Debre Markos University College of Business and Economics Department of Economics

Debre Markos University
College of Business and Economics

Department of Economics
Monetary Economics (Econ 3121)
prepared by : Yeshiwas Ewinetu(MSC)

Gmail : yeshiwasewinetu@gmail.com
Tell no : 0912381830
Department Head Office No : 104
12/13/2020 July 10, 2013E.C. 1
Schedule
Regular
1. Tuesday 8:00-11:20 Section B: B-07; R- 2
2. Wednesday 2:00-6:20: Section A :B-07;R-1
Extension
Saturday 8:00-10:30
“Take the job mentality to make the job”.

“Think good and do goo to others.”
12/13/2020 BY: Yeshiwas Ewinetu Tegegne 2

Introduction
Definition of monetary economics
Monetary economics is a branch of economics centred on money
and monetary relationships in the economy .
 Focus on the role of money for economic development .
The fundamental questions of monetary economics concerns with
the proper definition of money.
How ever, it has micro and macro economic components .
The microeconomic part of monetary economics focus on theory of
money demand, money supply,equilibrium,the central bank and its
formation .
The macroeconomics part of monetary concerns the formulation of
monetary policy and its impact on the economy .
For short-run analysis, monetary economics is a central part of
macroeconomics.
“Give respects and take respects”.
 It concentrates on the links between money (shift of money
supply and money demand) on the one hand and general
prices level (inflation), national output (GDP), employment
,export and import, exchange rate and balance of payment and
so on the other hand .
 In sum, monetary economics investigates the relationship
between real variables at the aggregate level (like, output,
employment, real interest rates) & nominal variables (such as
inflation, money flow, nominal interest rates, etc .
 It also deal with how actions of the central bank or
government transmit from money market to the rest of the
economy, and the effects of such monetary policy actions on
various economic variables like output and employment; and
what an optimal conduct of monetary policy should look
like.
Chapter 1 : Money and Monetary Theory(5hrs).
Objective of this chapter
After the end of this chapter, students be able to ;
 Define meaning, characteristics and functions of money.
 Measure the value of money.
Under stand the evolution of the payment system.
 Appreciate the different type of monetary theory.
Introduction
•We have had two types of economic system, barter economic system
and monetary economic system.
•In the former the direct exchange takes place goods with goods, but in
the later case, exchange takes place with money.
•In monetary economy is one which money is widely used and accepted
as a medium of exchange . It is monetized economy.
•In monetary economy money buy goods and goods buy money but
goods are not exchanged for goods directly but indirectly it did.
• The origin of money is linked with the problems of the barter
economic system such as:
 Lack of double-coincidence of wants=>Time consuming and
hindrance to the development and expansion of trade.
 Lack of a common measure of value (Lack of common unit of
value)=>very high transaction cost=>one party is disadvantageous
in terms of trade.
The value of each good is required to be stated in as many quantities
as there are types and qualities of other goods and services .The
exchange rate formula given by professor Culbertson formula )
of exchange rate :
R=
Where R is exchange rate and N is number of item .

Example : N=1,000 . No of price needed to exchange N(R) will .
R=Ans . 499, 500 pricesBY:.Yeshiwas
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(lineEwinetu
of communication
Tegegne
). 6
 Indivisibility of certain goods(example cattle) => It difficult
to fix exchange rate for goods.
 Transportation costs:- Due to the heavy nature of commodity
leads to high transportation cost .
 Storage problem (perishable goods)=> obsolete or deteriorate
in value over the long period.
 Lack of specialization i.e peoples are a jack of all trades => no
economic progress.
 Difficulty in making deferred payment.It is impossible to
make payment in the future .
1.1. Meaning and functions of money
•The most important foundation of Economics is the foundation of money .
•When most people talk about money, they're talking about currency(paper money
and coins).
•Currency consisting of paper money like birr and coins, clearly fits this definition
and is one type of money.
•According to Paul Samuelson, money is the modern medium of exchange and the
standard unit in which price and debt are expressed .
•Similarly money is referred as the money supply and it is anything that gets
generally accepted in payment for goods or services or in the repayment of debts.

• It also refers to anything that is generally accepted in
payment for goods and services or in the repayment of
debts and is distinct from income and wealth.
• Wealth is all resource owned by an individual including all
assets while money is total collection of pieces of property
that serve to store value.
• Wealth includes not only money but also other assets such as
bonds, common stock, art, land, furniture, cars, and houses.
• Income is flow of earnings per unit of time but money is a
stock concept while money is a certain amount at a given
point in time.
• Professor Coulborn defines money as the means of valuation
and of payment; as both the unit of account generally
acceptable medium of exchange.
• Coulborn's definition is very wide, he includes in it the 'concrete'
money such as gold, cheque , coins, currency notes, bank draft,
etc. and also abstract money which is the vehicle of our thoughts
of value, price, and worth.
• John Hicks to say that money is defined by its functions:
anything is money which is used as money: money is what
money does.
• These are the functional definitions of money because they define
money in terms of the functions it performs.
• Money is an asset which is used as a , a store of value and a
standard for deferred payment or value.
• Some economists define money in legal terms, saying that
anything which the state declares as money is money. Such
money possesses general acceptability and has the legal power
to discharge debts. But people may not accept legal money by
refusing to sell goods and services against the payment of legal
tender money.
• On the other hand, they may accept some other things as money
which are not legally defined as money in discharge of debts
which may circulate freely. Such things are and notes issued by
commercial banks. Thus, besides legality, there are other
determinants which go to make a thing to serve as money.
Characteristics (criteria ) of money
•The characteristics of money is the quality for a thing to be money .
•For a commodity to function effectively as money, it has to meet the

following several criteria:
1.It must be easily standardized, making it simple to ascertain its

value;i.e Standardization .
2.It must be widely accepted for any thing to be money ,it should be
acceptable by every body i.e general acceptability.
3.It must be divisible, so that it is easy to make change . The material

should be capable of being divided in to small part with out losing
value i.e divisibility .
4. It must be easy to carry and transfer from one place to another
place i.e portability .
5. It should be stored and last long without losing its value . It must
not deteriorate quickly i.e Durability .
6. The material with which money is made should be easily

recognizable by sight or touch i.e conginizabilty .
7. Money should be stable in value because it has to serve as a

measure of value and their supplies can be increased or decreased
when required i.e Stability.
8. The material with which the money should be of the same

quality i.e Homogeneity.
Type of money
i)Based on the physical criteria which money is made or monetary system criteria
It Classify money in to three. They are ;Metallic ,paper and bank (credit )money.
1)Metallic money
•Money made of any metal such as gold ,silver ,nickel and cooper .
•Metallic money has three sub- classifications .
•Standard money (Full bodied metallic money )
i)Money whose value as a commodity for non-monetary purpose is as greater as its value as
money i.e Face value equal to intrinsic (metallic) value.
ii)It has unlimited legal tender in which any amount of payment can be made.
B) Token money
•It is representative whose intrinsic value of the metal is less than its face value
Example : Ethiopian ;5 ,10 ,25 ,50 cents and one birr coin , if it is melted ,it metal will not
be sold for one birr .
C) Subsidiary money
i)It is to assist the token money .
ii)All coin of the denominations from 5 cent to 50 cent in Ethiopia are subsidiary money for
one birr .
iii) Such coin has limited legal tender but in Ethiopia it has unlimited legal tender .

2) Paper money
• It the note of different denominations made of paper and issued by the
central bank or the government of the country such as ;1birr , 5 birr ,10 birr ,
50 birr and 100 birr note denomination in Ethiopia are the best example for
paper money. It can be classified in to four ;
A)Representative(Full bodied) paper money
•It is not money by it self but, some thing that represent money .
•It is in effect a circulating warehouse receipts for full-bodied coin or their
equivalent in bullion .
•It is fully backed by(converted in to ) gold coin or gold bullion held by
treasury .
•It is the gold certificate which circulated in the economy.E.g USA before
1933 .
B) Convertible paper money
•It can be converted into gold or bullions. But it does not have 100 %
backing in the form of standard coin or bullion .
•But it can be converted in to coin or bullion on demand but not fully
backed
12/13/2020up with gold or bullion
BY: .Yeshiwas Ewinetu Tegegne 15
C) Inconvertible paper money(Fiduciary money )
•It depends on for its value on the confidence that it will be generally accepted
as a medium of exchange .
•Peoples are not required by law to accept it as a means of payment .
• It can not be converted into gold or bullions and is also not convertible into
them.
Example : bank note or drafts faced in this category .
D) Fiat money
•Paper money which circulate in the economy on the authority of the
government .
•It gets its value from the government order .
•It is not backed by any physical commodity .
•It is created and issued by the state .
•Its intrinsic value is significantly lower than its face value .
•Practically ,there is no difference between fiat money and inconvertible
paper money .

• Its value is derived from the relationship between supply and
demand .
• It will have value only, when the government (national bank )
declares that paper has accepted as money .
• It exists only, when the society accepts the government of the
country .
• Most modern economies are based on the fiat money system .
Example:- Birr notes issued by the central bank of Ethiopia, issued

by the government of Ethiopia .
There is a sentence “Payable to the bearer on demand” to show

the order of the government.
3. Credit money(bank money):- It is transferred by commercial
bank in the form of cheque or draft .
• Cheque is not money and may not accepted as a means of
payment or medium of exchange but only transfer money transfer
money from one individual to an other individual .
ii) Based on acceptable criteria
1)Legal tender money
2) Non - legal tender money
1) Legal tender money:-It is a money in which the state and the

people accept as the means of payment and in discharge of debts .
• It has the authority of the government,such money is accepted
compulsorily by the people .
• It can be classified in to two ;
A)Limited legal tender money
• Payment can be made legally up to a certain limit .
B) Unlimited legal tender money
• Payment can be made in it legally in unlimited quantity .
• All paper note and coins of Ethiopia are example of unlimited legal
tender.
2) Non-legal tender (optional) money
• Money which does not posses any legal authority of the state or
central bank .
• People are not bound to accept such money because there is no legal
sanction behind their issue .
Example: cheque ,draft ,bond ,debenture ,treasury bill ,bill of exchange
security
12/13/2020 etc. BY: Yeshiwas Ewinetu Tegegne 19
iii) The relationship between the value of money as money and
the value of money as a commodity (Keynes classification )
A)Money of account
•It refers the term and conditions in which accounts are maintained in
a country .
•In which the price of goods and services, debt and purchasing power
are expressed.
B) Money proper (actual money i.e benham ) or unit of currency
i.e Seligman)
A)It is the actual money in which contract or debt are settled, such as
the British pound, Indian rupee,USA dollar, Ethiopian birr .
B)It can be representative or commodity money .
C)When the accounts in country are maintained in money proper
there is no difference between money of account and money
proper .

• When the accounts in country are maintained in some other
courtiers currency there is difference between money of
account and money proper .
• Example: Germany after WWI,when money of account is
USA dollar and money proper was the Germany mark .

Function of money
John law “What blood is to the body, Money to the state”.
The importance of money for modern economics is known by the
functions that it performs.
Money perform primary, secondary ,contingent and other functions .
1. Primary function
1)As a medium of exchange or payment
• This is the primary function of money because it is out of this
function that its other functions developed or it is the most basic
function of money is to serve as the medium of exchange.
•It is absolutely essential function of money.
• In our economy, money in the form of currency or checks is a medium
of exchange; it is used to pay for goods and services.
•The use of money as a medium of exchange promotes economic
efficiency by minimizing the time spent in exchanging goods and
services
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and permits specialization.
BY: Yeshiwas Ewinetu Tegegne 22
• By serving as a medium of exchange, money removes the
need for double coincidence of wants and the inconveniences
and difficulties associated with barter.
• The introduction of money as a medium of exchange
decomposes the single transaction of barter into separate
transactions of sale and purchase thereby eliminating the
double coincidence of wants.
• When money acts as a medium of exchange, it means that it is
generally acceptable. It, therefore, affords the freedom of
choice.
• This function of money also separates the transactions in time
and place because the sellers and buyers of a commodity are
not required to perform the transactions at the same time and
place.
• This is because the seller of a commodity buys some money
and money, in turn, buys the commodity over time and place.
2) As a unit of account or unit of value or standard of value :
•Money is the standard for measuring value just as the yard or meter
is the standard for measuring length.
•It is used to measure value (value of goods and services ) in the
economy. Barter system lacks this function .
•Money is the common denominator which determines the rate of
exchange between goods and services which are priced in terms of
the monetary unit.
• When values are expressed in terms of money, the number of prices
are reduced from n(n-l) in barter economy to (n-1) in a monetary
economy.
•Money enables an orderly pricing system which is essential for:-
Rational economic calculation and choice .
Transmitting economic information among individuals.
•It12/13/2020
is the central property BY:
ofYeshiwas
money .
Ewinetu Tegegne 24
2. Secondary(Subsidiary)function
1)As a store of value(asset function):

•It is a repository or storage of purchasing power over time.
•A store of value is used to save purchasing power from the time income is
received until the time it is spent.
•The ability to hold value over time .
• It means help to meet unforeseen emergency and to pay debt .
•Money is a bridge from the present to the future .i.e money allow you to
transfer value or wealth in to the future.(keynes ).
•Money is not unique as a store of value; any asset whether money, stocks,
bonds, land, houses, art, or jewelry-can be used to store wealth.
•It is the necessary property of money .
• Many such assets have advantages over money as a store of value:
They often pay the owner a higher interest rate than money,
experience price appreciation, and deliver services such as
providing a roof over one’s head.
• On the other hand, they have certain disadvantages as a store of
value, among which are the following:
1. They sometimes involve storage costs.
2. They may depreciate in terms of money; and
3. They are “illiquid” in varying degrees, for they are not generally
acceptable as money and it may be possible to convert them into
money quickly only by suffering a loss of value.”
2)Money as a standard of deferred payment
•Money act as a standard of deferred post ponded payments .i.e
a property of an item that makes it desirable for use as a means of
setting debt maturing in the future .
•Money has simplified both taking and repayment of loan
because the unit of account is durable .
•It is essential property of money .

• Money links the present values with those of the future.
• It simplifies credit transactions.
• It makes possible contracts for the supply of goods in the
future for an agreed payment of money.
• It simplifies borrowing by consumers on hire-purchase and
from house building and cooperative societies.
• Money facilitates borrowing by firms and businessmen from
banks and other non-bank financial institutions.
• The buying and selling of shares, debentures and securities are
made possible by money.
• By acting as a standard of deferred payments, money helps in
capital formation both by the government and business
enterprises.

• In fine, this function of money develops financial and capital
markets and helps in the growth of the economy.
• But there is the danger of changes in the value of money over
time which harms or benefits the creditors and debtors.
• If the value of money increase over time ,the creditors gain
and debtor loss.
• To over come this difficulty,some of the countries have fixed
debt contract in terms of a price index which measure changes
in the value of money .
• It makes possible contracts for the supply of goods in the future
for agreed payment of money .
3) Money as a transfer of value
•Since money is a generally acceptable means of payments, and
act as a store of value ,it keeps on the transferring of value from
one person to person, place to place .
•A person who holds money in cash or assets can transfer that to
any other person.
3.Contingent function/incidental function /
Money also performs certain contingent or incidental functions,
according to Prof. David Kinley.
1)Money as the most liquid of all liquid assets
•Money as the most liquid of all liquid assets in which wealth is
held .
2) Basis of the credit system
•Money is the basis of all credit system . Credit economies the use
of money
• A commercial bank cannot create credit without having sufficient money. on
various goods which he want to purchase .
3) Equalization of marginal utility and productivity
• For producers profit maximization MPL=w for single factor input.
• For consumer utility maximization Mux=Mum(Px) for a single commodity
case .
4) Measure of national income
• It help to measure national income .
• This is done when the various goods and services produced in a country are
assessed in money term .
5) Distribution of national income
• It help in the distribution of national income .
• Rewards for factors of production are determined and paid in terms of money .
4.Other functions of money
 Help in making decisions . Money as a store of value and the consumers
meets his daily requirements on the basis of money held by him .
 Money as a basis of adjustment in capital and money market was done
through money .
Static Vs Dynamic function of money
The classification of function of money is also given by Einzing as
follows ;
•Money is of vital importance to the operation of the nation and
international economy due to the static and dynamic roles played by
it .
•Static functions are also known as 'passive;' ‘traditional’, ‘fixed; or
‘technical’ functions of money.
•They are performed under all conditions without causing any change
in the economy .
•Here money play the role money lies in removing the difficulty of
barter system in the above way i.e money serve as medium of
exchange, act as a unit of account ,act as a standard of deferred
payment ,store of value and as a portable materials.
•It is the stability value of money which is an essential quality to enable
money to fulfill its static function efficiently .
• By its dynamic functions, money tend to exert a very
powerful influence on the general economic level of
progress .
• It is the role of money in life of a person in every economic
activities engagement such as its role to consumer
,producer , to the government, to the society (base of credit ),
in the division of labour and specialization, as a mean of
capital formation ,as index of economic growth.
• Money perform its dynamic function by acting as a means of
distribution of social income ,and also as a means of
achieving social justice in the distribution .
• It bring equalization of in marginal utility in expenditure,
serve as a basis of credit ,imparts liquidity , mobility and
uniformity to capital .

