MBARARA UNIVERSITY OF SCIENCE AND TECHNOLOGY

MONETARY ECONOMICS

ECO3207

GROUP 2

NAME REG NO

NASAASIRA BLAIR 2021/ECO/033/PS

KIIZA BERNARD SAMUEL 2021/ECO/014/PS

KANOEL AFRAH 2021/ECO/010/PS

KIRENDA PIUS LYAMU 2021/ECO/030/PS

1a). What is the relationship between money stocks and money supply?

Money stocks refer to the total quantity of money held by individuals, businesses, and
institutions within an economy. This includes physical currency (like coins and banknotes) as
well as various types of deposits in banks and other financial institutions.

On the other hand, money supply refers to the total amount of money available in an economy at
a given point in time. It encompasses not only the money stocks but also other liquid instruments
that can be readily converted into cash, such as certain types of savings deposits and money
market funds.

MONEY SUPPLY COMPONETS

Monetary policy deals with money supply in the economy with broad aim of regulating its
growth so as control rate of inflation.

From April 1997 RBI employs 4 components of money supply.

M1 = Currency in circulation + Demand deposits with banking system +Other deposits of RBI
(UTI, NABARD, World Bank, IMF, IDBI & IFCI) M1 is known as Narrow Money

M2 =M1 + Post office saving deposits

M3 =M1+ Time deposits with banking system. M3 is known as Broad Money

Suppose the amount of money in circulation increases from M0 to (1 + t) M0, where t is a positive
constant. It will be seen that a new equilibrium position will come to exist in which prices and
wages have risen in the same proportion as the amount of money and the rate of interest has
remained unchanged.

Thus, when the amount of money in circulation was M0, the equilibrium of the economy was
attained by p0, w0 and r0. But when the money increases to (I + t) M0 the new equilibrium is
attained at the price level (I + t) P0, wage rate (I + t) w0 and interest rate remaining unchanged at
ro. Now, when the prices rise in the same proportion as the amount of money, the real value of
cash balances is exactly the same as it was in the beginning or in the initial period t and the rate
of interest remains unchanged.

Hence, the new aggregate demand (function) must be identical with the aggregate demand
(function) of the initial period and as the market for goods was in equilibrium in the initial period
it must be in equilibrium now. Similarly, if wages and prices rise in the same proportion then the
real wage rate remains the same as it was in the initial period and, therefore, the labour market
which was in equilibrium at the initial real wage rate (w0) must be in equilibrium now.
The position in money market is slightly different. When the amount of money supplied has
increased from M0 to (I + t) M0, it is clear that the demand function (schedule) for money must
also change and if the demand schedule for money does not change and remains in its original
position, then it is obvious that the equilibrium cannot be attained at the initial rate of interest ro.
We know that the demand schedule for money cannot remain in its original position because the
nominal amount of money demanded depends upon the price level and if the price level
increases, so must also the demand for money.
In other words, in the initial period when the price level is p0 and the rate of interest is r0, people
wish to hold M0 (amount of money)—but when the price level has increased from p0 to (I + t) P0,
people must wish to hold the larger amount of money; say, (I + t) M0. Hence, when the amount
of money in circulation is (I + t) M0, the money market, too, is or becomes in equilibrium at the
price level (I + t) p0 because the demand for money has gone up to (I + t) M0 but the rate of
interest will remain unchanged at r0 as shown in the Fig. 29.1.
Patinkin has shown that the same kind of equilibrium is possible even when the analysis is
dynamic, that is, through different time periods. The typical time paths of the variables would be
such as to generate equilibrating forces e.g., the quantity theorists assert that in the initial stages
after an increase in the amount of money the rate of interest would decline (from Or0 to Or1 in
Fig. 29.1); but that when prices begin to rise due to increase in money supply, the interest rate,
too, would rise again to its original level (from Or0 to Or1). In other words, with an increase in
the quantity of money the price level no doubt rises continuously towards the new equilibrium
level and the same will be true of the wage rates. Under these circumstances, Patinkin’s analysis
has shown that the interest rate may decline first but rises once again to its original value.
Equilibrium in the market can be established only at a rate of interest lower than r 0, for only by
such reduction could individuals be induced to hold additional money availableM4 = M3 + Total
Post office saving deposits (excluding NSC)

The relationship between money stocks and money supply is that money stocks are a component
of the broader money supply. Money stocks represent the actual quantity of money held by
individuals, businesses, and institutions within an economy, including physical currency and
various types of deposits. On the other hand, money supply encompasses not only money stocks
but also other liquid instruments that can be readily converted into cash, such as certain types of
savings deposits and money market funds.

