International and Monetary Economics

Course Code: 30054

Professor: Dmitriy Sergeyev

Lecture 6

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 Roadmap
• Money and Interest Rates
– What is money?
– Money supply
– CBDC
– Money demand
– Money market equilibrium

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Money and Interest Rates

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 What is Money?
• Lay English
“That person has a lot of money”
= “That person is wealthy”
• In Economics
– “Money” has a more specific meaning
– Roughly
• The asset that people use to make transactions and set prices in terms of
– Today: dollars, euros, yens, etc.
– Past: gold, silver, corn, etc.

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 Functions of Money

1. Store of Value: obvious

good medium of exchange should be information insensitive asset
—> in the sense that no new information affects too much

2. Medium of Exchange: money solves double-coincidence-of-

wants problem We say that a security is information-insensitive if no agent
finds it profitable to produce private information about the
payoffs to the security and all agents know that this is the
case. The cost of producing the private information is
greater than the expected value of the information.
3. Unit of Account
Definition: A standard numerical unit of measurement of market value for
goods, services, and other transactions. Use: Can be used to compare goods
using a common system. Example: Housing prices in Japan can be compared
using the yen as a unit of account. 5
Money Supply

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 How to measure money supply?
• Idea
– Add things that people use for transactions

• In reality Private banks use Central Bank Reserves

– Some assets are used more frequently in transactions than others

– As a result, central banks compute several measures of money supply
Public money vs Private Money

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 Money Supply
Central Bank issued money from most liquid to less liquid
• Monetary base
= notes and coins in circulation
+ notes and coins in bank vaults
Bank
+ reserve deposits at the Federal reserves
Reserve
• 𝑀1 = 𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒 • 𝑀1 = currency, overnight deposits
notes and coins in circulation
+ demand deposits
+ other checkable deposits
• 𝑀2 = 𝑀1 • 𝑀2 = 𝑀1
+ retail money market mutual funds + deposits with agreed maturity up to 2 years
+ savings and small time deposits + deposits redeemable at notice up to 3
+ overnight repurchase agreements months
• 𝑀3 = 𝑀2 + repurchase agreements, money
market mutual funds debt securities up to 2 years’
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maturity
US Money Supply

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 ENTRY

A “new” liability of the Fed: Treasury Balances

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Euro Area Money Supply

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Central Bank Digital Currency
(CBDC)

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Source: Atlantic Council
 CBDC
• What is CBDC?
– Digital tokens (i.e., digital records of value that can be exchanged in
transactions) created by central banks
– Essentially, firms and regular people have access to central bank
reserves With CBDC, now, firms and regular people can have access to CB reserves too

• Why do central bankers talk about CBDC these days?

– Important recent trend: digitalization of money
• Cryptocurrencies, WeChat's/Alipay's digital wallets, M-Pesa, Facebook’s Libra

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 One of the Biggest New Questions in Central Banking

• The UK House of Lords report (Jan 13, 2022)

– CBDCs are a “solution in search of a problem”

• A report on a digital euro for the European parliament (Jan, 2022)

• The Federal Reserve discussion paper (Jan 20, 2022)

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 What should be the purpose of a CBDC?
• The UK House of Lords report
– CBDCs are a “solution in search of a problem”
• A report on a digital euro for the European parliament
– “The main rationale for developing a digital euro is therefore to preserve
the role of public money in a digital economy.”
– What is so special about public money?
• Central banks money does not face banks’ solvency problems because it is supported
by governments’ power to tax and by legal tender.
• CB money provides the ultimate settlement asset between banks [very useful in time
of crises].
• CB money also defines the unit of account [allowing a conduct monetary policy].

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 Would it disrupt the activities of banks?
• What do banks do?
– Issue deposits
– Distribute credit
– Clear payments
• If customers find CBDS more attractive to park their deposits
and to use for payments, funding will be more expensive for
traditional banks. This will increase the cost of credit to firms
and people, harming investment
– This will be costlier in Europe where bank intermediation is more
prevalent than, for example, in the US
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Money Demand

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 Individual Money Demand
• Interest rates/expected rates of return
– (Usually) no interest on money
– 𝑅 = opportunity cost of holding money (interest rate on gov. bonds)
• Risk
– the risk comes from unexpected inflation, which reduces the purchasing
power of money.
– But same risk with other assets (e.g. bonds)!
• Liquidity
– The fact that money is a convenient medium of transaction is the key
reason why people want to hold it despite a lower return compared to
government bonds
– The volume of transactions will affect the demand for money
 Aggregate Money Demands
• Aggregate money demand is the sum of individual money
demands of people, financial and non-financial firms

• Determinants
– Interest rates (opportunity cost)
– Income
– Price level (because money is usually a nominal variable)
 Aggregate Money Demand
• The aggregate demand for money can be expressed as:
𝑀𝑑
= 𝐿 𝑅, 𝑌
𝑃 -, +
– P is the price level
– Y is real national income GDP = value of transactions
– R is a measure of interest rates on nonmonetary assets
– L(R,Y) is the aggregate real money demand L refers to liquidity
Aggregate Money Demand

the higher the R, the less the demand

Money Market Equilibrium

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Money Market Equilibrium

𝑀 𝑠 𝑀𝑑
=
𝑃 𝑃

𝑀𝑠
= 𝐿(𝑅, 𝑌)
𝑃
Money Market Equilibrium
excess supply if we were at 2, at 2
people are willing to but interest
bearing assets, with the increased
demand, the price of these assets
increase (interest rate decreases)
—> Money demand goes up
 Money Market Equilibrium
• Adjustment to equilibrium
– Suppose 𝑀s > 𝑀d
– People are willing to buy interest bearing assets (bonds)
– The price of these assets increases
(or the interest rate decreases)
– Money demand goes up
𝑀 𝑠 = 𝑀𝑑
 Exercise 1
A Decrease in Money Supply

𝑅1 1
𝐿(𝑌, 𝑅)

𝑀1𝑆 𝑀
𝑃 𝑃
 Exercise 1
A Decrease in Money Supply

𝑅2 2

𝑅1 1
𝐿(𝑌, 𝑅)

𝑀2𝑆 𝑀1𝑆 𝑀
𝑃 𝑃 𝑃
 Exercise 2
A decrease in real income

𝑅1 1
𝐿(𝑌1 , 𝑅)

𝑀1𝑆 𝑀
𝑃 𝑃
 Exercise 2
A decrease in real income

𝑅1 1
𝐿(𝑌1 , 𝑅)
2
𝑅2
𝐿(𝑌2 , 𝑅)

𝑀1𝑆 𝑀
𝑃 𝑃
 Readings

• Next lecture:
– KOM, Chapter 16

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