Chapter 5

Money is for Lunatics

Demanders and Suppliers of Money

LEARNING OBJECTIVES

Functions of money

Four forms of money

Money creation by the Bank of Canada and

chartered banks

Relate bond prices and interest rates and

explain how money and bond markets

determine the interest rate

Differentiate the “Yes” and “No” camps’

positions on the monetary transmission

mechanism

IS IT SMART TO NOT WANT MONEY?DEMAND FOR MONEY

People demand money for its liquidity as a medium of exchange, unit of account, store of value. People willingly

give up interest on bonds to hold wealth as money.

DEMAND FOR MONEY

Money

anything acceptable as means of payment;

money has three functions

a) medium of exchangeacceptability solves barter problem of double coincidence of wants

b) unit of accountstandard unit for measuring, comparing prices

c) store of valuetime machine for moving purchasing power from present to future; earn now, spend later

Bondfinancial asset where borrower promises to

repay

original value, and make fixed interest

payments

Why hold wealth as money which pays no

interest, rather than as bonds which pay

interest?

money provides liquidity —assets easily convert into medium of exchange

money is most liquid asset — acceptable by sellers as means of payment

money pays no interest, but has liquidity; bonds pay interest, but do not have liquidity

Why hold money as a store of value?

“Yes” camphold more wealth as interest-paying bonds, since savings safely invested in loanable funds (bonds)

“No” camphold more wealth as money because fundamental uncertainty about future makes bond investments risky

Interest rate

price of holding money;

what you give up by not holding bonds

determined by demand and supply in both money and bond markets

Law of demand for money

as the price of money — interest rate — rises,

quantity demanded of money decreases

Fig. 5.1 Macroeconomic Demand for Money

Price(interest rate)

Quantity Demanded

(billions of dollars)

2% 100

4% 90

6% 80

8% 70

10% 60

Changes in real GDP or average prices

cause

change in demand for money

increase in real GDP increases demand for money; decrease in real GDP decreases demand

increase in prices increases demand for money; decrease in prices decreases demand

Fig. 5.2: Macroeconomic Demand for Money Before and After Real GDP Increases

Price(interest

rate)

Quantity Demanded (QD)

billions of dollars)

QD after Real

GDP Increases (billions of

dollars)

2% 100 200

4% 90 180

6% 80 160

8% 70 140

10% 60 120

SUPPLY OF MONEY

Forms of money

a)commodity money — saleable product with alternative uses

b)convertible paper money — paper money converted into gold on demand

c)fiat money — currency (government-issued paper bills and coins) with no alternative uses, valuable simply by government decree

d)deposit money — demand deposits — balances in bank accounts depositors withdraw on demand using debit card or cheque

CURRENCY IN CIRCULATION

M2

OTHERDEPOSITS

DEMANDDEPOSITSM1

$465 b

BILLIONS OF $

$951 b

Supply of money is

currency and deposit

money

M1 = currency in circulation and demand deposits

M2 = M1 plus all other less liquid deposits

continued…

Fig. 5.3 The Money Supply

Bank of Canada is Canada’s central

bank — government institution responsible

for supervising chartered banks and

financial institutions and for regulating the

supply of money

Bank of Canada roles issuing currency

banker to chartered banks — chartered banks pay each other with deposits at Bank of Canada

lender of last resort — making loans to banks to preserve stability of financial system

banker to government — managing government accounts, foreign currency reserves, national debt

conducting monetary policy — changing money supply and interest rates

Chartered banks create money (demand deposits) because of fractional reserve banking — banks hold a fraction of deposits as reserves

Banks face a tradeoff between profits and prudence

– smaller fraction of reserves, more loans, and higher-risk loans may yield more profits

Supply of money determined by Bank of Canada and chartered banks

– quantity of money supplied is a fixed amount at a moment in time

– supply of money does not change when interest rate changes

continued…

$ billion (August 2009)

Percentage of deposits

Total Funds 1925.3 169.0

Sources

Deposits 1139.1 100.0

Borrowing and own capital 786.2 69.0

Uses

Reserves 6.2 0.5

Liquid assets 319.4 28.0

Securities and other assets 169.8 14.9

Loans 1429.9 125.5

Fig. 5.4 Chartered Banks: Sources and Uses of Funds

Fig. 5.5 Supply of Money

Price(interest rate)

Quantity Supplied

(billions of dollars)

2% 80

4% 80

6% 80

8% 80

10% 80

WHAT IS THE PRICE OF MONEY?INTEREST RATES, MONEY, AND BONDS

Bond prices and interest rates are inversely related and determined together in money and bond markets.