Significance of money
Marshal “money is the pivot around which the economic science
cluster”.
1.The role of money in capitalist economy
•Money is the life blood of the capital economy with out money.
• It does not function smoothly with out money or the symbol of
capitalism.
•Price mechanism is the main source of guidance, has to be
expressed in terms of money.
•Money is important for the producer to maximize the scale of
production and , important to maximize the satisfaction level of the
consumers under capitalist economy .
•It provide incentive for innovation and technological change .
•But some time money leads to business fluctuation or market failure
in capitalist economy and monopolistic exploitation .
•Al rage part of the economy is non monetized, so the market not
function properly .
2.The role of money under command economic system
•Some socialist thinker believed that money play little role in
socialist economy(karl Marx and Lenin(surplus value theory)
since money is as the fundamental causes of exploitation of
labour by capitalist and he argued that in planned economy.
• It is possible to have trade of goods directly with goods,
following this soviet union abolished the uses of money in 1917.
•But the mistake was soon realized and the uses of money
essential for the success of planning and this calculation is
possible only with money (1920) .
•Money important for allocation of scarce resource .
•Money used for calculation and distribution of income .
•It is useful to use comprehensive social planning .
•Money allow freedom of choice in restricted manner .
3.The role of money for mixed(hybrid) economic system
• The concept of mixed economy is of recent origin developed by
Latin American economists and many developing countries have
adopted the system of mixed economy including Denmark,
Sweden, Switzerland and Ethiopia .
•It is characterized by co-existence of public and private Sectors
economic welfare, economic planning, price mechanism and
economic equality.
•In this economic system money play a role of giving adequate
Freedom, rapid and planned economic development, social
welfare and fewer economic inequalities and reward based on
ability to work .
•But money may leads economic fluctuations, corruption and
black markets, if the private sector is not properly controlled and
if government policies, rules and directives are not effectively
implemented.
Draw back or Defects of money
“Money is the source of all evil” rightly so . The bible says.
•Perhaps acting on this saying of the bible the classical economists did not attach
much important to money .
•Classical economists regard money as veil or garment or wrapper for goods and
service.
•They stated that money a tool for convenience to facilitate the exchange of
goods and services but it is not determinant of the quantity produced but money
is a useful servant ,often misbehaves when it tries to act like a master i.e it is said
“ Money is a good servant but a bad master’’ . Now economists regard money is
not merely veil (misbehave) but also extremely valuable (like good servant )social
instrument promoting wealth and welfare .
•As a master it leads to economic and non economic defects .

Economic defect
1)Instability of value of money or fluctuation in the value of money
•When the value of money fail,i.e rise in price level or inflation it fails to
function of a standard of unit and store of value .
• When the value of money rise ,fall in the general price level or deflation.
•These change are brought about by increasing or decreasing in the supply

of money .
2) Unequal distribution of income and wealth due to inflation (income

flow from poor to rich ) .
•Inflation and deflation brings benefit to some and damage to other leads to
distribution of income and wealth from person to person .

3) Wastage of resource or reinforce capitation : money as
abases of credit .
•When bank create too much credit ,it may be used for
productive or non productive purpose.
•If it is used for productive =>over capitalization resulting in
glaring inequality in the distribution of wealth as well as over
production .
•If it is used for unproductive use => misuse utilization of resource
which is wastage .

4) Black money: It is created when people hoard or store money ,evade tax and
hide their income .
•The tendency to hoard money and become rich is the root cause of the evil of
black money .
5) Money leads to trade cycle or economic fluctuation : The nature of the

supply of money leads to the fluctuations in the economy .
•Money supply => Boom=>output, employment and income rise =>over
production and vice versa . In monetary economy slump is followed by a boom .
6) Growth of monopolies (tendency to exploitation) :Too much money and the

redistribution of income and wealth leads to the concentration of capital in the
hands of a few capitalist, which leads to monopolistic exploitation of workers and
consumers.

7) Money instead of being a blessing become a curse in abnormal
condition .
•Normally money and purchasing power are synonymous .
•If a person has money he has purchasing power. But during extraordinary
condition like war people have money but no purchasing power .
Example: Germany after WWI.
2. Non economic defects money
oIt has encouraged greed and acquisitiveness (interest to get money).
oIt has stimulate fraud ,theft , dacoit (armed robber) ,murder and so on .
oIt has created in men the desire to exploit others .
o It is responsible for the decline in spirituality in modern society .
oPolitical instability, tendency to exploit.
oGenerally ,It brought down the moral , social and political fiber of the
society i.e Political instability ,murder ,corruption ,artificiality in religion
based on materiality .

• To summarize ,all these defects are not due to money but are
the result of the attribute of man to wards the use of money .
• It is impossible to image this world with out money.
• Money has made more people mad than love.
• So the best way is to keep money under control like a faithful

and obedient money is the government which can achieve this
by a judicious monetary policy .

1.2 Measuring the value of money
•The term “Value of Money” means the purchasing power of
money or its buying capacity.
• It is the quantity of goods and services a unit of money can buy.
•It means the purchasing power of money over goods and

services in a country.
•The value of money is related to the price because goods and
service are purchased with a money unit at a given price.
•Value of money is the amount of thing in general which will be
given in exchange for a unit of money (Robertson).
“Think good and do good to others.”
There are two type of value of money
1)Internal value of money: It refers to the purchasing power of

money over domestic goods and services .
2)External value of money: It refers to the purchasing power of

money over foreign goods and services .
•Obviously, the purchasing power of money depend upon the
level of general price of goods and services to be purchased. .

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46
• Hence, the value of money is defined and measured in relation
to the general level of price.
• However, the general price level is based on the mixture of the
price level of all commodities which means nothing specifically.
• The general price level is a mere abstraction.
• No individual is interested in general price level .
• Generally individual interested only in the price of those

commodities which they buy .

• Hence, the value of money is not the same to every individual
when he goes out to spend it .
• According to Crowther “The value of money with out
qualification is almost meaning less”.
• To get over this difficulty, economists have arbitrarily laid
down certain standard to measure the value of money .
Crowther has distinguished three standard of the value of
money.

1. The wholesale standard
• The value of money is expressed in terms of all those goods
and services that are transacted in the whole sale market.
• It is measured through the whole sale price indices.
• It is usually preferred because whole sale prices are
recorded regularly and are readily available.
2. The retailer (consumer)standard
• The value of money is expressed the value those goods and
services that ordinarily constitute the consumption item of
an average family.

• Thus ,through consumer price index number, the value of money
is measured.
• Two difficulty arise in formulation such standards .
1) As consumption pattern differ from family to family ,depending

up on the a number of factors such as; income ,taste, customs etc.
• So it is difficult to ascertain what goods and services are bought by
an average family with its income. This may involve extensive
inquiry .
1) There are no standard retail price quotations available, the

difficulty is problem of aggregation .

3. The labour standard(Earning standard )
•It express the value of money by the value of money obtaining
from labour service or human effort .
•It is determined by the rate of wage paid for a days work .
•Here again difficulty is arise due to lack of homogeneity of

labour .
•In deed, all these conception are arbitrary and are merely
intended to reduce the complexity involved in the definition of
the value of money as the reciprocal of “the general level of
price”.
• It must be noted that ,the value of money in absolute term can’t be
measured, but can be measured relatively.
• Even, the relative measurement of value of money is done indirectly,
by comparing the price at any time with the price in earlier period.
This can be done by the statistical device called index number of
price or price index.
• It is a figure showing the height of average at one time relative to
relative their height at some other time (i.e base period).
• It shows the change in purchasing power of money.
• The value of money changes in inversely proportional to the

variation in the trend of price indices over a given period of time. .
Steps of constructing index number
1.Purpose of the index number:- Identify the purpose for which
it is needed i.e objective and scope.
2.Selection of the commodities:- It will be done based on the
objective of the index number to be constructed .
• Selection of the commodity is not too large not too small but
must be representative of the group of commodity .
3. Selection of price of the commodity:- Based on the whole
sale/customer price or wage .
4. Selection of an average:-Using arithmetic mean(simpler) or
geometrical mean(more accurate and it is used when the data is
growth rate, average rate of change,ratio,percentage distribution
and logarithmically distributed item or when the data increases in
the productions are given for many years of periods.

5) Selection of weight: Due weight age or importance
should be given to the various commodity .
6) Selection of the base period: Base year is a year
against which comparison are made .
• It should be normal and free from any unusual
events such as famine ,war ,earth quick drought.etc .
• It should not be either very recent or remote.

There are two methods of selecting the base year
1.Fixed base method :- Either the average price of a period of a
years or the average price of some arbitrarily chosen can be
taken as abase year.
2.Chain base method :- The price relatives for each year are
calculated ,taking the previous year data as a basis year .
7. Selection of formula
•The construct of the appropriate index formula (simple price
index formulaorweighted price index),depends on availability
of data, the degree of accuracy desired, the nature of the problem
under investigation and purpose of the index number.

• The Consumer Price Index (CPI) is a measure that examines
the weighted average of prices of a basket of consumer goods
and services, such as transportation, food, and medical care.
• It is calculated by taking price changes for each item in the
predetermined basket of goods and averaging them.
• Changes in the CPI are used to assess price changes associated
with the cost of living.
• The CPI is one of the most frequently used statistics for

identifying periods of inflation or deflation.
• It may be compared with the producer price index (PPI),

which instead of considering prices paid by consumers looks
at what businesses pay for inputs.

1)Paasche Price index

Advantages
• Takes into consideration consumption patterns by
using current quantities (current weightings)
• Is not upward-biased in terms of price increases
(compared to the Laspeyres Price Index)
Disadvantages
• Data on current weightings (i.e., quantities for each
item) can be difficult to obtain
• Costlier than using a Laspeyres Price Index
• Tends to understate the changes in price because
the index already reflects changes in consumption
patterns when consumers respond to price changes
2) Laspeyres Price Index
• Laspeyres index, index proposed by German economist Étienne Laspeyres
(1834–1913) for measuring current prices or quantities in relation to those of
a selected base period.
• A Laspeyres price index is computed by taking the ratio of the total cost of

purchasing a specified group of commodities at current prices to the cost of
that same group at base-period prices and multiplying by 100.
• The base-period index number is thus 100, and periods with higher price
levels have index numbers greater than 100.
• The distinctive feature of the Laspeyres index is that it uses a group of
commodities purchased in the base period as the basis for comparison.
• In other words, in computing the index, a commodity’s relative price (the

ratio of the current price to the base-period price) is weighted by the
commodity’s relative importance to all purchases during the base period.
(Compare Paasche index.)
• The Laspeyres price index tends to overstate price increases because,
as prices change, consumers typically alter their purchasing decisions
by selecting fewer products with large price increases while buying
more products that show low or no price increases.
• If consumers can do this without reducing their total satisfaction, the
use of base-period commodity selections tends to overstate declines
in the standard of living.
• Similar to the price index, the Laspeyres quantity index uses base-
period prices to compare aggregate production levels in two periods.
• The Laspeyres Price Index is a consumer price index used to measure
the change in the prices of a basket of goods and services relative to a
specified base period weighting.
• Developed by German economist Etienne Laspeyres, the Laspeyres
Price Index is also called the base year quantity weighted method.

Where:
Pi,0 is the price of the individual item at the base period and Pi,t is the price of the
individual item at the observation period.
Qi,0 is the quantity of the individual item at the base period.

Example

Advantages
• Easy to calculate and commonly used
• Cheap to construct
• Quantities for future years do not need to be calculated – only base year
quantities (weightings) are used
• Presents a meaningful comparison, as changes in the index are attributable to the
changes in price
Disadvantages
• it is upward-biased and tends to overstate price increases (compared to other
price indices). Therefore, it tends to overestimate price levels and inflation. This
is due to:
• New goods: More expensive new goods that cause an upward bias in prices.
• Quality changes: Price increases solely due to quality improvements should not
be considered inflation.
• Substitution: Substituting goods or services that have become relatively
cheaper for those that have become relatively more expensive.

3)Fisher Price index
• The Fisher Price Index, also called the Fisher’s Ideal
Price Index, is a consumer price index (CPI) used to
measure the price level of goods and services over a
given period.
• The Fisher Price Index is a geometric average of
the Laspeyres Price Index and the Paasche Price
Index.
• It is deemed the “ideal” price index as it corrects the
positive price bias in the Laspeyres Price Index and
the negative price bias in the Paasche Price Index.

• As you can see, the Fisher Index number lies
between the Laspeyres and Paasche Price
Index numbers. It is ideal index number
which capture factor variable and time
effects .

Example:Illustration about the construct of a simple wholesale price
index as follows by assuming the year 2010 E.C as abase year .

•This show an increase of 95 percent in the year 2011 over 2010E.C
or the general price level in 2011 E.C was 95 percent as high as in
2010E.C. Weight index gives highest price index than simple
method .

• Not applicable to an individual belonging to a group for which it is
constructed .
• Even thought it face the above difficulty index number is are at best
approximation to measure change in the value of money .
The most commonly used indices are of;
1. Consumption or retail index: It is contracted by taking the price of
all final goods and service that enter in to the final consumption of the
people .
• Each item is weight on the basis peoples money income spent on it.
2. The whole sale index : It is contracted on the basis of the price of
wholesale commodity.
• It measures the changes in the value of good whose price are quoted
regularly in the wholesale market .
• The index is measured on the basis of the relative importance of
different commodity in the national economy as stated by census of
production .
3) The cost of living index: It includes the retail price of the main
commodity of consumption entering in to the budget of the working
class people .
•It does not include persons services. In this way, it differ from
consumption index.
•It indicates the changes in the cost of living of the working class .
•It should be given special attention for giving weight to various goods .
4) International index :It is based on import and export of the country
•The main commodities that enjoy international market should be take
into account .
•On the basis of each commodity in the trade the country index is
weighted
•It helps to indicate the terms of trade of the country .
5) Industrial index number:The production statistics of various
industries are included while preparing this indices .
• It measure the change in industrial production .
• For all index number the price relative method is used .
• It is generally preferred for two reasons;
1) Even if ,there were only a single commodity being bought and
sold, a price relatives and would most conveniently show
relatives and the index number is usually written ,with out the
decimal point ,as percentages .
2) The use of price relatives is all the more important when we
are working with many different price .

The use of index number
•In measuring change in the value of money .
•In measuring cost of living.
•In analyzing market for goods and services .
•In measuring changes in the industrial production.
•In measuring external trade.
•In determining foreign exchange rate .
•For economic policy.