In summary, changes in money stocks can affect the overall money supply, as money stocks are
one of the components used to calculate the total money supply in an economy. The relationship
between the two highlights the importance of monitoring both money stocks and broader money
supply aggregates for understanding the liquidity and functioning of an economy.

b). Differentiate between money stocks and money supply

Definition: Money stocks refers to the total quantity of money held by individuals, businesses,
and institutions within an economy, including physical currency and various types of deposits
while Money supply represents the total amount of money available in an economy at a given
point in time, including money stocks as well as other liquid instruments that can be readily
converted into cash.

Scope: Money stocks focuses specifically on the quantity of money held by economic agents,
such as households, firms, and financial institutions whereas money supply encompasses a
broader range of liquid assets beyond money stocks, including certain types of savings deposits,
money market funds, and other near-money assets.

Components: Money stocks includes physical currency (coins and banknotes) and various types
of deposits held in banks and other financial institutions whereas money supply comprises
money stocks along with other liquid instruments that can serve as a medium of exchange, such
as certain types of savings deposits and money market funds.

Measurement: Money stocks are measured in terms of the quantity of currency in circulation and
the balances held in different types of bank accounts while money supply is measured as the total
stock of money available in the economy, which includes money stocks as well as other liquid
assets.

Regulation:
Money stocks are not typically regulated directly, but changes in money stocks can influence
monetary policy decisions whereas money supply often regulated by central banks through
monetary policy tools to achieve macroeconomic objectives such as price stability and economic
growth.

c). What is the relationship between normal and real value of money?

The relationship between the normal and real value of money relates to the purchasing power of
money over time.

Normal Value of Money: This refers to the face value or nominal value of money, which is the
amount printed on currency notes or coins. For example, if you have a $10 bill, its normal value
is $10.

Real Value of Money: This takes into account the purchasing power of money, adjusted for
inflation or changes in the general price level of goods and services. In other words, the real
value of money reflects how much goods and services a unit of money can buy. If inflation
erodes the purchasing power of money, the real value decreases, meaning the same amount of
money can buy fewer goods and services over time.

The relationship between normal and real value of money is influenced by inflation or deflation.
When inflation occurs, the real value of money decreases because prices rise, reducing the
purchasing power of money. Conversely, during deflation, the real value of money increases
because prices fall, increasing the purchasing power of money.

Monitoring the relationship between normal and real value of money is essential for
understanding the impact of inflation or deflation on individuals' purchasing power and overall
economic conditions. Central banks often aim to maintain price stability to preserve the real
value of money and support sustainable economic growth.

2.Explain factors that determine money multiplier

Money Multiplier (m): It refers to the degree to which money supply expanded as a result of
increase in high power money
𝑀
Thus m = where M =Money Supply and H =Monetary Base
𝐻

The size of money multiplier is determined by

cash reserve ratio set by commercial banks (r),

excess reserves set by banks (e) and • currency deposit ratio of public (c) 𝑀 𝟏+𝒄
Money Multiplier (m) = =
𝐻 𝒓+𝒆+𝒄

Where r = cash reserve ratio e= excess reserves ratio set by banks c = currency deposit ratio

𝟏+𝒄
Money Supply M = ×H
𝒓+𝒆+𝒄

• The above equation can be interpreted in the following way

1. Money Supply (M) is directly proportional to the monetary base (H).

2.Money Supply (M) inversely related with r, e and c.

Thus, money supply in the economy depends upon the behavior of central bank,
commercial banks and general public

The money multiplier is influenced by several factors, including:

Reserve Requirements: The percentage of deposits that banks are required to hold as reserves by
the central bank. Lower reserve requirements lead to a higher money multiplier, as banks can
lend out more of their deposits.

