MODULE 2

MONEY: A Unique Financial Instrument

MONEY
 the set of liquid assets that are generally accepted in exchange for goods and services.
FUNCTIONS of Money
 the primary function of money is to facilitate exchange of goods and services.
1. As a medium of exchange – because money is a readily acceptable thing, it serves as an intermediary
in facilitating exchange transaction. It eliminates the problem of “double coincidence of demand” in a
barter system.
2. As a unit of account (Measure or standard of value) - money serves as a common denominator or
yardstick by which goods or services may be measured in terms of their exchange value. It eliminates
the problem of “inequality of value” in a barter system.

 in the performance of the basic function, money discharges these secondary functions:
3. As a store of value - money can be temporarily saved or invested at the present until you will need it to
exchange for goods or services in the future.
4. As a means of deferred payment - money serves as a standard of payment in all debt contracts
expressed in terms of money.
 as long as the value of money is constant, (Ex: no inflation or deflation, or exchange rate does not
change) it serves as an equitable standard of deferred payments.
5. As a transfer of value – money can be transferred from one person or place to another.

DEMAND for and SUPPLY of Money

Quantity of money demanded – the amount of money that people wants to hold, either in their wallets or
bank deposits, instead of using it to buy assets that generate income.

Factors Affecting Money Holding

1. PRICE Level – as price level of goods and or services increases, money holding increases
2. Nominal INTEREST RATE of investment assets- as nominal rate increases, money holding decreases
Nominal rate of interest in investment assets x%
Nominal rate of interest in money y%
Opportunity cost of holding money x-y %
 Inflation erodes money value, simulates the increase in interest rate on investment assets and therefore
increases opportunity cost of holding money.
3. REAL GDP –as volume of expenditure increases, money holding increases
4. FINANCIAL INNOVATION – technological changes and arrival of the following new financial
products decreases the necessity for money holdings
a. Daily interest checking deposits d. Credit cards and debit cards
b. Automatic teller machines (ATM) e. Internet banking and bill paying
c. Automatic transfers between checking and savings deposits
QUANTITY Theory of Money – states that in the long run, an increase in the quantity of money brings
an equal percentage increase in the price level (inflation).
INFLATION = money growth rate – real GDP growth rate

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 MONEY SUPPLY
 the stock of all liquid assets available for transactions in the economy at any given point in time. T he
most common measures of money supply are as follows:
M1 is defined broadly as money that is used for purchases of goods and services. It typically includes
coins, currency, checkable deposits (accounts that allow holders to write checks against interest-bearing
funds within them), and traveler's checks.
M2 is defined broadly as M1 plus liquid assets that cannot be used as a medium of exchange but that can
be converted easily into checkable deposits or other components of M1. These include time certificates
of deposit (CDs) less than $100,000, money market deposit accounts at banks, mutual fund accounts, and
savings accounts.
M3 includes all items in M2 as well as time certificates of deposit in excess of $100,000.

INTEREST RATES and the SUPPLY of and DEMAND for Money

1. DEMAND for Money is INVERSELY RELATED to Interest Rates
 as interest rates rise, it becomes more expensive to hold money (opportunity cost due to lost income),
thus reducing the demand for money.
2. SUPPLY of Money is Fixed at a Given Point in Time
 the supply of money is determined by the Central Bank and is therefore fixed at any given point in time
at the level set by the Central Bank.
 The following graph illustrates the demand for and supply of money. The intersection of the money
demand curve and the money supply line determines the interest rate.
The Money Market

Interest Rate MS MS 1

Equilibrium
interest rate;
I0
I1
Demand for Money

Quantity of Money

The Money Market: The equilibrium interest rate is found where the demand for money intersects the supply of money. The
money supply curve is vertical since the Central Bank controls the supply of money (thus it is independent of the interest rate). If
the Central Bank increases the money supply, interest rates will fall, as illustrated by the fall in interest rates from I0 to I1.
MONETARY POLICY AND THE MONEY SUPPLY
MONETARY POLICY is the use of the money supply to stabilize the economy. The Central Bank uses
monetary policy to increase or decrease the money supply in an effort to promote price stability and full
employment. Understanding the effects of changes in the money supply is important because changes in the
money supply lead to changes in interest rates, changes in the price level, and changes in national output
(real GDP).