1.3 The evolution of the payment system (Evolution of money)
•The world money derived from the Latin term “Moneta” which was the
surname of the Roman Godden's of Juno in whose template in Rome, where
money was confined .
•The type of money in every age depends on the nature of its livelihood
In hunting society=Skin and hide ( Africa tiger jaw and Ivory)
Pastoral society = Livestock or cattle .
Agricultural society=Grain and food stuff (Bar salt Ethiopia during the
19th century) .
Greek was the first country to use coin as money
Ethiopia use coin as money during the Axumit kingdom .
•The evolution money or development of money has passed through the
following seven stage depending upon the progress of human civilization
at different time , place and circumstance
•Money is one of the most fundamental of all mans invention hence, the
fundamental discovery of economics is creation of money.
1. Animal money
• In primitive society cattle was being used as a medium of exchange in Africa
,Europe and Asia.
• In the 4th century B.C in Rome cow and sheep were used as money for
collecting taxes and fine.
• Cattle occupy a place of pride as wealth.
• In hunting society skins of wild animal and in pastoral society livestock used
as a money .
2. Commodity money
 Commodity money is money whose value comes from a commodity out of
which it is made
 In the primitive society in certain communities, commodities served as money .
 The first commodity money was rice and wheat .
 And the choice of the particular commodity to be used as money was
determined by factors such as: Location of the community, Climate, Culture
and Economic development etc. of the community.
 Example: people who live in Sea shore used shells and fishes, and cold region
used skins and furs and so on. .
The problem (defect ) of commodity money
Lack of uniformity ,such as grain or cattle. And hence, it is
the difficulty in verifying quality.
Difficult to store and prevent loss of value in the case of
perishable commodities.
such a form of money is very heavy and is hard to transport
from one place to another.
Supplies of such commodities were uncertain .
They lacked in portability and hence ,were difficulty of
transfer from one place to another .
There was the problem of indivisibility such as using cattle as
a money.
Lack of transferabilityetc.

3. Metallic money
• The spread of civilization and trade relations by land ,sea ,metallic money took
the place of commodity.
•It is a money which is made from metal .
• Many nations started using gold, silver, copper and bronze etc. were used as a
medium of exchange.
• But metal was an inconvenient things to accept ,weight divide and assess in
quality. Accordingly, metal was made in to coin of predetermined weight. Thus
coins came to be accepted as convenient methods of exchange.
• The ancient Greeks used coins as money in the first time in the world .
Defects of metallic money
•According to official records it was since the 3rd century A.D (during the reign
of King Endybis and Aphilas) that Axumite kingdom was using its own coins for
both internal and external trading. Then after during 18 and 19 the century Maria
Theresa.

• On account of its bulkiness or Being heavy, it was not
possible to carry large sum of money in the form of
coin from one place to another place by merchant ,
• It was not possible to change its supply according to
the requirement of the nation both for internal and
external use ,
• lack of feasibility for rapid transactions, additionally
metallic money was unsafe and inconvenient to carry
precious metal for trade purpose over long distance .
• Metallic money very expensive because their
debasement and their minting cost a lot to the
government metallic money could last only up to 17th
century .
4. Paper money
•The first recorded use of paper money was purported to be in the country of
China during the 7th century A.D. as a means of reducing the need to carry
heavy and cumbersome strings of metallic coins to conduct transactions. (Tang
dynasty ).
•It economies the uses of metallic money .
•The development of paper money started with goldsmiths which kept strong
safe to store their gold .
•As goldsmith were thought to be honest merchants, people started keeping their
gold with them for safe custody.
•In turn ,the goldsmith gave the depositors a receipts for promising to return
the gold on demand .
•These receipts of the goldsmith given to the sellers of commodity by the buyers
. Such paper money was backed up by gold and can be converted into gold on
demand .
•This ultimately led to the development of bank note .
•The bank note are issued by the central bank of the country .
•The price of bank note increase as the demand for gold and silver increase .
• Gradually, the convertibility of bank note in to silver and gold given
up during the beginning and after WWI in all courtiers of the world .
• Since then the bank money has ceased to be representative money
and is simply fiat money which is inconvertible and is accepted as
money because it is backed by law .
• The paper money was introduced by John lock in china
• In Ethiopia the paper money issued by the bank of Abyssinia for
the first time in 1914 .
• But, it was strange to the society and it failed to get acceptance since
the people were familiar only with the metallic coins.
• Paper money was again issued by the bank of Ethiopia (the successor
of the Bank of Abyssinia) in 1932.
• These notes were 100 percent backed by gold deposits and hence
were being used as a medium of exchange along with the sat bar and
the Maria Theresa until the interruption by the Italian occupation of
1936.
• In 1941 when the country was liberated from the brief Italian
occupation it had no national currency and financial
institutions.
• Following the evacuation of Italy in 1941, many foreign
currency started to be used as medium of exchange including
Italian Lire.
• The Maria Theresa Dollar, the East African Shilling, the
Indian Rupee, and the Egyptian Pound circulating as medium
of exchange.
• While the Lire was a relic of the Italian occupation and the
Maria Theresa Dollar a carry over from earlier periods, the
rest of the currencies were introduced by the British military
forces who helped liberate the country and assumed
responsibility in its administration .
• It was only in July 1945 that the Ethiopian government issued
the new national currency birr.
Defect of paper money
•Restricted accessibility. The acceptability of paper money
limited to domestic country but the rest of the world are not ready
to accept it for payment.
•Fluctuation in the rate of exchange for paper money than
metallic money.
•Demonetarization of paper money i.e if it demonetized, it will
have a worthless piece of paper in his hand like Ethiopia 2020.
•Lack of durability i.e it can be easily destroyed ,and then it will
have no value .
•Dangerous inflation (serious defect) due to over issue .
•Less stability: some time it is over issued and people lack
confidence in the value of paper money and they keep their saving
interns of gold and silver .

5. Credit money (bank money)
•With the growth of banking system credit or bank money developed .
•To day most large transaction were carried out through cheques and
only small transactions were managed through currency money .
•Credit money is create and transferred by the commercial bank in the
form of cheque .But they are not legal tender money .
•The cheque is like a bank note in that it performs the same function.
•It is a means of transferring money or obligations from one person to
another. But a cheque is different from a bank note.
• A cheque is made for a specific sum, and it expires with a single
transaction.
•But a cheque is not money. It is simply a written order to transfer
money.
•However, large transactions are made through cheques these days and
bank notes are used only for small transactions.
• Credit money is the creation of monetary value through the
establishment of future claims, obligations, or debts.
• These claims or debts can be transferred to other parties in
exchange for the value embodied in these claims.
• Fractional reserve banking is a common way that credit
money is introduced in modern economies.

6. Near money (qusi- money)
•They are close substitutes for money and are liquid assets.
•The final stage in the evolution of money has been the use near
moneys such as ;bill of exchange , treasury bill, bond ,debenture
,saving certificate etc.
Draft and Bill of exchange :
•Financial documents which are attached with promise to pay the
specific amount in the future .
•It is I owe you ,
•The time period last for 3 months not more than 90 days .
•It is used to make payment regarding export ,import and other
domestic or international transaction .
Treasury Bills
•Whenever government wants to borrow from public it sells its
treasury bills.
• Such bills are sold when govt. faces budget deficit .They are
called bills because they are attached with a specific time period
and promise to pay in future. It is paid in 30,60 and 90 days by
the government .
• It is like bill of exchange paid at discount with a short period
 Bonds: The bonds are the written form of loans. Whenever,
govt. or some institution is in need of money they issue bonds.
• Bond ,security and debenture falls in the same category .
• Bond issued by the government while ,debentures are issued by
the private sector .
• They are the means to borrow fund for short ,medium and long
period and carry a fixed rate of interest.
• They are near money assets because they convertible into cash at
short notice in the money .

 Saving Certificates
• In addition to banks so many non-bank institutions have also
emerged which issue a variety of saving certificates.
• In addition to above mentioned, the travelers cheques, insurance
policies, savings of general provident fund, prize bonds and
money orders also represent Near Moneys.
 Life insurance policy
• The holder of a life insurance policy can obtained cash in the
form of loan on his policy at a short notice .
7.Electronical money
Electronic money (or e-money), money that exists only in
electronic form. Like CEB
12/13/2020 birrEwinetu
BY: Yeshiwas , Amola
Tegegne etc . 94
• One form of e-money is the debit card.
• Debit cards enable consumers to purchase goods and services
by electronically transferring funds directly from their bank
accounts to a merchant’s account.
Problems related with electronic money

 It is very expensive to set up the computer, card reader, and
telecommunications networks necessary to make electronic
money form of payment system.
 Electronic means of payment raise security concerns.

7)Plastic money is a term used to represent the hard plastic cards used in day
to day life in place of actual banknotes.
• They come in several forms
• such as debit cards, credit cards, store cards and pre-paid cash cards.
• Australia was the first country to introduce plastic currency, with a
commemorative $10 note in 1988. It began replacing its paper money in
1992. The substrate consists of layers of biaxially oriented polypropylene
—a plastic commonly used for packaging snacks or bagging lettuce
8) Electronic money is currency that is stored in banking computer systems.
Electronic money is backed by fiat currency, which distinguishes it from
cryptocurrency.
• Various companies allow for transactions to be made with electronic
money, such as Square or PayPal.
• Electronic Money uses Internet, Digital Stored Value systems, and
Computer Networks. Some of the examples of electronic money are
Direct Deposit, EFT (Electronic Funds Transfer), Virtual Currency, and
Digital Gold Currency.
• Existing e-money and mobile wallets provide improved
security, efficiency, privacy, affordability and transparency in
financial transactions.
• They eliminate some middlemen with the use of mobile
devices for payment.

1.4 Theories of money
• Broadly there are four important approaches to the definition of
money.
1.Conventional approach
2. Chicago approach
3. Gurley and Shaw approach
4.Central bank approach

1. The Conventional Approach
• This is the oldest approach developed by J.M Keynes .
• A method of defining money supply or money by looking at money as a

medium of exchange .
• According to this the most important function of money in society is to act
as a medium of exchange.
• It is a measure of money stock intended primarily for use in transactions.
It implies superior liquidity and high power money .
• It consists of Currency in the hands of the public plus checkable
deposits in commercial banks .
• Currency (c)
• Demand deposits in commercial banks (DD)
• Thus according to the conventional definition M=C+DD
• This is the narrow definition of money.
• It excludes time deposits in the commercial banks because

such deposits must first be converted in to either currency or
demand deposits before they can be spent.
• Demand deposits are deposits at a lower or zero interest rate
and payable on demand through cheque or other wise.
• It allow depositor to withdraw with out warning as per the
requirements of the depositor .

• Such as checking account checking or saving account
accessible by Teller or ATM.
• Where as Time deposit is an interest bearing bank deposit
account that has a specific date of maturity and include the
under standing that the depositor can make withdrawal by
giving notice. Example: Certificate deposit (CD).
• Time deposit(term deposit) impose condition on the amount
,frequency and period of withdrawal.
• It is important to note that among deposits, it is only demand
deposits which serve as a medium of exchange.

2. The Chicago approach
•The Chicago economists led by Professor Milton Friedman
adopted a broader definition of money and symbolized as M2.
•A method of defining and measuring the money supply by looking
at money as a temporary store of value .
•Their argument is that since in the economy money income and
spending flow streams are not perfectly synchronized in time in
order to function as a medium of exchange, money should be
temporarily stored as a general purchasing power.
•M2=M1+savings deposits in commercial banks.

• This could be in the form of currency, demand deposits or
time deposits (including saving deposits).
M = C + DD + SD + TD,
Where M is money , C–Currency SD –Saving deposits , DD–
Demand deposits ,TD –Time deposits .
• The Chicago economist advanced two reasons for including
time and saving deposits in the definition of money.
i. National income is more highly correlated with money that
includes saving and time deposits than money narrowly
defined.

ii. According to economic theory, perfect or near perfect
substitutes of a commodity should be included in the definition
of a single commodity.
• According to Chicago economist time deposits (deposits which
are not payable on demand and on which cheques can’s be
drawn) are very close substitutes for currency and demand
deposits.

3.Gurley and Shaw approach
•This approach is associated with the names of Professor John G.
Gurley and Edwards Shaw.
•According to these economists there exists a fairly large spectrum
of financial assets which are close substitutes for money.
•They emphasized the close substitution relation ship between
currency, demand deposits, commercial deposits, saving
deposits, credit issued by credit institution, shares, government
bonds etc all of which are regarded as alternative liquid stores of
value by the public.

• A rapid growth of deposits held by non-bank financial
institutions (n.b.f.is) has increased their practical importance as
a source of credit.
• M= C + DD + SD + TD + non– clearing bank Deposits +
n.b.f.i deposits.
• The definition includes all deposits of and the claims of all
types of financial intermediaries.
• It assigns weights to each asset in the definition of money to
come up with the total supply of money.

• For instance it gives a weight of one to currency and demand
deposits as they are perfect substitutes and zero to houses
which are imperfect substitutes weights such as 0.25, 0.5,
0.75, 0.8, etc would be assigned to different assets according
to the degree of substitution.
• Theoretically this approach is superior to the Chicago which
assigns equal weights to all items in the definition of money
ranging from currency to time deposits. However practically
it is difficult to implement it.

4) The central bank approach(Radcliff committee)
• This approach, which has been favored by the commercial bank authorities,
take the widest possible view of money.
M = C + DD + SD + TD + non–clearing bank deposits + NBFI(Non-bank
financial institution) deposits + credit lines.
•Non- clearing bank deposit :
•Credit line(LOC) is an arrangement between finical institution, usually a
bank ,and a customer, that established the maximum amount of loan that the
customer can borrow .
•NBFI they are financial institution but don’t have full banking license such as
insurance agencies , microfinance, credit union and friendly society etc
•Money is identified with the credit extended by various sources. The reason
for identifying.
• Money with credit used in the broadest possible sense of the term lies in the
central banks historic position that “total credit availability’’ constitutes the
key variable for regulating the economy.
• In general two pragmatic means could be uses to define the money supply of a
particular country.
1) The definition utilized should depend on the particular problem being studied.
Example: if an analysis of the effect of the money supply on economic activity is
being undertaken, the appropriate definition of money supply is the one that
provides the best statistical results. If M1, is statistically predictable than M2,
monetary policy should be couched in terms of that narrow definition.
2) A method of identifying a break in the spectrum of assets to separate money
• If the substitutability b/n DD and TD is lower than that between TD and other
liquid assets, then the definition of money should be limited to currency and
demand
12/13/2020 deposits. BY: Yeshiwas Ewinetu Tegegne 109
Chapter Review questions
1.Discuss the principal difficulty faced by a barter economy ?
2.Define the meaning of money in your own word ?
3.Money is what money does explain this statement and define
money ?
4.Describe the various stages in the evolution of money ?
5. Discuss the nature and functions of money ?
6.List and distinguish the different type of money ?
7. Discuss precisely the theories of money ?
8.What is the value of money ?
9.How are changes in the value of money measured ?what are the
limitation of this measurements ?
10.What are index number ? How they are constructed ? Discuss the
difficulty faced in constructing an index number ?
11.List the uses of index number ?
Money related quotes
1.Money is what money does? Explain
2.Money is the source of all evil ?Explain
3.Money is the pivot around which the economic science cluster”.
Examine critically
4.Money is a good servant but a bad masters ? Explain

Chapter 2
Chapter 2: An overview of the Financial System and Interest
Rates (7Hrs)
2.1 Functions and structures of Financial Markets
2.2 Financial Instruments
2.3 Financial intermediaries
2.4 Interest rates and their measurement

Objectives of chapter two
• After the end of this chapter, the students be able to
under stand ;
• The meaning of financial systems.
• Explain the meaning and type of financial markets .
• Identify the type of financial institutions .
• Differentiate capital marker from money market .
• Appreciate the role of financial institutions for the
development of a nation .
• Understand different theories of interest rate .

• Financial system consists of financial market
and financial institutions.
• Financial institutions are the rules of the game

which facilitate the flow of funds from
savers(lender) to borrower's in the most
efficient manner.

• Guiding purchasing power from surplus sending's
(savers) to deficit spending units(borrowers).
• Such as; some households, some state and local
government, federal governments and a large number of
businesses firms.
• There are three types financial institution; Formal
(banks),Informal(equb and Semi-formal financial
institution(Saving and credit cooperatives(SACCOS ) .