Currency Drain: The portion of deposits that individuals hold in cash rather than depositing in
banks. A higher currency drain reduces the effectiveness of the multiplier, as less money is
available for banks to lend out.

Excess Reserves: The amount of reserves banks hold beyond what is required by regulations. If
banks hold more excess reserves, the money multiplier decreases, as they are less likely to lend
out additional funds.

Bank Behavior: The willingness of banks to lend out deposits or hold excess reserves affects the
money multiplier. During economic uncertainty, banks may be more conservative in lending,
reducing the multiplier.

Central Bank Policies: Monetary policies implemented by the central bank, such as open market
operations and changes in reserve requirements, can directly impact the money multiplier.
Adjustments in these policies can influence banks' ability and willingness to create credit.

3. Find out what is the monetary base multiplier approach

The monetary base multiplier approach, also known as the money multiplier approach or the
simple money multiplier, is a method used to estimate the potential increase in the money supply
resulting from changes in the monetary base. The monetary base, also called the monetary base
or high-powered money, consists of currency in circulation and reserves held by commercial
banks at the central bank.

The formula for the monetary base multiplier approach is:

Money Multiplier= Total Money Supply/Monetary Base

Where:
Total Money Supply: The total amount of money circulating in the economy, including currency
and demand deposits.

Monetary Base: The sum of currency in circulation and reserves held by commercial banks at the
central bank.

The money multiplier indicates how much the money supply will increase for each unit increase
in the monetary base. It depends on several factors, including the required reserve ratio set by the
central bank and the behavior of banks in lending out their reserves.

Money Multiplier approach to Supply of Money identifies 3 factors as immediate

determinants to supply of money

a.The stock of high powered money (H)

b. The Ratio of reserves to deposits (Reserves/ Deposits ER/D) and

c. The Ratio of Currency to deposits c =(C/D)

The supply of money varies directly with monetary base or high power money and
varies inversely with the currency and reserve ratios

Commercial banks do keep a certain percentage of deposits as reserves stipulated

by central bank.

➢Impact of increase/decrease in such reserves

➢In practice banks keep more than required percentage as reserves to meet any
unexpected contingencies.

➢Any such excess reserves do not lead to creation of money

➢Excess reserves involve an opportunity cost

➢If deposit outflow is likely to increase, then banks hold excess reserve and vice
versa The Behavior of the Public
 The amount of currency held by public relative to deposits will determine the
nominal deposits of commercial banks

➢For example public hold more cash on their hand and then lesser the credit
expansion in the economy and vice versa

The formula for calculating the money multiplier is simplified for illustrative purposes. In
reality, the actual money multiplier may vary due to factors such as the existence of excess
reserves, the desire of the public to hold currency, and the behavior of non-bank financial
institutions.

The monetary base multiplier approach is a theoretical concept used by central banks and
economists to understand the relationship between changes in the monetary base and the broader
money supply in the economy. However, its accuracy in predicting changes in the money supply
may be limited in practice due to the complexity of real-world banking operations and other
factors affecting money creation.

4. Identify any empirical literature of 2 different countries. What is driving money in that
economy?

Below are examples of empirical literature from two different countries exploring factors driving
money in their respective economies:

Nigeria:

Study: "Determinants of Money Demand in Nigeria: An ARDL Approach" by Mohammed

Amino Bello and Abu-Bakr Musa.

Findings: This research investigates the determinants of money demand in Nigeria using the
autoregressive distributed lag (ARDL) approach. The study identifies variables such as income,
interest rates, inflation, and financial innovation as key drivers of money demand in the Nigerian
economy. Additionally, the authors examine the impact of monetary policy measures and
banking sector reforms on money demand dynamics.

South Africa:

Study: "Determinants of Money Demand in South Africa: A Structural Vector Auto Regression
Approach" by Thabo Mokwena and Tendani Ramukumba.

Findings: This study employs a structural vector auto regression (SVAR) approach to analyze the
determinants of money demand in South Africa. The authors find that factors such as income,
interest rates, inflation, and financial deepening significantly influence money demand dynamics
in the South African economy. Moreover, the study explores the effects of economic policies,
financial market developments, and external shocks on money demand fluctuations.

