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 %

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 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

MONEY SUPPLY
⮚ the stock of all liquid assets available for transactions in the economy at any given point
in time. The 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.

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 ⮚ 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

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).

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.

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 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

Graph M illustrates the recession of 2001. During the recession, output (real GDP) is at Y0, 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 I0 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.