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 The Central Bank controls the money supply through:
1. Open Market Operations (OMO) - consist of the purchase and sale of government securities (Treasury
Bills and bonds) in the open market.
a. Increase in the Money Supply - When the Fed purchases government securities, it increases the money
supply (i.e., puts money into circulation to pay for the securities).
b. Decrease in the Money Supply - When the Fed sells government securities, it decreases the money
supply (i.e., takes money out of circulation).

2. Changes in the DISCOUNT RATE - the interest rate the Central Bank charges member banks for short-
term (normally overnight) loans.
a. Member banks may borrow money from the Fed to cover liquidity needs, increase reserves, or make
investments.
b. Raising the discount rate discourages borrowing by member banks and decreases the money supply.
c. Lowering the discount rate encourages borrowing by member banks and increases the money supply.

3. Changes in the Required Reserve Ratio (RRR) - the fraction of total deposits banks must hold in
reserve.
a. Raising the reserve requirement decreases the money supply.
b. Lowering the reserve requirement increases the money supply.

MONETARY POLICY and its EFFECTS

 Monetary policy has a direct effect on interest rates and an indirect effect on the price level, real GDP,
and the unemployment rate.
A. EXPANSIONARY (EASY) Monetary Policy (INCREASES in the money supply) - designed to
help stimulate economic recovery or to avoid the dangers of economic downturn. It affects the
economy through these chain of events:
1.An increase in the money supply causes interest rates to fall.
2.Falling interest rates reduce the cost of capital and hence stimulate the desired levels of firm investment
and household consumption.
3.Increases in desired investment and consumption cause an increase in aggregate demand.
4.Aggregate demand shifts to the right, causing real GDP to rise, the unemployment rate to fall, and the
price level to rise.

B. CONTRACTIONARY (TIGHT/RESTRICTIVE) Monetary Policy (DECREASES in the money

supply) – designed to counter inflationary tendencies.
 the Government thru the Central Bank and BTr increase interest rates to increase savings and
decrease spending of the consumers and business sectors. It affects the economy in the exact
opposite of expansionary monetary policy.
1.A decrease in the money supply causes interest rates to rise.
2.Rising interest rates reduce the desired levels of firm investment and household consumption.
3.Decreases in desired investment and consumption cause a decrease in aggregate demand.
4.Aggregate demand shifts to the left, causing real GDP to fall, the unemployment rate to rise, and the
price level to fall.

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 EXAMPLE
The 2001 Recession and Monetary Policy
After growing steadily for almost a decade, the U.S. economy started to slow down at the end of 2000.
The slowdown in the economy was accompanied by a large drop in stock prices that marked the end of the
bull market of the late 1990's. In 2001, the U.S. economy experienced two consecutive quarters of
negative real GDP growth implying the economy had slipped into a recession. As the economy began to
falter, Alan Greenspan, the Chairman of the Federal Reserve, initiated expansionary monetary policy.
Specifically, the Federal Reserve began lowering interest rates by increasing the money supply. Lower
interest rates helped keep the economy from slipping even further into a recession. Specifically, lower
interest rates led to a large increase in home purchases starting in 2001 and continuing through 2002. In
addition, lower interest rates made it possible for the auto industry to offer attractive financing rates,
including zero-percent financing! This helped increase consumer purchases of automobiles and overall
demand for goods and services in the economy. The recession of 2001 and the actions taken by the
Federal Reserve are illustrated in Graphs L and M.
Graph L Graph M
Interest Rate Price Level
MS 0 MS 1 LRAS
SRAS

I0
P1

I1 P0
Money Demand AD 1
AD 0
Mo M1 Quantity of Money
Y0 Y1 Real GDP
Graph M illustrates the recession of 2001. During the recession, output (real GDP) is at Y 0, which is below
the potential level of output Y1, indicating a recession. Graph L illustrates the money market and the
expansionary monetary policy of the Federal Reserve. By increasing the money supply, the Federal
Reserve caused interest rates to fall from I 0 to I1. Lower interest rates spurred new home investments and
consumer consumption of durable goods such as automobiles. The increased consumption and
investment led to a shift right in aggregate demand as depicted in graph M. As aggregate demand shifted
right, real GDP began to increase and the economy began to recover from the recession.

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