These studies shed light on the factors driving money demand in Nigeria and South Africa,
providing insights into the unique characteristics and challenges of their respective economies.

Question 5

Differentiate between demand pull and cost push inflation

Demand-Pull or excess demand inflation is a situation often described as “too much money
chasing too few goods.” According to this theory, an excess of aggregate demand over aggregate
supply will generate inflationary rise in prices. Its earliest explanation is to be found in the
simple quantity theory of money.

The theory states that prices rise in proportion to the increase in the money supply. Given the full
employment level of output, doubling the money supply will double the price level. So inflation
proceeds at the same rate at which the money supply expands.

In this analysis, the aggregate supply is assumed to be fixed and there is always full employment
in the economy. Naturally, when the money supply increases it creates more demand for goods
but the supply of goods cannot be increased due to the full employment of resources. This leads
to rise in prices.
Modem quantity theorists led by Friedman hold that “inflation is always and everywhere a
monetary phenomenon. The higher the growth rate of the nominal money supply, the higher the
rate of inflation. When the money supply increases, people spend more in relation to the
available supply of goods and services. This bids prices up. Modem quantity theorists neither
assume full employment as a normal situation nor a stable velocity of money. Still they regard
inflation as the result of excessive increase in the money supply.

The quantity theory version of the demand-pull inflation is illustrated in Figure 3. Suppose the
money supply is increased at a given price level OP as determined by the demand and supply
curves D and S1 respectively. The initial full employment situation OYF at this price level is
shown by the interaction of these curves at point E. Now with the increase in the quantity of
money, the aggregate demand increase which shifts the demand curve D to D1 to the right. The
aggregate supply being fixed, as shown by the vertical portion of the supply curve SS1 the D1
curve intersects it at point E1. This raises the price level to OP1.
The Keynesian theory on demand-pull inflation is based on the argument that so long as there are
unemployed resources in the economy; an increase in investment expenditure will lead to
increase in employment, income and output. Once full employment is reached and bottlenecks
appear, further increase in expenditure will lead to excess demand because output ceases to rise,
thereby leading to inflation.

The Keynesian theory of demand -pull inflation is explained diagrammatically in Figure 3.

Suppose the economy is in equilibrium at E where the SS1and D curves intersect with full
employment income level OYF. The price level is OP. Now the government increases its
expenditure. The increase in government expenditure implies an increase in aggregate demand
which is shown by the upward shift of the D curve to D1 in the figure. This tends to raise the
price level to OP1, as aggregate supply of output cannot be increased after the full employment
level.
Cost-Push Inflation

Cost-push inflation is caused by wage increases enforced by unions and profit increases by
employers. This type of inflation has not been a new phenomenon and was found even during the
medieval period. But it was revived in the 1950s and again in the 1970s as the principal cause of
inflation. It also came to be known as the “New Inflation.”

Cost-push inflation is caused by wage-push and profit-push to prices for the following
reasons:
1. Rise in Wages:

The basis cause of cost-push inflation is the rise in money wages more rapidly than the
productivity of labor. In advanced countries, trade unions are very powerful. They press
employers to grant wage increases considerably in excess of increases in the productivity of
labor, thereby raising the cost of production of commodities. Employers, in turn, raise prices of
their products.

Higher wages enable workers to buy as much as before, in spite of higher prices. On the other
hand, the increase in prices induces unions to demand still higher wages. In this way, the wage-
cost spiral continues, thereby leading to cost-push or wage-push inflation. Cost-push inflation
may be further aggravated by upward adjustment of wages to compensate for rise in the cost of
living index.
2. Sectoral Rise in Prices:

Again, a few sectors of the economy may be affected by money wage increases and prices of
their products may be rising. In many cases, their production such as steel, raw materials, etc. are
used as inputs for the production of commodities in other sectors. As a result, the production cost
of other sectors will rise and thereby push up the prices of their products. Thus wage- push
inflation in a few sectors of the economy may soon lead to inflationary rise in prices in the entire
economy.