1)Informal financial institutions are financing activities that
are mostly. legal but their activities are often unrecorded,
unregistered and unregulated by government. (Todaro, 1997 in
Akintaye, 2008.
2)Formal financial institutions is an institution which has a
legal basis and subject to regulation by the government. In
contrast to the informal financial institutions no government
regulations that govern them.
3) Semi formal financial institutions they are formally registered
but not supervised by financial services .

2.1. Functions and structures of Financial Markets
Financial market is an institutional in which long term and short
term financial assets were transacted between buyers and sellers i.e.
•The institutional arrangements for dealing in financial assets and
credit instruments of different type such as currency,cheques, bank
deposit, bill and bond etc.
•They are in essence the credit markets.
The main function of the financial market
To facilitate creation and allocation of credit and liquidity.
To serve as intermediaries in the process of mobilization of
saving in the economy.
To provide financial convenience to the people.
To assist the process of economic development through a more
balanced regional and sectorial distribution of investible fund .

There are two types of institutions in financial markets
I)Depository institution: The institution which keeps deposit.
• Those which accepts deposit from the individual and firm and use
these funds for advancing loan in the debt market or purchase
other debt instruments such as treasury bill.
1. Commercial Bank: They are the larges and most important
depository institution which keep deposit of individuals and
firms in various type of accounts in the form of cash and assets
and use them for advancing loans .
2. Saving and Loan Association: They are operate by individual
by collecting their savings in in mutual association .

They convert their saving funds in to mortgage loan.
3. Mutual Saving Bank: They operate like saving and
loan associations.
• They only difference in that they are established
on the basis of co-operation by employee of some
company ,trade union or other institutions .
4. Cooperative Saving and Credit Society: The
members of saving and credit cooperative societies
purchase share of the cooperative societies, deposit
their saving with them and borrow from them.
• They establish based on cooperative proclamations
(FDRE cooperative proclamation No .147/98)
II)Non- depository
• Non-depository institutions operates in financial market as financial
intemidaires and provide insurance against financial risks such
as ;
1) Mutual fund: Sell their shares to individual and firm and invest the
proceeds in various type of assets . Some mutual funds ,known as
money market mutual funds, invest in short term safe assets such as
treasury bill, certificate of deposit of banks etc.
2) Insurance company: It protects individuals and firms against risk .
• The premium they receive from the individuals by insuring their
live ,they invest the same in advancing loans for long term assts
,mortgage, construction of house ,etc.
• on the other hand , the premium received by them for insurance
against loss, from fire ,theft ,accident, etc. of truck ,car ,building
,etc .
• Is invested in short term asset .
3) Pension fund : private and government cooperates,
,and central ,state and local government deposit
some amount in pension funds by deducting a
certain amount from the salaries of their
employees(15%) .
• Pension fund institutions or corporate invest these
funds in long term assets .
4) Brokerage firms : They link buyers and sellers of
financial assets .
• As such ,they function as intermediaries and earns a
fee for each transactions .
• They operate only in the secondary debt market and
equity market .
Based on the credit criteria, we have two type of financial
market.
1)Money market(Short term Credit market)

•Refers to the institutional arrangements facilitating borrowing
and lending of short term fund such as promissory note ,short
term security, treasury bill, bill of exchange, certificate of
deposit, short term government security, banker acceptance
and commercial paper.
• It is the market for short term instruments that are close
substitute for money.

• Short term instruments are highly liquid, easily marketable,
with little chance of loss .
• It meets the short term requirements of borrowers and
provide liquidity or cash to the lenders.
• It is used for financing current business operations and
short term need of the government, the need of the
consumers and agriculture .

• All this market are closely interrelated, so as to make the money
market.
• It is a wholesale where large number of financial asset or instruments
are traded.
• The money market is divided into two ;
1. Direct money market, negotiated or personal (customer) money

market .
• Banks and financial firms supply fund directly to the local customers .
2. Open (impersonal) money market: The bank may provide short term
fund to business and government by simply purchasing the debt
instrument issued by business firm and government .
• Such short run term advance are made in the open market ,and
being negotiated through the broker ,the lender banks and the
borrowers do not meet .
• The intermediaries comprise ,central bank (federal reserve
banks, commercial banks, insurance company, business
corporations, brokerage houses ,financial companies.

Function of money market
•It provide short term fund to the public and private institution.
•It provides an opportunity to the bank and other institution to
use their surplus funds profitably for a short period .
•It remove necessary borrowing by the commercial bank from
the central bank .
•It help the government in borrowing short term fund at a lower
interest rate on the basis of treasury bill.
•It help financial mobilization .
•It promote liquidity and safety which encourage investment
and saving .
•It helps to bring Equilibrium between money supply and
money demand of loanable fund.
•Economizing the use of cash, since it uses near money.

Institutions of money market
1.Central bank(Federal reserve bank)

•The central bank is the apex institution in the banking system
lend to the commercial bank by rediscounting the bill of exchange
.
•Thus they become a lender of the last resort .
•Mostly the central bank does not directly enter in transaction.
• It control the money market through variation in the bank

rate policy, open market operations and occasionally through
variation in cash reserve ratio .

• It the pivotal around which the entire money market revolves.
• It act as a guardian of money market and increase or decrease

the supply of money and credit in the interest of stability of the
economy .

2. Commercial bank
•All over the world, it is the most important financial institution.
•They usually deploy (bring) their short term deposit to lend for
short term loan to provide working capital to industry and trade .
•They invest bill of exchange and treasury bill.
•These assets are considered as the secondary reserve for the bank.
•The commercial bank also borrow from other banks and central
bank.

3. Non bank financial intermediaries
• This are non -bank financial intermediaries lend short term funds to borrower in the
money market .
• Such financial intermediaries are; investment house, insurance company ,provident
fund, other financial corporations.
4. Bill market or Discount house and bill broker

• Bill market is a market where short tem papers or bills are bought and sold.
•Discount house is a house that discount bill of exchange .
•In developed economy, private companies operate discount house .
•They act as intermediaries between those who have surplus fund to invest in bill and those
who are in need of fund.
•Its primary function is to discount bill on behave of other.
•They in turn form the commercial bank and accept the houses.

• Along with the discount house there is a bill broker in the
money market who act as inetremidariery between borrower
and lender by discounting bill of exchange at nominal
commission .
• In developing economy only bill broker will operate .
6.Acceptance house or market
• It is specializes in providing credit worthiness to the bill of
exchange of their customers by giving their acceptance to the
bill.
• They act as the agent between the exporters and importers
and between lender and borrower traders .
• By accepting the trade bill they guarantee the payment of bill
at maturity.
• But to day, this activity conducted by the commercial bank of
a given nation.
7) Collateral loan market
• When loans are offered against collateral securities like; stock
and bonds ,they are called collateral loans and the market is
known as collateral loan market.
• This market is geographically most diversified .

Characteristics of developed money market
•Developed commercial banking system since it is the major
suppliers of short term credit .
•Presence of a powerful central bank since it is the guardian of
the money market.
•Integrated interest rate structure that is change in central bank
rate should be quickly followed by change in other rate of
interest .
•Well defined and sensitive sub- markets.

• Varity of financial instruments that is there should be
adequate supply of a varity of cheap remittance facilities will
enable flow of funds as well as result in making the interest
rate sensitiveness .
• Sensitiveness to change central bank policy .
• Legal factor should favor the healthy development of a

money market .
• Economic factor should be a good volume of trade and
commerce which give rise to short term financial paper.

The above is not doing so in least developing counties and hence
, the following measure must be taken to strengthen the money
market in LDCs .
1) Improving the existing arrangements.
•Introducing measures in registration.
2) Encouraging sound market .

2.Capital market (Long term funds market )
•It is used to describe the institutional arrangement for facilitating
the borrowing and lending of long term funds or long term loan
i.e it is the market for long term fund .
•Capital markets deal with the trading of securities.
•The fund which flow in the capital market comes from individual
who have saving to invest ,the merchant banks ,the commercial
bank ,non bank financial intermediaries, such as insurance
company, finance house , unit trusts ,investment trust ,venture
capital , leasing finance ,mutual fund building society .
• Capital markets provide avenue/opportunity where
companies can raise funds to expand on their businesses or
establish new ones by issuing securities owned by the
companies.
• Like businesses in the private sector, government issue its
securities to raise funds in capital markets to build
electricity dam, construct new roads, bridges by issues.

• Long term fund required by the industry or the government .
• It is a period up to 25 years .
• It functions through the stock exchange market.

• It relates DD and SS for new capital and the stock exchange
facilitates such transactions .
• Capital market uses ordinary stock,shares,debentures of
corporations, bonds of industrial concern, mortgage and
security of the government etc as long term instruments .

We have two types of capital market
1.Primary Capital market :It is a market where a new security's

were sold .
2.Secondary Capital market: It is a market where bonds,

debentures ,stocks and shares were sold or old securities were
sold .

Function of capital market
•It act as an important link between saver and investors since
capital market is the transmission mechanism between surplus
unit and deficit unit .
•It gives incentive to savers / reward interest/ and investors /
allow capital formation.
•It creates stability in the value of stock and security by providing
capital at to the need at reasonable interest rate and help in
minimizing speculative activity.
•It encourage economic growth since they convert financial assets
in to physical assets .
• It promote employment.
• Promote wealth.
• It provides a revenue for channelizing the saving for productive
economic activity.
Institution of the capital market
1) The Stock Exchange market is one of the institutions in the
Capital markets.
• It is an organized market in securities (shares, stocks and bonds).
• On this market, individuals and companies can buy shares of
companies through licensed dealing member (stockbrokers) of the
stock exchange and hence become part owners or shareholders of
these companies.
• No stock market in Ethiopia ,chamber of stock market in Ethiopia
is institutionally established in 2011E.C .

• Similarly, individuals or companies through stock brokers can buy
stocks and bonds of other companies and the government,and become
lenders to or creditors of these companies or the Government.
• Any individual or company who at one time or the other lent money
or bought shares through the stock exchange can also sell back the
relevant shares or stocks through the stock exchange at any time.
• The stock exchange has its rules and regulations which govern it.
• These rules and regulations are designed to protect all market

participants, including the individual who puts up some funds to
invest.

2)Mutual funds
• An investment programme funded by share holders that trades in
diversified holding and is professionally managed .
• They sell equity shares (equity) to the investors and use this fund
to purchase stock and or bond .
• The value of a share of a mutual funds is not fixed(no fixed
interest),it change with the change in the price of stock in the
investment portfolio .
3) Insurance company: They obtained funds by selling insurance

policies that protect against loss of income,death or retirement,
and loss of property.
4) Investment banks
•A bank that purchase large holding of newly issued share and

resell them to the investor.
•A bank which deals with the under writing of new issues,
adverse corporations on their financial affairs.
5) Investment trust:
•A limited company which buy and sell shares in selected
companies to make a profit for its members.

• A company whose shares can be bought on the stock exchange
and whose business is to make money by buying and selling
stocks and shares. Also called investment company .
• It is a vehicle established to enable many small investors pool
their funds together and enjoy the benefits of diversification
and professional management at low cost without impairing
the liquidity and safety of the investment.
• In some jurisdictions it is called Mutual Fun.

6) The development bank: A bank which lend money for
investors in agriculture and construction or developmental
activities. E.g. Ethiopian Development Bank .
7. Community Savings Schemes otherwise known as eqube is
the informal way of capital formation by traders or other
individuals by making periodic contributions of various amounts.
• These schemes are used by low income earners to acquire
assets, initial capital for petty trading, etc.

2.2 Financial Instruments
2.2.1 Instruments of the money market

•The money market operate through a number of instruments.
1)Promissory note(trade bill) : It is a written promise on the part

of a business to day to another a certain sum of money at any
agreed future date. Till 90 days, but to day low importance.
•It is drawn (produce)by the debtor and has to be accepted by the
bank has his account to be validate.

2) Bill of exchange or commercial bills (trade or commercial bill)
• It is a written order requiring a person to make a specified
payment to the signatory or to a named payee .
• It is a written promise on the part of a business to day to another a
certain sum of money at any agreed future date.
•It is arises from genuine trade transaction.
•The seller after selling his good, draw a bill upon the buyer who
agree to pay the specified amount either on demand after a
stipulated period generally not exceeding 3 months .
•When the buyer signs the document signify his acceptance,it
become a commercial paper called a bill of exchange .
•It is drawn by the creditor and has to be accepted by the bank or
the debtor.
•The creditor can discount the bill of exchange either with broker
or bank .

3. Treasury bills
•They are payable to the bearers.
•They are short tem debt instruments used by the federal

government to obtain fund or issued by the government when ever
they borrow the short tem .
•Treasury bill is government security, yielding no interest but
issued at a discount on its redemption price.
•They are the major instruments in the money market and issued
for less than a year . They are issued for 30,ususally (90),180 and
360 day treasury bill issued by the government of Ethiopia.
• Even though ,its interest rate is low they have become an
attractive form of investment for commercial bank to get profit
by short term deployment of their surplus funds. It is traded
for discounting .
• They don’t pay regular interests(don’t pay explicit interest )
but instead are sold at discount(the difference between price
and face value ) i.e implicit interest rate .
• They are different from;
• Treasury note: It is an intermediate-term interest-bearing
bond issued by the government treasury .The maturity period
is 1-10 years .
• Treasury bond : It is a long-dated interest-bearing bond
issued by the government treasury.
• The maturity period is more than 10 years .
4) Notice and call money
•Call money market in which fund are borrowed and lent for
mostly for one day and some times 7 day.It is money loaned by a
bank or other institution which is repayable on demand. It is a very
short money market.
Notice money market, they are borrowed and lent for 14 days with
out any collateral security .
•But the deposit recipient is issued to the lender by the borrower
who pay the borrowed amount with interest on call .
5. Inter-bank term market
•This market is exclusively for commercial bank and other
cooperative banks or sister banks in Ethiopia ,which borrow and
lends for funds for a period of over 14 days and up to 90 days with
out any collateral security at market determined rate .
6. Certificate of deposit market: It is a market where a debt
instruments sold by the bank and other depository institutions.
• Certificate of deposit shorter to medium length deposit with a financial
institution that draws interest .
•These are set for a specific term and have a specific maturity date,
where if you withdraw the funds early, you would pay a penalty.
•Compared to savings account, you typically get more interest, but

you don’t have immediate access to your funds.

7. Commercial paper market
•It is issued by high rated company to rise short term working
capital requirements directly from the market instead of
borrowing from the bank .
•Commercial paper is a promise by the borrower company to pay
the loan at specific date ,normally for a period of 3-6 months.
•It is short term unsecured promissory note issued by companies .
•It is very popular in USA,UK and Japan .

• All this financial institution comprise the money market and work
interdependently and interrelated with one another.
2.2.2The financial instruments in capital market

• The capital market uses medium and long term security such as ;
1. Security of the government

• Securities are financial instruments or legal documents signifying either
an ownership position in a company (i.e. shares) or a creditor
relationship with a company or government. It is government paper .
2. Debenture of corporations:
• An acknowledgement of a debt issued by a limited company. Debentures
pay a fixed interest and are very long-dated.
3. Stocks and bonds are long-term fixed interest bearing
securities issued by Government and companies.
•Stock is the capital raised by a company through the issue and
subscription of shares(usually stocks) a portion of this as held by
an individual or group as an investment.
•Bond is a certificate issued by a government or a public
company promising to repay borrowed money at a fixed rate of
interest at a specified time.

• When one invests in stocks and bonds, one gets interest
income, which is paid periodically until the loan matures or
is called back by the issuer.
• The holder of stocks and bonds gets interest even if, the
issuer does not make a profit.
4. Share: One of many equal parts into which a company’s

capital is divided.
• The owners of shares are shareholders or, more formally,
members.

• It represent part-ownership in a business concern.
• Shareholders, therefore, between them own the company,
have a vote in how it's affairs are run and if the company
makes profit, they are entitled to a share of it.
• However, the dividend which shareholders receive is
dependent on the company's profitability and management
decisions such as company shares, bonds issued by
governments in private companies, units in collective
investment Schemes, debentures, commercial paper and note

6) Mortgages: They are debt instrument used to finance the
purchase of a home or other form of real estate when the under
lining real estate serves as collateral for the loan .
•It is a legal agreement by which a bank, building society, etc.
lends money at interest in exchange for taking title of the debtor's
property, with the condition that the conveyance of title becomes
void upon the payment of the debt. They are two type
1.Adjusted rate Mortgages: The celling (maximum) and floor
interest rate will be charged during the life of the mortgage is
determined .
2.Fixed rate mortgages: interest rate is fixed .

