLATION
 Who creates money?
The Reserve Bank
Depository Institutions
The Public
 Fractional Reserve System
Required Reserves
Excess Reserves
 How a bank creates money
Assets Claims
Reserves Transactions Deposits
Securities Savings Deposits
Loans CDs
Equity
 Money and Banking in the
Digital Age
Cybertechnologies:
– Technologies that connect savers, investors, traders,
producers, and governments via computer linkages.
Electronic money (e-money):
– Money that people can transfer directly via electronic
impulses.
Wire transfers:
– Payments made via telephone lines or through fiber-
optic cables.
 Money in the Digital Economy
Electronic Payments
– Automated clearinghouses:
Institutions that process payments electronically on behalf of senders and receivers of those
payments.
– Point-of-sale (POS) transfer:
Electronic transfer of funds from a buyer’s account to the firm from which a good or service is
purchased at the time the sale is made.
– Automated bill payment:
Direct payment of bills by depository institutions on behalf of their customers.
FOR THE NATURE AND HISTORY OF MONEY see Lipsey Ch 41
Next Lecture

MONEY SUPPLY PROCESS

If monetary authorities wish to conduct monetary policy they have to decide which assets to
include in the definition of money and, therefore, which assets they are going to monitor.
We have seen that most monetary authorities work with three measures of money, namely the
monetary base, narrow money and broad money, variously denoted MO, M1, M2, M3, M4.
The aim of this lecture is to find out how changes in the quantity of money occur.
We shall consider two approaches to money supply determination. The two approach we shall
consider are:
1. The base-multiplier approach (B-M) to money supply determination
2 The Flow of Funds Approach (FoF).
Because money consists predominantly of bank deposits we need to be familiar with the
balance sheet of commercial banks and that of the central bank. This will help to under stand
the flow of funds between commercial banks on the one hand and the flow of funds between the
commercial banks and the central bank on the other hand.
BANK BALANCE SHEETS.