3. Rise in Prices of Imported Raw Materials:

An increase in the prices of imported raw materials may lead to cost-push inflation. Since raw
materials are used as inputs by the manufacturers of the finished goods, they enter into the cost
of production of the latter. Thus a continuous rise in the prices of raw materials tends to sets off a
cost-price-wage spiral.
4. Profit-Push Inflation:

Oligopolistic and monopolist firms raise the prices of their products to offset the rise in labor and
production costs so as to earn higher profits. There being imperfect competition in the case of
such firms, they are able to “administer prices” of their products. “In an economy in which so
called administered prices abound there is at least the possibility that these prices may be
administered upward faster than cost in an attempt to earn greater profits.
To the extent such a process is wide-spread profit-push inflation will result.” Profit-push
inflation is, therefore, also called administered-price theory of inflation or price-push inflation or
sellers’ inflation or market-power inflation. Cost-push inflation is illustrated in Figure 4. Where
S1 S is the supply curve and D is the demand curve. Both intersect at E which is the full
employment level OYF, and the price level OP is determined. Given the demand, as shown by the
D curve, the supply curve S1 is shown to shift to S2 as a result of cost-push factors. Consequently,
it intersects the D curve at E1 showing rise in the price level from OP to OP1 and fall in aggregate
output from OYF to OY1level. Any further shift in the supply curve will shift and tend to raise the
price level and decrease aggregate output further.
Policy Response:

Cost-push inflation: Addressing cost-push inflation often involves measures to mitigate the
factors driving up production costs. This may include policies aimed at increasing productivity,
reducing regulatory burdens, or managing wages and prices through government intervention.

Demand-pull inflation: Policymakers typically respond to demand-pull inflation by

implementing monetary or fiscal policies to manage aggregate demand. This may involve raising
interest rates to reduce borrowing and spending, implementing fiscal austerity measures, or using
contractionary monetary policy tools to cool down the economy.

In summary, while both cost-push and demand-pull theories of inflation describe situations
where prices rise, they differ in their primary causes, effects on output, and policy responses.
Cost-push inflation originates from increases in production costs, while demand-pull inflation
stems from excess demand relative to supply in the economy.

Cost-push inflation is driven by rising production costs, while demand-pull inflation is driven by
excess demand relative to supply.

Question six

Explain the concept of;

I). Money growth and inflation

The concept of money growth and inflation is closely linked, as changes in the money supply
often have implications for the overall price level in an economy:

Money is a medium of exchange, a unit of account, and a store of value. It's used to facilitate
transactions and represent value. Inflation, on the other hand, is the rate at which the general
level of prices for goods and services rises, eroding purchasing power over time. This means that
the same amount of money buys fewer goods and services as time goes on. Inflation typically
occurs when the supply of money exceeds the supply of goods and services available in the
economy, leading to a decrease in the value of money. Central banks often aim to manage
inflation to ensure price stability and promote economic growth.

Money Growth: Money growth refers to the increase in the supply of money in an economy over
time. This increase in the money supply can occur through various channels, such as central bank
monetary policy, banking activities (such as lending), or government spending.

Inflation: Inflation is the sustained increase in the general price level of goods and services in an
economy over a period of time. When inflation occurs, each unit of currency buys fewer goods
and services than it did before. Inflation can be caused by various factors, including increases in
demand relative to supply (demand-pull inflation), increases in production costs (cost-push
inflation), or increases in the money supply (monetary inflation).

The relationship between money growth and inflation can be summarized by the Quantity
Theory of Money, which states that the price level in an economy is directly proportional to the
money supply and the velocity of money (the rate at which money changes hands). Therefore, if
the money supply increases faster than the growth rate of real output (i.e., goods and services
produced), inflation tends to occur.

In the 1980s, Argentina, Bolivia, Brazil, and Israel have experienced very large inflation rates,
all over one hundred percent a year and some over a thousand. We can confidently expect
several more cases of large inflation over the next decade.

But why? If the relation between money growth and inflation is so clear, why don't these
countries simply print less money? If only it were so easy! The real problem most of these
countries had was a large fiscal deficit. Let's think how that influences monetary policy. If a
government is running a deficit, then it must issue iou's of some sort to pay for it. Roughly,
speaking, it may issue money (dollar bills or their local equivalent) or interest-bearing debt
(treasury bills and notes) denoted with the variable B. Mathematically we can express this as

Pt (Gt - Tt) = dMt + dBt,

or, in real terms:

Gt - Tt = dMt / Pt + dBt / Pt

where the two terms on the right are issues of new money (dM) and new interest-bearing debt
(dB), respectively. This is an example of a government budget constraint: it tells us that what the
government doesn't pay for with tax revenues, it must finance by issuing debt of some sort.