Interrelation ship between money and capital market
• In practical there is a thin line of demarcation between money
and capital market, because quite often, the same institution
participate in the activity of both market ,and there is a flow of
fund between the two market.
•Lender may choose to direct their funds to either or both markets
depending up on the availability of fund ,the rate of return, and
their investment policy .
•Borrower may obtain their funds to either or both market
according to their requirements.

• Some corporation and financial institutions serve both markets by
buying and selling short term and long term securities .
• All long term securities become short term at the time of maturity.
• So some capital market instruments also become money markets.
• Yields in the money market are related to those of the capital

market.
• A fall in the short term interest rates in the money market shows a
condition of easy credit which is likely to be followed by a more
moderate fall in the long term interest rate in the capital market .

2.3. Financial intermediaries
•Financial intermediaries are institutions that intermediate in the
financial process between ultimate borrowers and ultimate lenders in
the economy.
•The process of indirect finance using financial intermediaries,
called Financial intermediation, is the primary way for moving
funds from lenders to borrowers.
•Financial intermediaries are a far more important source of
financing for corporations than securities markets are.
•Financial intermediaries are financial institutions operating in a
money
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• They are the link between the borrowers and the lenders.
The ultimate borrowers include;
A. Consumers who need to borrow to finance part or all of their
consumption.
B. Firms that borrow to invest in physical capital;
C. The government when it borrows to finance its deficits.
• The financial intermediaries transfer the savings of lenders
(also known as surplus units) to the borrowers also known as
deficit units)by purchasing primary securities and issuing
secondary securities.
• These secondary securities are the currency issued by the
central bank, demand and time deposits of commercial
banks, savings deposits, insurance and pension funds of non-
monetary intermediaries both the primary and secondary
securities are known as financial assets.
• When the primary securities are purchased directly by surplus
income units, it is called as direct financing and when theses
are purchased through financial intermediaries then it is called
as indirect financing.

• The ultimate lenders are the economic units that save part of
their current income by spending less than their current
income on their purchases of commodities and want to lend
some or all of these savings to others for some duration.
• Householders form the major bulk of the ultimate lenders,
saving part of their current income.
• Some of the firms engaged in production also do not spend all
of their sales revenue on immediate purchases of inputs or
distribute them to shareholders as distributed profits but save
part of them (i.e. keeping some profits as retained earnings).

• They are sometimes willing to lend part of these retained
earnings to others. The government does the same on a net basis
when it runs a surplus.
• Financial intermediaries borrow from the ultimate lenders or
from other intermediaries by issuing their own liabilities in
exchange and relend to others by accepting the latter’s liabilities.
• In the modern economy, only a small proportion of the savings
is directly transferred from the savers to the ultimate
borrowers.

• Most of the savings are directed by the savers to financial
intermediaries such as banks, mutual funds, pension funds,
insurance companies, etc., which re-channel the funds thus
obtained to firms and the government, either directly by buying
their shares and bonds or indirectly through other financial
intermediaries such as investment banks.
• The basic reason for this intermediation is the differences in the
preferences of the savers for asset characteristics, such as
liquidity and security, and those attaching to the instruments
issued by the firms and the government.

• Consequently, there is in general a considerable difference in
the characteristics of the liabilities sold to the savers by a
financial intermediary and those of the assets bought by it,
resulting in what is sometimes called the asset–transmutation
process.
• Banks are financial intermediaries that borrow from the public
by inviting demand and time deposits or issuing their own
securities and hold the liabilities issued by others .

There are two types of financial intermediaries:
A. Banking institutions
•Banks are the most important financial intermediary in the monetary system.
For example, the intermediation by the commercial banks means the ultimate
borrowers sell their primary securities to these banks and receive money in the
form of demand deposits in these banks.
• The demand deposits are mostly spent by the borrowers to produce and
purchase current output.
•The lenders acquire financial assets from the borrowers through bank deposits.
•The bank intermediation has therefore, led to the transfer of un spent incomes
form the surplus to deficit units.

B. Non bank financial intermediaries
• The non bank financial intermediaries refer to those financial
institutions, other than the banking companies, which are
engaged in some form of borrowing and lending activities.
• These include building societies, hire purchase companies,
Insurance companies, causality insurance companies , saving
and credit cooperatives, pension, common trust fund ,mutual
saving bank, credit union , the investment and unit trusts.
•They pool funds from net savers and lend them to finance
expenditure of business firm and local bodies .

• Regarding to the intermediation by the non-banking financial
intermediaries, ultimate lenders issue checks and present them
to these financial institutions making a demand on their deposits
with commercial banks.
• These institutions endorse the checks and send them to the
commercial banks.
• The commercial banks purchase primary securities from ultimate
borrowers who now have demand deposits in them which they
spend for the purchase of current output and are ultimate received
by the financial institutions have created secondary securities and
the lenders have acquired financial assets.
• This process only involves the transfer of bank deposits from the ultimate lenders
to the non banking financial institutions then to ultimate borrowers and finally
back to ultimate lenders.
• The banks have not intermediated in this process and their role has been confined
only to that of administering the transfer of demand deposits in their ledgers.
TYPES OF FINANCIAL INTERMEDIARIES
We have three types of financial intermediaries.
1. Depository institutions
2. Contractual Savings Institutions
3. Investment Intermediaries

1. Depository institutions are financial intermediaries that accept
deposits from individuals and institutions and make loans.
• These intuitions include commercial banks and the so-called
thrift institutions (thrift):
A) savings and loan associations,
B) mutual savings banks,
C) credit unions or cooperative credit society .
D) Commercial bank
• Their behavior plays an important role in determining the
money supply.
2. Contractual Savings Institutions
•It includes insurance companies and pension funds, mortgage
stock exchange ,are financial intermediaries that acquire funds at
periodic intervals on a contractual basis.
•Because they can predict with reasonable accuracy how much they
will have to pay out in benefit in the coming years, they do not have to
worry as much as depository institutions about losing funds.
• These institutions include life insurance companies, Fire and
casualty insurance, companies, and pension funds and government
retirement funds.

3. Investment Intermediaries
•This category of financial intermediaries includes Finance
companies, money market mutual funds ,investment trust etc.
The Role of financial Intermediaries in developing economics

•They play a very useful role in the modern financial system.
• They mobilize savings which are essential for capital formation.
•They keep the rate of interest low and thus promote investment
which is essential for the economic growth of the country.

• In the LDCs these financial intermediaries have a very special role
to play.
• Reduce risk and bring stability in capital market .
• Create new asset and liability.

• The financial intermediaries channelize these savings into
productive uses.
• They encourage people to hold financial assets in place of
physical assets and thereby make available resources for
development purposes.
• In most of the LDCs owing to the want of effective lending
institutions proper environment for entrepreneurship is lacking.
• The financial intermediaries can fill this gap that is, they can
create investment opportunities and help small and new
enterprises in explaining them.
• Since securities are close substitutes for money, these financial
intermediaries by dealing in securities economies the use of
money and there by help in controlling inflation directly.
• Finally, by mobilizing savings and channelizing them into
productive uses, through investment, the financial
intermediaries raise the level of saving and investment.

• Non-Bank financial intermediaries (NBFIs) pool resources from
the savers and channelize them to provide funds, to business
firms and local bodies.
• The NBFIs provide all round help to the different sectors of the
economy. i.e they enable the households sector to put its surplus
funds into profitable uses. They also provide its consumer
credit loans and mortgage loans etc.
• Thus, they promote saving and investment habit among the
members of the society.
• They help the business sector by providing loans, mortgage for
their projects and by purchasing bonds and shares, etc. In this
way they facilitate investment in plant, equipment, etc.
• By purchasing their bonds and securities they lend a helping
hand to the governments at various levels.

• These intermediaries can be of immense help to the central bank
in the execution of its credit and monetary policies and thus in
promoting economic growth. They create large financial assets
and liabilities.
• They provide the economy with money supply. In this way
they smooth the working of financial markets and thus help the
growth to the economy.
• Since the financial markets provide directions to the economy,
the monetary and credit policies of the central bank are
implemented in such a way that the functioning of the financial
markets is not disturbed.
• Since the NBFIs are an important link between the ultimate
lenders and the ultimate borrowers, they discourage hoarding,
mobilize saving and channelize them in to investment and thus
promote economic growth.

• They compete among themselves which results in the
lowering of interest rates.
• Since the NBFIs invest their savings into primary securities,
the prices of securities go up and the rates of interest fall.
• Low rates of interest benefit both the savers and the
investors.
• The real costs of lending to borrowers are reduced, which in
turn, reduce the costs and prices of goods and services.
• The savers benefit because the NBFIs provide greater safety
to their funds and other facilities and services and thus
increase real return and income from their savings.
• Since these intermediaries take the risk on themselves, they
reduce the risk of the lenders and borrowers.

2.4. Interest rates and Their Measurement
2.4.1 Meaning of interest rate
•In common under standing, interest rate is the payment made by

the borrower to the lender of a money loan .
•It is the price paid for the use of other capital funds for a certain
period of time.
•In real economic sense, interest is the returns for capital as
factors of production .
•It is also all a price, paid for the use of credit or money.
•For all practical purpose ,interest is as price of a money loan .

• It is the amount charged, expressed as a percentage of
principal, by a lender to a borrower for the use of assets.
• Interest rates are typically noted on an annual basis, known as
the annual percentage rate(r).
• The assets borrowed could include ,cash, consumer goods,
large assets, such as a vehicle or building.
• Interest is essentially a rental, or leasing charge to the
borrower, for the asset's use.
• In the case of a large asset, like a vehicle or building, the
interest rate is sometimes known as the lease rate.
1) Simple interest rate : lender provides funds to borrower,
borrower pays back principal and interest at maturity date.
• r= I /p*t ,where I interest income, p stand for principal ,t is time
period in year and r stands for interest rate
Example: P= Birr18,000, Interest income=Birr3240 and Year =3
Required?
r=?
Soln. r=0.06 percent

2) For compound interest rate
• If interest rate is calculated yearly basis;
A = P(1+r)t
Principal =Birr 2000 and amount Birr 8000 ,Year =2 assume

further that interstate is calculated annually basis . The required
(r)
Soln: r=1percent

• Nominal interest rate makes no allowance
for inflation.
• Real interest rate is adjusted for changes in price level
so it more accurately reflects the cost of borrowing
• Ex-ante real interest rate is adjusted for expected
changes in the price level.
• Ex-post real interest rate is adjusted for actual changes
in the price level.

• The equation that links nominal and real interest rates
can be approximated as;
• Nominal rate = real interest rate + inflation rate, or
• Nominal rate - inflation rate= Real interest rate
• Inflation rate is the rate at which money is losing its
value.

Empirical facts about the impact of interest
rate
• To what extent interest rate affect economic
growth on a country?
• Real interest rate is the lending interest rate
adjusted for inflation as measured by the GDP
deflator in Ethiopia .
• Real growth rate: This entry gives GDP
growth on an annual basis adjusted for inflation
and expressed as a percent. The growth rates are
year-over-year, and not compounded.
Descriptive statistics of real interest rate and Real GDP growth (1985-2008)
Source: own computation from World bank data base 2020

Two way line graph on the Trend of real interest rate and Real GDP growth rate(1985-2008

1)Determination optimal lag length

2)Stationery test for Real interest rate

2)Stationery Test result of real GDP growth

3) Johnson co-integration equation

4) VECM Result

Result
• Real interest rate influence real GDP growth
negatively ,so government must adjust interest rate
based on inflation rate of Ethiopia.
• When real interest rate changes by one percent on
average ,GDP growth percentage by 60 percent and
statistically significant(1perenct) in Ethiopia between
the year 1985-2008.
• There is 61.3 percent speed of adjustment of real
GDP growth percentage were made to ward long run
equilibrium is made with real interest rate changes .

Diagnostic test
1)Autocorrelation
2)Normality test

Stability test

The major function of interest in modern economy
1.It encourage consumer to save more .
2.It provide capital for constructive productive service and their by
helps the economic growth.
3.It help the allocation of savings in different productive channel .
4.It regulate the flow of funds .
Measuring Interest rate
Gross and net interest
Gross interest :The actual amount paid by the borrower to the
capitalists as the price of capital fund borrowed .
• It includes the following elements;
1.Compensation for risk : giving loan to some body always
involve a risk that the borrower man not repay it .
2.Net interest rate (pure interest ): The payment made
exclusively
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for the use of capital .
3) Compensation for inconvenience
• A leader lends only by saving ,i.e,by restricting consumption out of
his income, which obviously involve some inconveniency which
is to be compensated and lenders may not get back his money
when he may need it for his own use.
• Hence, a payment to compensate this sorts of inconvenience may
be charged by lender ,then interest rate will be higher .
4) Payment for management service
• A lender of capital fund has to spend money and energy in the
management of credit and hence, gross interest rate also include
payment for management expense .
5) Compensation for change in the value of money (inflation
rate )
• When price are rising ,the purchasing power of money will
declines over a period of time ,and the creditor losses ,to avoid
such loss ,a high rate of interest demanded by the lender.
• Gross interest rate =Net interest +Payment of risk +Payment
of management service +Compensations for changing the
value of money .
Example :Calculate gross interest rate ?
• Given a Rural Saving and Credit Cooperatives having net
payment for the use of capital is 5%, management expense 1%
, inflation rate 1% ,compensation of risk 2% and compensation
of inconveniency 3%
Ans . Gross interest rate is 12 percent .
Note:Net interest rate is the same every where ,but gross
interest rate is different from place to place ,case to case and
different time and for different individual .
• Because ,different type of borrower, the money market is not
homogenous ,duration of loan is varies, duration of supply
condition of capital fund are different in different courtiers .
There are a number of problems in implementing this theoretical model
• Political support for the price-stability objective is not

guaranteed.
• It is difficult, if not impossible, to determine what
natural rates might be at any one time.
• There is uncertainty about the transmission
mechanisms through which Central Bank interest
rates feed through into market rates.
• National economies are increasingly open to the
influence of international financial markets.

2.4.2Theory of interest rate
•Different theories have been put forward regarding interest. However,
all these numerous theories can be grouped under the two headings:
i.Theories which explain why interest is paid;
ii.Theories which explain how the rate of interest is determined.
I. Based on why interest is paid ;
1.Productivity Theory: It says interest is paid on capital because
capital is productive.
•The borrower can get additional income from borrowed capital and in
easily afford to pay interest.
Criticism
•If capital were free,no interest will be paid in spite of its productivity.
•Hence, it is scarcity rather than productivity which explains interest.

2)Austrian or Agio Theory: According to which interest is paid to equate the future
satisfaction to the present satisfaction, as it is said that one bird in hand is
better than two in the bush.
• According to this theory, Interest is the price of time of reward for agio, i.e., time
preference.
• It has been argued that man generally prefers present income to a future income
and consumption.
• There is an 'agio' or premium on present consumption as compared to a future one.
• It is also called the Time Preference Theory:- Fisher’s theory says that interest is
the price for time preference.
• This time preference depends on the size of a man’s income, the distribution of
income over time, the degree of certainty regarding its enjoyment in the future
and the temperament(human behavior) and character of the individual.
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• Austrian or Agio Theory of Interest:
• The Austrian or Agio Theory of interest was first advanced by
John Rao in 1834 and later on, it was developed by the
Austrian economist, Bohm-Bowerk. According to Bohm-
Bowerk
• "Interest is the premium or agio which present goods
command over future goods.
• The reason as to why present goods are preferred over future
goods are as follows:
1)Future is shrouded in mystery and so is uncertain.
2) Present wants are more urgently felt than the future ones.
3) Present goods posses a technical superiority over future goods.
Keeping in view all the conditions stated above, an individual
prefers present satisfaction to a future satisfaction"

Example: For instance, you give a choice to a person either to
have one bird which is in hand or two -in the bush. If the man
is wise, he will prefer the bird in the hand rather than two in
the bush.
• Take another example, you give a choice to a man either to
have Birr100 now or the payment of same amount after, say, a
year. The man if he is not a lunatic will prefer the present
payment. But in case you give the choice of the payment of
Birr100 now or Birr130 after six months, the man may be
tempted to take Birr130 at the future date provided he is
satisfied that the extra payment of Birr 30 compensates the
sacrifice involved in postponing the present satisfaction.
• Interest is, thus, the payment which a borrower has to make to
the tender for inducing him to put off the satisfaction of
present consumption to some future date.
Criticism: The theory is criticized on the following
points:
(i) It attaches too much importance on the supply side of
the problem and ignores the demand side.
(ii) The theory does not throw light as to how the rate of
interest is determined.
(iii) It is also pointed out that interest is not paid merely
because the tender must be induced.
• The interest is paid because the borrowers are willing
and able to pay the loan.