MONEY AND BONDS

a) Interest rate is the price of money

– opportunity cost of holding money

– cost of borrowing money

b) Bonds promise to pay back original

value plus

fixed dollar amount of money

– bonds do not promise fixed interest percent

– when interest rates rise, market price of bond falls, vis-à-vis

– holding a bond until maturity, you receive fixed dollar payments plus original value

Fig. 5.6 Macroeconomic Demand and Supply for Money

Price(interest

rate)

Quantity of Money

Demanded(billions of

dollars)

Quantity of Money Supplied (billions of dollars)

2% 100 80

4% 90 80

6% 80 80

8% 70 80

10% 60 80

Interest rate determined by demand and

supply

in money and bond markets

at market-clearing interest rate, quantity of money demanded equals quantity of money supplied

when interest rate below market-clearing rate, excess demand for money; people sell bonds to get money; increased supply of bonds causes bond prices to fall, interest rate to rise

Many different interest rates on financial assets, but most interest rates rise and fall together

continued…

J.B. SAY AND J.M. KEYNES AS FACEBOOK FRIENDS?

MONEY, INTEREST RATES, INVESTMENT, & REAL GDP

“Yes” and “No” camps disagree about money’s effect on the frequency of business cycles and on how quickly markets adjust.

MONEY AND BUSINESS CYCLES

Does money affect key macroeconomic

outcomes of real GDP per person,

unemployment, inflation?

– money can affect inflation, according to quantity theory of money

– money does not directly increase aggregate supply or economic growth

continued…

Money indirectly affects real GDP and

unemployment through monetary transmission

mechanism —

how impact of money transmitted to real GDP

– demand & supply of money determine interest rate

– when interest rate falls, interest-sensitive purchases become cheaper so consumer spending (C) and business investment spending (I) increase

– increases in C and I increase aggregate demand

continued…

Fig. 5.7 Transmission Mechanism from Money Demand and Supply to Real GDP

lower interest rates are positive demand shock, increasing aggregate demand, increasing real GDP, decreasing unemployment, causing inflation

higher interest rates are negative demand shock, decreasing aggregate demand, decreasing real GDP, increasing unemployment, causing deflation

continued…

Economists disagree on the question “How

much does money change the economy

when economy is not in equilibrium?”

Say and “Yes, markets quickly self-

adjust” camp answer “not much.”

o money does not affect external supply shocks that are main source of business-cycles

o money allows savings to flow easily through loanable funds market for business borrowing, for investment spending

o money helps quick adjustments to equilibrium

continued…

Keynes and “No, markets fail to adjust”

camp answer “a lot”

o money gives people a way to save, creating possibility of financial crises and new internal demand shocks for business cycles

o money gives people a way not to spend, blocking transmission mechanism so loanable funds market does not match spending to savings

o money slows market adjustments to equilibrium

Fig. 5.8 How Much Does Money Matter for Business Cycles?

Camp

Compared to a barter economy, how does money

affect:

Yes — Left Alone, Markets Quickly Self-Adjust (Say)

No — Left Alone, Markets Fail to

Adjust (Keynes)

How Often Business Cycles

Happen

Money has no effect.

Money does not affect external supply shocks that are main source of business

cycles.

Money creates new shocks.

Money gives people a way not to spend, adding new internal

demand shocks.

How Quickly Markets Adjust

Money helps loanable funds market quickly

adjust to equilibrium.

Money blocks transmission mechanism,

slowing adjustment to equilibrium.