So why do these countries increase the money supply? The problem, typically, is that a political
impasse makes it nearly impossible to reduce the budget deficit. Given the government's budget
constraint, it must then issue debt. Now for US debt there is apparently no shortage of ready
buyers, but the same can't be said for Argentina or Russia. If they can't issue debt and they can't
reduce the deficit, the only alternative left is to print money: in short, when they can't pay their
bills any other way, they pay them with money, which is easy enough to print. The effect of this,
of course, is that these countries experience extremely high rates of inflation.

Note that whenever a central bank prints "fresh money" it can obtain goods and services in
exchange for these new pieces of paper. The amount of goods and services that the government
obtains by printing money in a given period is called "seignorage". In real terms, this quantity of
goods and service is given by the following expression:

Seignoraget = dMt / Pt = New bills printed during the period / Price level during the period.

The monetary aggregate that the central banks control directly is the "monetary base", consisting
of currency in the hands of the public and reserves of the commercial banks deposited in the
central bank. Thus, when we refer to a central bank as "printing more money", we mean
increasing the monetary base.
Note that since the government, by printing money, acquires real goods and services, seignorage
is effectively a tax imposed by the government on private agents. Such a seignorage tax is also
called the inflation tax. The reason is the following. From the definition of seignorage:

Seignoraget = dMt / Pt = (dMt / Mt ) (Mt/Pt)

Since the rate of growth of money (dM/M=m) is equal to inflation (p) (assuming, for simplicity,
that the rate of growth of output 'y' is zero), we get:

Seignoraget = pt (Mt/Pt)

Central banks closely monitor money growth and its potential impact on inflation when
formulating monetary policy. They aim to manage money growth to maintain price stability and
support sustainable economic growth.

ii).money and employment

The concepts of money and employment are fundamental to understanding economic activity
and policy. Here's a breakdown of each:

Money: Money serves as a medium of exchange, a unit of account, and a store of value in an
economy. It facilitates transactions by eliminating the need for bartering and enables individuals
to trade goods and services efficiently. Money can take various forms, including currency (coins
and banknotes) and bank deposits. Central banks typically have the authority to issue and
regulate the money supply, which plays a crucial role in influencing economic activity, including
employment.

Employment: Employment refers to the number of people who are currently working for pay in
an economy. It is a key indicator of economic health and plays a central role in determining
individuals' standard of living. Employment levels are influenced by factors such as labor market
conditions, technological advancements, government policies, and overall economic
performance. High levels of employment typically indicate a healthy economy with ample job
opportunities, while low employment levels may signal economic downturns or structural
challenges.

The relationship between money and employment is complex and can be influenced by various
factors:

Monetary Policy: Central banks use monetary policy tools, such as interest rates and money
supply management, to influence economic activity, including employment levels. For example,
lowering interest rates and increasing the money supply can stimulate borrowing, spending, and
investment, which may lead to increased employment. Conversely, tightening monetary policy
can slow down economic activity and potentially lead to unemployment.

Aggregate Demand: Changes in the money supply can affect aggregate demand in an economy,
which, in turn, influences employment levels. When consumers and businesses have more
money to spend (due to increased money supply), aggregate demand tends to rise, leading to
increased production and employment. Conversely, a decrease in the money supply can dampen
aggregate demand and result in lower levels of employment.

Inflation: Changes in the money supply can also impact inflation levels, which, in turn, can affect
employment. High inflation rates may erode purchasing power, leading to reduced consumer
spending and potentially lower employment levels. Conversely, moderate inflation can
sometimes be associated with economic growth and higher employment levels, as it may
stimulate investment and spending.

Overall, the relationship between money and employment is complex and multifaceted, with
various factors influencing their dynamics within an economy. Policymakers must carefully
manage monetary policy to promote economic stability, sustainable growth, and full
employment.
.