4) Loanable Fund Theory of Interest (Neo Classical Version):
Definition:
• The theory was first put forward by Wicksell and later on it was elaborated
by Ohlin, Robertson and Pigou, Myrdal etc. According to the
neoclassical economists:
• "The rate of interest is determined by the interaction of the forces of
demand for loanable funds and the supply of it in the credit market".
• We briefly analyze the forces behind the demand for and supply of
loanable funds and then see how they interplay in the determination of the
rate of interest.
• (i) Demand for Loanable Funds: The demand for loanable funds comes
from households who need money for consumption purposes and from
entrepreneurs who require it for productive purposes.
• The total money borrowed by consumers for consumption purposes forms
only a small part of the total loanable funds, while a major portion of the
funds is borrowed by businessmen of all types. When an entrepreneur
borrows money, he keeps in mind two things:

(a)the expected net return on newly invested funds, and
(b) the interest which has to be paid to the lender.
• So long as the marginal efficiency of capital is above the
interest rate, the entrepreneur continues borrowing
additional funds.
• When he finds that due to the operation of law of
diminishing returns, the marginal efficiency of capital
has fallen to the level of rate of interest, the entrepreneur
stops borrowing additional funds.
• Because if he invests more, the interest rate will be
higher than the marginal efficiency of capital and his
profit will be adversely affected.

• The last unit which an entrepreneur has thought
worthwhile to employ because the net revenue earned
from it equals the prevailing rate of interest, is railed
marginal unit and its productivity as marginal
efficiency of capital.
• As all the units of capital employed are very similar
and interchangeable to one another in a competitive
market, so the rate of interest which- is paid to the
marginal unit will also be paid to all other units.
• Thus, we conclude that on the side of demand, the rate
of interest tends to be equal to the, marginal efficiency
of capital.

ii) Supply of Loadable Funds:
• The supply of loanable funds comes from savings by
individuals, business concerns.
• discharging of idle cash balances, bank credit.
Disinvestment is another source of the supply of loanable
funds.
• All the sources of the supply of loanable funds are directly
related to the rate of interest.
• The higher the rate of interest, the larger is the supply of
the loanable funds and vice versa.
• There is no doubt that higher rate of interest usually
induces people to save more but that is not always the
case.
• There are people in the world who will save even if
the rate of interest is zero.
• But as their number is not very large, so the savings
of these people will not meet the demand for loanable
funds.
• Thus, rate of interest must be high to equate the
supply of loanable funds with the demand for it.
• Let us now examine with the help of the following
imaginary schedule as to how the supply of loanable
funds is adjusted to the demand for it.

3) Abstinence or Waiting Theory:- The lender of capital has to be
compensated for abstinence from consumption or for not immediately
using his own capital.
• But some people will wait and save even, If there is no interest. Hence
this theory does not explore interest satisfactorily.
• Interest is a reward for abstinence. When a person saves money from his
income and lends it to somebody else, he in fact makes sacrifice. Sacrifice
in the sense, that he abstains from consuming the whole of his income
which he could have easily spent. As abstaining from consumption is
disagreeable and painful, so the lender must be rewarded for this.
• Thus, according to Senior, interest is the reward for abstinence from the
use of capital on the part of the lender".
• This theory is rejected on the ground that saving does not necessarily
involve discomfort or sacrifice. A millionaire may save and lend a major
part of his income without undergoing any hardship or suffering
• Marshall, Realizing this flaw in Senior's definition, substituted the term
waiting for abstinence. According to Marshall.
• Interest is the reward for waiting.
• When a man saves a part of his income, he simply postpones his present
consumption to some future date. During a period when money is loaned,
he himself might stand in need of money.
• But he cannot get it back from the borrower as the period of loan is fixed.
He has to wait for the return of loan. In order to encourage the spirit of
waiting amongst the lenders, some inducement is necessary and this
inducement according to Marshall, is interest.
Criticism
• (i) The theory is criticized on the ground that it lays undue emphasis on the
supply side of the problem and ignores the demand side which is equally
important for explaining the economic cause of rent.
• (ii) It is not true that all the money saved is only due to the inducement of
interest. Some persons may save money even if the rate of interest is zero.

5. Liquidity Preference Theory:
•According to Keynes, who propounded this theory, interest is not a
reward for waiting, nor is it a payment for time preference, but it is
a reward for parting with liquidity i.e Speculative motive .
•This theory not only explains why interest is paid; it also explains how
the rate of interest is determined.
•All these theories we have been discussing since answers the question
of why interest is paid.
II. Based on how interest rate is determined
2.4 Determining interest rate

1. Classical or Real Theory
• Interest is determined by the demand for and supply of capital or investment
. i.e demand for investment capital and supply for investment capital .
• For the classical economists, the rate of interest was therefore determined by
the interaction between the demand for investment capital (the fisherman
making a net) and the supply of savings (the friends surplus fish).
• Interest in real term is the reward for productive use of capital or investment.
• According to the classical theory, the rate of interest rate is determined by
the intersection of demand for and supply of investment (or capital). Interest is
the price of investment because. firms borrow money for investment. Thus,
investment depends on interest rate.
A) Demand for capital
• It comes from entrepreneur who wish to invest in capital good industry .
• It is demand for savings i.e investment .
• The marginal productivity curve of capital ,thus determine the demand curve
for capital .
• While deciding about an investment , the entrepreneur, however ,compare, the
marginal productivity of capital with the prevailing market rate of interest .
• i.e MPK=r .
Figure 2.1 The investment function
I=f(r)=dI/dr <0, where, I amount of investment and r is rate of interest .
•Investment function is down ward sloping curve .

• (r) is rate of interest ,(q) is investment volume, when r is
falling from r1to r2 ,investment volume rise from q1 to q2, it
follow that the investment demand curve is down ward.
B) Supply of capital
• Saving is the source of capital formation .
• It depends on the availably of saving in the economy .
• Saving emerge from the desire and capacity to save ,to some
classical economists like Sinor, abstinence from
consumption is essential act of saving .
• For fisher, time preference is the basic consideration of the
people who save.
• In both case the rate of interest play an important role in the
determination of saving .

• For classical economists saving is a direct function of
interest rate.
Figure 2.2 The saving functions

F
Figure 2.3 The equilibrium interest rate

Mathematical Example
Given the saving and investment function :
S=-8+7r
I=20-7r
A)Determine the equilibrium level of interest rate ?
Solution ;
At equilibrium
S=I
= -8+7r=20-7r
= -8-20=-7r-7r
= -28=-14r
= r*=2 percent

• Indeed ,the demand for capital is influenced by the productivity of
capital ,and the supply of capital.
• In turn ,saving are conditioned by the thrift habit of the commodity and
productivity in the economy ,are the fundamental determinates of the
rate of interest .
Criticism
1. Interest is not the reward for saving according to Keynes , one can get
interest by lending money which has been saved but has been inherited
from ones forefather .
• If a man hoards his saving in cash ,he earns no interest.
• The amount of savings depends upon not only interest rate but also the
level of income.
2) Keynes’s further maintains that the classical theory of
interest rate is indeterminate and confounding .
r=f(S,I), however ,
S=f(r) direction function ,and I=f(r) inverse function ,hence, we

can not know the interest rate unless we know the saving and
investment schedules, which gain ,can not be known unless the
rate of interest is known.
•Thus,the theory fail to offer a determinate solution .

3) The classical theory looks upon money merely as a medium of
exchange.
•It does not take into account the role of money as a store of value
.
•It assume that income is not spent on consumption should
necessary be diverted to investment; it ignore the possibility of
saving being hoarded .
•This factor makes the classical theory unrealistic and inapplicable
in a dynamic economy
•It fail to integrate monetary theory in to general body of
economic theory .
4) According to classists , the rate of interest is an equilibrating
factor between saving and investment .
• In the view of Keynes, the rate of interest is not the price which
brings equilibrium of the demand for resource to invest with the
readiness to ascertain theBY:present
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Yeshiwas Ewinetu Tegegne . 225
• It is the price which equilibrates the desire to hold wealth in the form
cash with the availability of quantity of each .
5. Keynes point out that equality between saving and investment was
brought about by changes in the level of income and not by the rate of
interest as a asserted by the classical economists .
6. The classical interest theory is narrow in scope .

• It considers only the capital meant for investment .
• It does not consider the consumption loan .
7. The classical theory pay no attention to the significant of newly

created money and bank credit in the determination of interest rate. .

2) Loanable funds theory of interest rate (Neo -classical theory of interest
rate )
•Professor Knut wicksell explain the loanable fund theory .
•It is attempt to improve upon the classical theory of interest rate .
•According to this theory, the rate of interest is the price that equate the
demand for and supply of loanable fund .i.e
•Interest as determined by demand for and supply of loan able funds.
•Loanable fund are the sums of money supplied and demand at any time in
the money market.
•The Total supply of loanable fund, saving(S) plus new money supply or bank
credit or money dishoarded (M).
TSSLF= S+M
•The Total demand side of loanable fund, demand for investment(I) or
investment demand for saving plus the demand for hoarding money(H) or
inactive cash balance :
DDLF= I+H

• Loanable fund is the function of four variables:
r=f(I,S,M,H)
• The determination of interest rate can be seen as follows :

• S+M is Total supply of loan able Fund at different interest rate, is
up ward sloping ,indicating the highest rate of interest, the highest
the supply of loan able funds and vice versa .
• H+I is Total demand for loan able fund at different interest rate,
its slope is down ward sloping ,because the lower the rate of
interest ,the higher is the demand for loan able funds and vice versa.
• At point E the two curve intersect each other ,which indicates the
level of the market rate of interest (OR*) .
• Thus, the rate of interest is determined by the intersection of the

demand and supply of loan able funds.

• The classical rate of interest would be OR1.
• Hence under loan able fund theory the discrepancy between

saving and investment in classical theory is because of
algebraically sum of net hording(H) and net money(M) .
• Thus the loan able fund theory shows that money no longer play
neutral or passive role .
• Its inclusion on the supply side bringing the rate of interest down
to OR*from OR1 in real term .
• Loan able fund theory recognize the dynamic and active role of
money .
Figure 2: Summery of Determination of interest rate under loanable fund
theory.

Example :Given the loanable fund demand and supply function as follows :
S=-8+14r , I=20-70r , money dishoarded(M)=-40+20r and money horded
(H)=20-10r Birr
A)Determine the equilibrium level of interest rate ?
Solution :
At equilibrium
S+M=I+H
= -8+14r -40+20r=20-70r+20-10r
=-48+34r=40-80r
= -48-40=-80r -34r
= -88 = -114r
=r*=0.772 percent

Criticism
•Hansen criticizes, that the rate of interest is not known unless the
level of income is not known since TSSLF varies with income
level Robertson, but the level of income can not be known unless
the rate of interest is not known hence ,this theory is
indeterminate.
•The supply of loanable fund some time increase by a release of
cash balance or decrease by the absorption of various saving in to
cash balance .
•This give the impression that the cash balance of the community
can be increased or deceased .
•This is not actually the case. i.e fixed and necessarily equal to
the total supply of loanable funds and the cash balance increase
or decease actually results only change in the velocity of
loanable funds .
• It is illogical to combine factors like saving and investment
with monetary factor bank credit and liquidity preference .
• The theory is an exaggeration of the functional relationship
between between the rate of interest and saving .
• Critics argued that people usually save not for the sake interest
rate but out of precautionary motives ,where propensity to
save is interest inelastic.
• The were wrongly considered interest rate purely as a real
phenomena.

3. Keynes liquidity preference theory
•Interest rate is regarded by Keynes as purely monetary
phenomena in the sense that, the rate of interest is determined
by the interaction of the demand for and supply of money .
•Interest rate is a reward paid for parting with liquidity, i.e
giving up the cash balance held.
•The demand for money is the demand for liquidity preference
as coined by Keynes .
•Liquidity preference is the preference of the people to hold
wealth in the form of liquid cash rather than other non liquid
assets like bond, security ,bill of exchange etc

• Liquidity preference is the desired to hold cash .
• If demand for money rises ñ that is, if people decide
they would prefer cash to interest-bearing securities ñ
they sell them, and bond prices fall: i.e. interest rates
rise.
• Likewise, if the supply of money rises people will
move into bonds, the price of which will rise: i.e.
interest rates fall.

• According to Keynes ,there are three motives behind the desire of
the people to hold liquid cash ;
1) Transactional motive:-People need cash for the current

transaction of personal and business exchange.
2) Precautionary motive:- People desire to hold money to meet

unforeseen and sudden expenditure or to meet un expected
need such as illness, accident ,unemployment and unforeseen
emergencies.
• It depends up on income, business activity, opportunities for
unexpected profitability and the cost of holding liquid asset .
• The above two motives are interest inelastic.
3) Speculative motive
•People hold money for securing profit from knowing better than
the market what the future will bring forth .
•To get gain by investing on bonds. Bond price and interest rate
are inversely related .
•According to Keynesians ,it is expectation about change in bond
prices or in the current market rate of interest that determine the
speculative demand for money .

• The two determents of the rate of interest are ;
1) Liquidity preference schedule(demand for money):

• It expresses the financial relation between the amount of money
demanded for all liquidity motives and the rate of interest.
• The demand for money is the demand to hold cash balances.
• The composite of demand for money are two principal demand;
I. Demand for money as a medium of exchange (active cash

balance ) motivated by transactional and precautionary
motives) i.e L1.
II.Demand for money as a store of wealth(idel cash balance )

motivated by speculative
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motive i.e L2.
A)Active cash balance consists of demand for money for transactional
motive and precautionary motive is represented by L1.
• L1 is income determined and interest inelastic i.e L1(y)
B) Idle cash balance consists of demand for money for speculative motive
interest elastic and income determining is represented by L2(r) .
• Speculative demand for money is decreasing function of the rate of
interest rate to the matter of expectations about a safe future rate of
interest .
• The lower interest rate, the higher speculative demand for money.
• In the liquidity function, however, it is postulated by Keynes that
demand for money is positively correlated with income .

• An increase the level of incomes implies a rise in the demand for
money vice versa . On the other hand , an increase in interest rate
implies a fall in demand for money and vice versa
• Total demand for money represented by: Lp=L1+L2
• It is down ward sloping because, the amount of money demand

for liquidity purpose( Lp) is a decreasing function of interest rate .

2) The total supply of money(M): The total quantity of money in
the country for all purpose at any time .
•Though the supply of money is a function of interest rate to a degree,
yet it is considered to be fixed by the monetary authority i.e the
supply curve for money supply is taken as perfectly inelastic.
Figure 3.2.2 Money supply curve

• According to the liquidity preference theory ,the equilibrium
rate of interest is determined by the interaction between
liquidity preference (demand for money) and the supply of
money .
r*=M=Lp=(-r,+y)
Figure 2.3.3 liquidity preference equilibrium rate of interest

Example: The short run amount of money supply or quantity of money
Birr 400.
The demand for money given as;
An active cash balance of the country(L1)=0.5Y,and;
Idle cash balance (L2)=200–400r
A) Determine the equilibrium level of interest rate in the above country?
Solution: At equilibrium level of interest rate is determined when; money
supply=money demand
M=L but L=L1+L2 and M is constant in the short run .
= 400= 200-400r +0.50Y
=200=-400r+0.50Y
=200-0.50Y=-400r
r*=-0.50 +0.00125Y
If the national income is assumed to be Y=2000 ,then r*=2 percent .

