LECTURE ONE

INTRODUCTION TO MONETARY ECONOMICS

Lecture Outline
1. Introduction
2. Objectives
3. Definition and Origin of Money
4. Characteristics of Money
5. Functions of Money
6. Forms of Money
7. The Liquidity Spectrum
8. The Value of Money
9. Narrow and Broad Money
10. Money Concepts in Kenya
11. Summary
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.1 Introduction
Monetary economics is concerned with the management of
money and other monetary variables to achieve economic
stability.

Therefore monetary economists study :

• what constitutes money,
• the demand for money
• the supply of money,
• the institutions that control money in the economy and
• the formulation and implementation of monetary policy
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.2 Definition and Origin of Money

Definition
Money is basically defined as a medium of exchange.

Origin
Money as we know it today was invented to overcome the limitations of barter trade.

Major limitations of barter trade:

1. It was not easy to achieve a double coincidence of wants in exchange.
2. The size of the economy was limited due to a small size of business transactions that could be
consummated.
3. Barter limited the division of labor which was required to increase efficiency and the level of
productivity.
4. Barter trade entailed significant shopping time. This reduced the time available for other productive
economic activities.
5. In the barter economy it was possible to confuse the use value and the exchange value of
commodities.
6. Commodities are perishable and therefore cannot be stored for long. When commodities that are
used as currency perish the barter system of exchange collapses.
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.4 Characteristics of Money

As money evolved certain characteristics came to be expected from the commodity
acting as money :
1. Acceptability: Money should be generally accepted by virtue of its intrinsic value: if
not because of that, then by decree, convention or convenience.
2. Scarcity: To be scarce, money’s supply should remain less than its demand.
3. Recognizability: Money should be readily recognized in order to avoid unfair
practices.
4. Divisibility: Money should be capable of being divided into small units without loss
of value.
5. Stability: The conditions of money’s supply and demand should remain stable so
that its ‘value’ remains stable.
6. Homogeneity: Each unit of money should be exactly the same as every other unit.
7. Portability: Each unit of money should have small weight and build compared to
its value, so that it could be easily carried out.
8. Durability: Any commodity acting as money should not be a wasting asset, either
physically or in terms of its value; no one wants to hold on to a wasting asset.
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.5 Functions of Money

Money performs at least the following five functions in the economy:

1. The Medium of Exchange

2. Unit of Account
3. Standard of Value
4. Store of Value
5. Standard for Differed Payment
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.6 Forms of Money

In the modern society different items are used as money.

1. Commodity money

2. Precious Metals

3. Coins

4. Paper Money

5. Bank Deposits

6. Near-Money
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.7 Liquidity Spectrum

A liquid asset is one which can be easily turned into cash without the risk of
loss.

The liquidity spectrum has two extremes and a middle point:

1. Most liquid extreme consists of real money with instant liquid purchasing
power.
2. The least liquid extreme consists of physical assets which are the least
liquid
3. In the middle we have near money assets which have a definite money
value but which do not directly function as a medium of exchange.

On the liquidity spectrum there are no clear boundaries between various

types of financial assets (it is a continuum) because there is substitutability
between assets at the margin.
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.8 The Value of Money

The value of money is measured by its purchasing
Thus the value of money changes inversely with changes in the general price level.

1.8.1 Index Numbers and the Value of Money

Changes in the value of money are measured by index numbers.

Index numbers attempt to measure changes in the purchasing power of money over time.

The most commonly used indices are:

1. Consumer Price Index (CPI)

2. Retail Price Index (RPI)

3. Wholesale Price Index (WPI)

4. Tax and Price Index (TPI)

 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.8.2 Inflation, Deflation and the Value of Money

Inflation
Inflation is an economy is manifested by an increase in the general price level.
The net result of inflation on the value of money is to decrease the purchasing power of money.
There are four major causes of inflation in the economy. These are:
1. High demand for bank loans which when granted and spent, increase money supply. The resulting increase
in demand pulls up the prices of consumer and capital goods.
2. Heavy government spending to reflate the economy, in order to bring it out of deep recession, can also
create inflation. This causes prices to rise until increased output matches increased aggregate demand.
3. A successful and continuous demand for higher wages will cause businessmen to raise prices continuously
in order to recoup their higher labor costs.
4. An inflationary psychology which motivates people to spend savings quickly in order to avoid a future
decline in the purchasing power of their money.

Deflation
Deflation causes a decrease in the general price level, due to a decrease in total spending relative to the supply
of goods and services on the market.
Deflation increases the value of money i.e. its purchasing power.
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.9 Narrow Money and Broad Money

There are blurring differences between money and quasi-money or near-
money.

Narrow money refers to financial assets which perform the medium of

exchange function of money.

Financial assets must have a high degree of liquidity to be regarded as narrow

money.

Broad money includes financial assets which are relatively liquid, but not as
liquid as narrow money items.

Broad money serves more than one of the four functions of money discussed
earlier in this lecture.
 LECTURE ONE
INTRODUCTION TO MONETARY ECONOMICS

1.10 Money Concepts in Kenya

The Kenya government uses monetary aggregates to define and measure money. The monetary
aggregates used locally are M0, M1, M2, M3, M3X, and M3XT.

Usually M0 and M1 are defined as narrow money whereas the remaining aggregates are referred
to as broad money.

The components that make up the each monetary aggregate are specified below:
M0 = currency in circulation
M1 = M0 + Demand Deposits
M2 = M1 + Time Deposits
M3 = M2 + Deposits of Non-Bank Financial Institutions
M3X = M3 + Foreign Exchange Deposits of all residents in a country
M3XT = M3X + Treasury Bills

The need for new and broader monetary aggregates arises from innovations in the financial
sector.

END