Home work
• For Ethiopia economy the following money-demand
function is given; Lp= 0.5Y-60r,
• If the national bank of Ethiopia has set money supply
to be 1520 Birr’s find out the rate of interest when
money market is in equilibrium ?
• Assume the level of national income is Birr 4000
Birr's .
Ans .r*= 8%

Criticism
•Hansen maintain that the Keynesian theory of interest rate is
indeterminate. Lp curve shift up or down with the change in the
level of income particularly L1 from liquidity preference for
transaction and out of precautionary motive being the function of
income, we are already know the income level and to know the
level of income, we must know the rate of interest rate.
•According to Hazlitt, the Keynesian theory is one side (interest
rate is a monetary phenomenon),since it ignore the real factor in
the determination of the rate of interest he ignore productivity and
time preference .
•It is incorrect to ignore the impact of the saving factor in the
determination of interest rate .
•The liquidity preference version is clearly wrong, vague and
confusing and narrow scope .
246
• It is unrealistic to have independent interest rate from demand for
investment fund.
• It ignore the long run period and only focus on the short run. but,
capital investment is along run interest which is really significant .
4) Neo- Keynesian (Modern ) theory of interest rate
• This theory is developed by Neo Keynesian economists like, Hicks
,Lerner and Hansen etc.
• According to the modern theory of interest, the equilibrium rate of
interest and equilibrium level of income are determined simultaneously
at the point of intersection between the IS and the LM curves.
• All other combinations of income and rate of interest are disequilibrium
combinations.
• It provide determinate theory of interest rate.
• It combines monetary and real factors to seek an explanation of the
determinants of the rate of interest.
• It is identified that four factors are determining the rate of interest .

1. The investment demand schedule
2. The consumption function
3. The liquidity preference schedule
4. The quantity of money

• To integrate the this four variable Neo- Keynesian have the
following synthesis . It evolved two schedules, the IS and LM
schedule.
• IS shows the equilibrium between the flow variable in the real
sector or equilibrium condition in the commodity market .
• LM shows the equilibrium of stock variable or equilibrium
condition in the money market .
• When the IS and LM curve plotted graphically ,give us the
equilibrium rate of interest at the point of their interaction.
• At this equilibrium ;
 Total saving =Total investment
 Total demand for money =Total supply of money
 The real sector as well as the monetary sector is in equilibrium.
To draw graphically ;
IS: denotes the equilibrium in the real sector, showing various combinations of the
level of income (y) and interest rate (r) at which there is equilibrium aggregate
real saving and real investment .
• It gives different level of income at which the saving and investments are equal .

IS curve:
r1
r2

• LM curve is derived from the Keynesian liquidity preference
theory.
• It shows all combination of interest rates and level of income at
which the demand for and supply of money are equal i.e ;
• It shows the combination of interest rates and the level of
income where the demand for money and the supply of money
are equal.
The LM cure M(supply
: L1=>L2 =>Y2>Y1
of money)
r2

IS

Two sector model example: Given the following data :
C = 200 + 0.75Y and I = 500 – 5r in the good
market and L1 = 0.25Y and L2 = 200 – 4r and M is
800 Birr in the money market . Then
A)Determine the equation of IS Curve ?
B)Determine the equation of the LM curve?
C)Determine the equilibrium level of interest rate ?
D)Show graphically the determination of equilibrium
level of interest rate ?
Solution :

C) From A and B ,we found that
The IS equations :Y=2,800- 20 r
The LM equation Y =2,400 +26 r
With the Neo-kensian theory of interest rate is determined as
follows :
LM=IS
2,800 -20r =2,400 +16 r
2,800-2,400 =16r+20r
400=36r
r* =11.11 percent and Y*=2578.

The determination of equilibrium level of interest rate graphically

• It is to be noted that Keynes’ analysis
contained all these four elements, but he could
not integrate them to form a determinate
theory of interest.
• The credit goes to Hicks and Hansen for using

the Keynesian tools to arrive at a complete and
a determinate theory of interest.

Three sector model : Given the following data C=100+0.8Yd
I=50-25i
G=T=50
Ms/p=200
Md=Y-25i
Where, Yd is deposable income, Md is demand for money
(liquidity preference), Ms/p real money supply balance, I is
gross domestic private investment and G is government
expenditure ,T is tax revenue(lump sum) .Then, required ;
A)Calculate the IS equation ?
B) Calculate LM equation ?
C) Calculate the equilibrium level of interest rate ?
Solution :

Criticisms
 It is a static theory that explains the short run behavior of the
economy.
 Interest rate is not flexible, if the interest rate happen to be rigid
because adjustment mechanism will not takes place .
 Highly artificial because real sector and monetary sectors are so
interrelated and interdependent that the act and react each other .
 Close model which did not take in to account the effect of
international trade .
 Price level exogenous variable in this model.
 This is un realistic because price change plays an important role in
the determination of income and interest rate in the economy .

• However, more contemporary economic thinking has tended
to reject the notion of a single long run equilibrium.
• Instead, concepts such as Professor James Tobin Portfolio
Selection theory focus on the choices made by both firms and
households between a wide range of physical or financial
assets, each generating varying returns (i.e having different
prices).
• These choices can in turn be affected by all kinds of financial
or other event.
• A real economy, in other words, is a spiders web of complex
interconnections, where interest rate levels and their effects
cannot be predicted from any simple theory of long-run
equilibrium.

Chapter review Questions
1.What is a money market and capital market ?
2.Why both markets are important ?
3.Discuses the financial institutions and instruments in money and capital market ?
4.Define the financial intermediaries ?
5.Discuss the bank and non bank financial intermediaries clearly ?
6.Distinguish between money market and capital market .How are they
interrelated ?
7.Critically discuss the classical ,loanable fund ,Keynesian and modern theory of
interest rate as an explanation of interest rate ?
8.Explain the determinates of term structure of interest rate ?

Chapter 3: The demand for Money and other assets (9hrs)
3.1.Quantity theory of money
3.2.Liquidity preference theory
3.3.Post Keynesians developments in monetary theory
3.4. Friedman’s modern quantity theory of money
3.5.Empirical evidence on demand for money

• The demand for money is not the same us the demand
for commodity.
• The demand for commodity satisfy the human wants
directly.
• According to classical view money is demanded by the
people not for its own sake ,but as a medium of
exchange .
• The demand for money comes from the public.

• The demand for money is the desire of the people to
hold financial assets in the form of money.
• Classical believed that the demand for money arises
from the demand for goods and services i.e the
demand for money depends up on the supply of
goods and services available.
• Hence, money do not has direct utility to the holders
but satisfy human wants indirectly.

3 .1 Quantity theory of money
•It is originated by Davenzath –the Italian writer .
•David hume was the one who was make it accepted in the classical thinking.
•It is the oldest and has been the most influential theory to explain the determination
of value at any one time and the variation of this value over period of time .
•Price are proportional to the plenty of money supply.
Let us see the two classical approaches in the quantity theory of money :
1)Transaction Balance version (Fisherian approach )
•According to Irving fisher in 1911 ,the demand for money relates to the amount of
money people have to hold to under take a given volume of transaction over a
given period of time .
•Thus the demand for money is determined by three objective factors
A)The volume of transactions (T)
B)The average price level per unit of transaction (P)
C)The average velocity of circulation of money (V).
Velocity of money is an average number of times per year that a birr is spent in
purchasing goods and services.
Assumptions
1)Fisher viewed velocity as constant in the short run. This is because he felt
that velocity is affected by institutions and technology that change slowly
over time.
•V are assumed to be constant and are independent of change in M , because
depend upon outside factors such as payment of individuals and commercial
custom ,density of development of transportation .
2) Fisher, like all classical economists believed that aggregate output at full-
employment level in the short run i.e ,
•T is independent of change in other factors like M and V rather ; T depends
upon natural resource, technological development and population etc which
are out side the equation .
•The supply of money (M) is exogenously determined constant .
•P is passive variable in the equation of exchange .
•The demand for money is proportion to the value of transactions.
•Changes in money supply affect only the price level i.e
•Movement in the price level results solely from change in the quantity of
money.
• Fisher argued that all other things remaining constant ,the quantity of money
circulating increase (M), the price level(p) also increase in direct proportion and
vice versa.
• He provide formalistic expression to the transaction approach in his equation of
exchange also known as cash transaction equation :
MV=PT where ;M=stock of money (Quantity of money ) or money supply
V =Average velocity of circulation
P =Average price level
T=Volume of transactions i.e the total amount of goods and services charged for
money.
• By algebraically manipulation in the above equation ,The fisher demand for
money (Md) function is derived as follows :
• When the money market is in equilibrium money supply (Ms) are equal to money
demand (Md) thus ,
Md=PT/V
Example1: Assume V as 10 if ,in a year ,T is 10,000 units and p is 20 per unit .
A) Calculate money demand (Md)?
Solution :
Md=PT/V=20x10,000/10
12/13/2020 =Birr 20,000//
We can also derive V=PT/M
V= Total spending /quantity of money.
Example 2: Suppose the nominal GDP (P x T) of country Ethiopia is

Birr 5 Billion and quantity of money (M) Birr 2 Billion. Then,
A) Calculate the velocity of money ? And ;
B) Interpret the result ?
Solution :
V= PT/M =5 /2
V= 2 .5, which means that the average Birr is spent 2.5 times in
purchasing final goods and services per year . —

Concussion
• T and V remaining constant ,in the short period ,the demand for
money varies with the change in price level .
• According to fisher ,changes in the price level are directly
proportional to the change in money supply (Ms) , in the short
period .
• Fisher consider, the demand for money from the view of the
velocity of money (V) rather than the motives for holding money
• Further , in the fisherian money demand function let 1/v equal to
K then we have
• M=KPT here k stand for constant , assuming v being a constant
factors .Thus , M=KPT,
• The level of transactions generated by a fixed level of PT
determines the quantity of Md but the demand for money is not
affected by interest rates.
Example 1: Suppose PT is birr 1,000 and the velocity is 5 ,then
A)Calculate the demand for money ?
B) If PT increase to birr 1,200, then estimate the demand for
money ?
Solution :
A)Md=kPT= 0.20 x Birr1,000 =Birr 200 .
B) Md=kPT= 0.20 x Birr1,200 increase to birr 240 .
• Thus ,the demand for money is directly related to the spending
involve in the volume of transaction .

The fisherian demand for money function
Demand for money

(Md)=kPT
PT
Figure 3.1.fisherian demand for money and value of transaction
• The slope of Md curve is K or 1/v . since k is assumed to be
constant the Md curve is a straight linear .
• Its slopes outward indicating a direct proportion relation ship
between the demand for money with the value of transaction
(PT). In fisherian sense ,the demand for money depends on the
institutionally determined needs .
• The relation ship between quantity of money supply and
,price level and value of money .
Figure 3.2 The relation ship between piece and quantity of money

• This approach has two serious problems ;
1) T includes all kinds of transactions.

• It include transactions relating to the current output as well as
transactions relating to just transfer of capital assets .
• The transactions just transferred in to capital assets will be
counted .
• They were counted as an output of certain company and they
will be counted as an output to the next producer such as semi-
proceed item ,tools ,raw material etc.

2) The measurements of the general price level (P)
• There is no comprehensive price index to measure all
transactions of goods and services and capital assets .
• Price index may be retail price ,whole sale price ,or the
manufactures price and there fore P used in the equation does
not represents any particular price and there is no price
comprehensive to all and the problem in this equation in which
price to take .

Criticism : The demand for money is defined objectively, in
mechanical sense only, i.e It is just mathematical truism i.e it
does not show the cause and effect relation ship between price
and quantity of money .
• No attention is paid to motives behind the demand for money .
• It assumes that people demand money not for saving but every
thing they get will be spendable which not true in real sense .
• He consider money from the view of the velocity of money
rather than the motive of holding money .
• Other things are not constant or equal in real life as M change
and ,as price changes ,total volume of transaction changes .
• The velocity of money (V) may not be a constant factor i.e V may vary with
the volume of trade (T) ,price level (P), volume of money ,population
density ,development of transport and payment habit of individuals .
• There is technical inconsistence : MV is not correct V is a periodic of time

which is dynamic concept, where as, M is stock concept i.e a point in time
or static concepts . M being constant V may increase causing the price level
to rise .
• The assumption of full employment is unrealistic i.e full utilization of
resource in an economy is a rear case .

• The ultimate determinates of the value of money is lie
behind the equation of exchange and not in it . Example M
determined by monetary base ,the community choice to hold
cash or cheques as a means of payment, cash reserve ratio
,level of monetization and government budgetary policy .
• It ignored the store of value function of money .
• Human element is absent

• Neglect the real balance effect
• The theory is weak theory i.e neglect price fluctuation in the

short run .
• Ignore the role of interest rate i.e the relation ship between
quantity of money and price is indirect.
• As money supply increase, interest rate decline ,then
consumption ,investment and employment increase hence , the
role of interest rate is greater in affecting the elements of the
equation of exchange
• It is a static theory i.e says that every thing remains constant .

B) The cash Balance version (Cambridge view or approach )
demand for money

•This school include Marshal , A.C pigous , and Robert son etc.
•They stressed on money as of value or store wealth rather than

•Money is the most liquid form of wealth .So it serve as an excellent
store of value.
•According to them the demand for money means the demand to hold
money or cash balance or the amount of money people want or
desired to hold for various motive than a medium of exchange .
•The demand for money is the cash balance held by the people .
• This view argued that the total demand for money or cash balance is the
proportion of nominal national income .
• The Cambridge equations show that given the supply of money at a point of
time, the value of money is determined by the demand for cash balances.
• The demand for money induced by transactions and precautionary motive
constitutes a certain proportion of its annual real national income which is the
community desires to hold in the form of money .
• Symbolically; The Cambridge demand for money function (Marshallian
equation ); Md=kpy . Where; Md is money demand and k is the proportionality
factor or the cash balance the people wish to hold i.e the proportion or fraction
of national income that people desire to keep in the form of nominal money
balance or cash balances.
• py is the nominal national income(p is price of final goods and y is real income
or final goods ).
• As the nominal income remaining constant ,the change in the
proportionality factors will change the demand for money i.e as the
proportionality factor (k) increase ,the demand for money also increase
and vice versa .
• Under this theory a money demand function is an equation that shows
what determines the quantity of real money balances people wish to hold.
A simple money demand function is :
• Real money balance (Md/P)= kY
• Where k is a constant that tells us how much money people want to hold
for every dollar of income. This equation states that the quantity of real
money balances demanded is proportional to real income.
• This money demand function offers another
way to view the quantity equation. To see this,
add to the money demand function the
condition that the demand for real money
balances (M/P)d must equal the supply M/P.
Therefore,
• M/p=kY
• M=kYP let k=1/v
• MV=YP

Example:- Assume that the nominal national income is birr 1,000 and the
proportionality factor is 10% .Then ,
A) Calculate the demand for money ?
Solution:Md=kpy
Md= 0.10 X1,000 birr =100birr// .
B) As the proportionality factor increases by 20%,while the nominal national

income remains constant ,then the demand for money will be : Md=0.20
X1,000 =200birr //.
• This school also mentioned a passing mark about the transaction and
precautionary motive behind the holding of cash balance by the people.

Criticism of cash balance approach
•Narrow view , they are dealing the purchasing power of money in terms of
consumption good only .
•Omission of crucial variable which determine K like monetary habit
,business integration ,price level etc.
•Circular reasoning as the value of money is determined by cash balance held
by the community(K) and at the same time the price and value of money
determine the amount of cash holding (K) .
•Ignore the role of interest rate i.e the effect of rate of interest on price .
•Un realistic assumption of K and Y are not constant or not given .
•Fails to explain dynamic behavior of price .
•Fail to explain the trade cycle phenomena i.e why economic peak followed
by economic depression.
•Fails to examine the degree of impact of change in money supply on output
and price.
•Ignore the significant of real factors that is the real force which enforce the
change in price level such as income ,saving and investment are roots for
change in demand .
Truisms:
• Like the transactions equation, the cash
balances equations are truisms. Take any
Cambridge equation: Marshall’s P=M/kY or
Pigou’s P=kR/M or Robertson’s P=M/kT or
Keynes’s p=n/k, it establishes a proportionate
relation between quantity of money and price
level.”

Price Level Does not Measure the Purchasing Power:
• Keynes in his A Treatise on Money (1930) criticised Pigou’s
cash balances equation and also his own real balances
equation. He pointed out that measuring the price level in
wheat, as Piogu did or in terms of consumption units, as
Keynes himself did, was a serious defect.
• The price level in both equations does not measure the
purchasing power of money. Measuring the price level in
consumption units implies that cash deposits are used only for
expenditure on current consumption. But in fact that they are
held for “a vast multiplicity of business and personal
purposes.” By ignoring these aspects the Cambridge
economists have committed a serious mistake.

Neglects other Factors:
• Further, the cash balances equation does not tell about changes in the price
level due to changes in the proportions in which deposits are held for
income, business and savings purposes.
More Importance to Total Deposits:

• Another defect of the Cambridge equation “lies in its applying to the total
deposits considerations which are primarily relevant only to the income-
deposits.”
• And the importance attached to k “is misleading when it is extended
beyond the income deposits.”

k and Y not Constant
• The Cambridge equation, like the transactions
equation, assumes k and Y (or R or T) as
constant.
• This is unrealistic because it is not essential that
the cash balances (k) and the income of the
people (Y) should remain constant even during
short period.
Neglect of Saving Investment Effect:
• Moreover, it fails to analyse variations in the
price level due to saving-investment inequality
in the economy.
Fails to Explain Dynamic Behaviour of Prices:
• The theory argues that changes in the total
quantity of money influence the general price level
equi-proportionally.
• But the fact is that the quantity of money
influences the price level in an “essential erratic
and unpredictable way.” Further, it fails to point
out the extent of change in the price level as a
result of a given change in the quantity of money
in the short period.
• Thus it fails to explain the dynamic behaviour of
prices.
Neglects Interest Rate:
• The cash balances approach is also weak in that
it ignores other influences, such as the rate of
interest which exerts a decisive and significant
influence upon the price level.
• As pointed out by Keynes in his General Theory,
the relation between quantity of money and price
level is not direct but indirect via the rate of
interest, investment, output, employment and
income. This is what the Cambridge equation
ignores and hence fails to integrate monetary
theory with the theory of value and output.
Demand for Money not Interest Inelastic:
• The neglect of the rate of interest as a
causative factor between the quantity of
money and the price level led to the
assumption that the demand for money is
interest inelastic.
• It means that money performs only the
function of medium of exchange and does not
possess any utility of its own, such as store of
value.

Neglects Speculative Demand for Money:
Another serious weakness of cash balances
approach is its failure to consider the
speculative demand for money.
• The neglect of the speculative demand for cash
balances makes the demand for money
exclusively dependent on money income
thereby again neglecting the role of the rate of
interest and the store of value function of
money.

Neglect of Goods Market
• Further, the omission of the influence of the
rate of interest in the cash balance approach
led to the failure of neoclassical economists to
recognise the interdependence between the
commodity and money markets.
• According to Patinkin, they laid an undue
concentration on the money market a
corresponding neglect of the commodity
markets, and a resulting ‘dehumanising’ of the
analysis of the effects of monetary changes.”
Neglects Real Balance Effect
• Patinkin has criticised the Cambridge economists for their failure to
integrate the goods market and the money market. This is borne out by the
dichotomy which they maintain between the two markets. The
dichotomisation implies that the absolute price level in the economy is
determined by the demand and supply of money, and the relative price
level is determined by the demand and supply of goods.
• The cash balances approach keeps the two markets rigidly apart. For
instance, this approach tells that an increase in the quantity of money leads
to an increase in the absolute price level but exercises no influence on the
market for goods.
• This is because of the failure of Cambridge economists to recognise “the
real balance effect.” The real balance effect shows that a change in the
absolute price level does influence the demand and supply of goods. The
weakness of cash balances approach lies in ignoring this.

Elasticity of Demand for Money not Unity:
• The cash balances theory establishes that the elasticity of demand for
money is unity which implies that the increase in the demand for money
leads to a proportionate decrease in the price level. Patinkin holds that “the
Cambridge function does not imply uniform elasticity.”
• According to him, this is because of the failure of Cambridge economists
to recognise the full implications of the “real balance effect”. Patinkin
argues that a change in the price level will cause a real balance effect. For
instance, a fall in the price level will increase the real value of cash
balances held by the people.
• So when there is excess demand for money, the demand for goods and
services is reduced. In this case, the real balance effect will not cause a
proportionate but non-proportionate change in the demand for money.
Thus the elasticity of demand for money will not be unity.

Similarity of the two approach
• The same conclusion there is direct and proportional
relationship between quantity of money and price
and inverse relationship between quantity of money
and value of money .
• Similar equation :
• fisher exchange equation MV=PT
• Robert son equation (M)=kpy
M/p=kY
M=kYP let k=1/v
MV=PY
Difference
1)Function of money
•Fisherian approach focus on medium of exchange .
•Cambrige approach focus on the store of value .
2) Flow and stock
•Fisherian approach considered money as a flow concept(related to a period of time ) .
•Cambrige approach considered money as stock concept(a point in time ) .
3) V and K different the meaning given to V and K are different
•Fisherian approach V is the rate of spending
•In Rober son K is cash balance which people wish to hold .
4) Nature of price level
•In fisherian p refers to is the average price level .
•In Cambridge p is the price of final or consumer goods.
5) Nature of T
•In fisherian T refers to the total amount of goods and services exchanged for money .
•In Cambridge T(Y) refers to the final or consumer goods exchanged for money.

6) Emphasize on supply and demand for money
•Fishers approach emphasizes the supply side of money .
•The Cambridge emphasize on the demand side of money .
7) Different in nature
•Fisher is mechanistic because it doe not explain how changes in
the V being about the change in p .
•Cambridge version was realistic because it considered
psychological factors which influence k.

3.2. Liquidity preference theory (the Keynesian approach ) or
cash balance approach
• The modern concept(restatement of the quantity theory ) of
demand for money associated with the Keynesians analysis of
demand for money .
• It is an extension of Cambridge theory of demand for money
and stresses on asset role or store of value functions of money .
• Demand for money is determined by what people want to hold
(the amount of money balances they want to hold)rather than
actual money balance held by the people(fisher view) .
• The demand for money means demand for money to hold cash
balances.
• Money is not just meant for spending. It can be held as a form of
wealth in exchange, all the time .

• Keynes ,in short ,viewed , the change in general price level do
not affect quantity of money(M)directly but they do so
indirectly through the rate of interest, investment,
employment ,income and output .
• Thus ,money being the most liquid assets ,can serve as an
efficient store of value ;so its demanded for its own sake.
• According to keynes ,the quantity theory of money would be
valid, if the elasticity money price is unitary .
em=dP/dM X M/P
• How ever , no such direct relation ship could exist between the
quantity of money and the price level, except in a full
employment phenomena.
• So long as there is unemployment ,employment will change in
the same proportion as the quantity of money .

• It this sense , the demand for money is the inverse of the
velocity of circulation .
• The desire of money described by Keynes as liquidity
preference .
• i.e demand for money is the demand for liquidity or liquidity
preference .
• Keynes distinguished three subjective motives which induce
people to hold money balance .
1. Transactional motives
2. Precautionary motives
3. Speculative motive

• Corresponding the above motives ,Keynes separated the
demand for money in three parts ;
1) The transaction demand for money
2) The precautionary demand for money
3) The speculative demand for money
• The total demand for money, implies total cash balances .
• Total cash balance can be classified in to two parts as the
active cash balance and idle cash balance .
1) Active cash balance (L1): It consists of the demand for
money held under transactional motive and precautionary
motive .
2) Ideal cash balance(L2) : It consists of speculative demand for
money .

1. Transactional demand for money
• This is related with the primary function of money as a
• Individuals do not receives money income as frequently as
they make payments .
• Thus when income is received at a discrete interval of
time ,but is paid out more or less continuously against the
exchange of goods and services, it is inevitable that people
should need a certain stock of money all the time in order to
carry out their transaction.
• Transaction motive refers to the demand for money for
bridging the gap between periodic receipt and payment .
• Keynes define the transaction demand for money as the need
of cash for the current transaction of a person or business
expenditure .
• Transaction demandBY:for
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money has two motives;
Yeshiwas Ewinetu Tegegne 305
A. The income motive refers to the holding of money balance to
facilitate their day to day purchase of consumption goods .
• The consumer demand for money depends upon the following
factors ;
1. The level of income(high income =high demand for transaction
purpose )
2. The price level (price rise=demand for transaction raise )
3. The spending habits of the people(spending high =demand for
money high)
4. The time interval (time interval increase =increase demand for
money).
B. Business motive
• It refers to the transactions motive to the entrepreneur class, or
business community.
• Demand for money balance held under this motive depends up on
business turn over of the
12/13/2020
firm .
• Business turn over high leads to high demand for money .
Thus the amount of money balance held under transactional
motive will depends on the time and size of the firm income
and the turn over of the business positively .
• Transaction demand for money Lt is income determined and
interest inelastic and relatively stable phenomenon i.e Lt
(y) .Hence, as national income(y) increase ,the transaction
demand for money will increase and vice versa.
2) Precautionary demand for money
• People generally desired to hold some additional money
balance against unforeseen contingencies .
• This demand mainly depends on the uncertainty of future
receipts and expenditure .
• It is sensitive to the anticipation of the level of income
hence ,it is income determined and is relatively stable .
• As income increase ,the cash balance held for precautionary
purpose will also increases.
Lp=f(y)
L1=Lt+Lp=L1=f(y)
L1=Lt+Lp
Income
Figure 3.3 demand for money and income .

• The above graph shows that transactional demand for money is
income determined and interest inelastic and relatively stable
phenomena .
3)The speculative demand for money(Idel cash balance )
• It refers to the demand for holding a certain amount of cash in
reserve to make speculative gains out of the purchase and
sale of bonds and securities through future changes in
the rate of interest
• It is for securing profit from knowing better than the market
what the future will bring forth.
• The speculative motive for holding cash balance arises from
uncertainty about the future rate of interest .
• It represents the demand for cash for being invested rapidly as
and when attractive opportunities for monetary investment
appear .
• The amount of money held under speculative motive depends
upon the rate of interest or interest rate elastic ,income
determining and very sensitive and fluctuating .
• Demand for speculative motives is essentially related to the
rate of interest and bond prices.
• There is an inverse relationship between the rate of interest and
the bond prices.
• People desire to have money in order to take advantages from
knowing better than others about the future changes in the
rate of interest (or bond prices).
• Money held for speculative purpose is a liquid store of value
which can be invested at an opportune moment in interest bearing
bond and security .
• Bond price and the rate of interest rate are inversely related to
each other .
• Current value of bond (V)=R(annual return on the bond)/(the
market rate of interest ( r) or rate of return currently earned .

Example : A bond carry a 4 % rate of interest ,gets an annual
return (R) of birr 4 .
A)Find the current value of bond ?
B) When the market rate of interest is fall to 2 % what is the
effect on the current value of bond ?
Solution :
A) The current value of bond=Annual return/market interest
rate=R/r =>V= 4birr/0.04=200 birr //
B) V=R/r 4birr/0.02 =birr 200 //
• According to Keynes, it is expectations about changes in
bond price or in the current market rate of interest rate
that determine the speculative demand for money .

• When people expect interest rate rise ,and the price of fixed
income yielding assets like bonds to fall , more balance will be held
in cash , then the idle cash balance will invested in the future in
such instruments that attracts higher income than investing on such
instruments with lower prevailing interest rate and vice versa i.e at
a very high rate of interest the speculative demand for money is
zero and people invest their cash in bonds .
• Keynes had critical rate of interest rate or normal rate of interest
(rc) ,
 If the current rate of interest (r) is above rc=>,business expected to
fall and bond price rise hence ,buy bond to sell them in the
future when their price rise in order to gain their by and their by
demand for money would fall .
• It is symbolically represented by L2=f(r) .
• Speculative demand for money is a decreasing function of interest
rate.
Let us see graphically
Figure 3.4The rate of interest and speculative demand for money

• There is always an inverse relationship between the
speculative demand for idle cash balance and the rate of
interest or interest elastic and income determining i.e its
purpose is to use it for speculation for earning income .
• When r is high ,speculative demand for money low .
• When r is low ,speculative demand for money is insatiable .
• Liquidity trap : It is a set up point on the liquidity preference curve
where the percentage change in the demand for money in response
to change in the rate of interest approaches infinity or perfectly
elastic at a particular low rate of interest
= dM/M /dr/r =∞(infinitely elastic liquidity preference curve)
• Any increase in the money supply will be held an idle cash balance
held by the people is called liquidity trap.
• Change in the quantity of money have no effect at all on the price
or income .
• This so at a lower interest rate is very low so that yields on bonds,
equities and other securities will also be low.
• At such a lower interest rate , people prefer to keep money in cash
rather than invest in bond because purchasing bonds will means a
definite loss.
• According to Keynes , as the rate of interest approaches to zero ,the
risk of loss .
• At a very low interest rate ,people prefer to keep money in cash
rather than invest in bonds .
• This situation arises from the facts that the income from the
assets at a very low rate of interest is so low and the risk of
holding assets is so high that the wealth holder are willing to
substitute money from the assets .
• The main reason of liquidity trap are as follows ;
1) At a very low rate of interest on alternative assets in the
financial market, the opportunity cost of hoarding idel balance
tend to be the minimum.
2) When r comes down to a minimum ,the opportunity cost of
hoarding idel money is expected to rise in the future rather
than decline further .
3) The process of substituting bond for money involves some cost
and inconvenience.
• The liquidity tarp sets the floor limit (r=2)to the rate of
interest . By expecting a higher rate of interest in the
future ,people will keep cash and will not purchase bond .
• As the rate of interest falls, the investor expect that it will
revert to the nominal level. But a rise in interest rate from a
higher level involves lesser capital losses than a rise in the
interest rate from a very minimum level .
The policy implication of liquidity trap
1. The infinitely elastic demand curve for money poses a serious
problem for monetary authority as it can’t reduce the rate of
interest below a particular level and can’t influence investment
and income. So the efficiency of monetary policy can be
jeopardize .
2. If the speculative demand for money becomes infinitely elastic
at a certain minimum rate of interest ,full employment can’t
be achieved .
• How ever , in deciding whether to hold wealth in money or a
bond form, an individual compares the current rate of
interest or critical rate of interest (rc) with the rate of
interest expected to prevail in future (re).
• If people feel that the current rate of interest is low (or
bond prices are high) and it is expected to rise in future (or
bond prices will fall in future), then they anticipate capital
losses of investing on bonds , and in order to avoid expected
losses on bonds, they will borrow money at a lower rate of
interest (or sell their already purchased bonds), and keep
cash in hand with a view to lend it in future at a higher rate
of interest (or to purchase the bonds at a cheaper rate in
future).

• Thus, when the expected rate of interest is higher than the current rate of
interest (re > rc) , the demand for money for speculative motive will rise.
• Similarly, if people feel the rate of interest is going to fall (or bond prices
going to rise), they will reduce the demand for money meant for
speculative purpose.
• So long as the Net yield from bond is greater than zero, the individual
will hold only bonds.
• If the Net yield is exactly zero, the individual will be indifferent
between bonds and money. The critical value of the current will be the
interest rate, at which the net yield is zero. This can be solved in
following way: Net yield from bond: r�𝑐 + 𝑔 = 0 . But G is expected gain or
loss ,rc is current rate of interest .

Example : Assume an investor want invest to one birr on bonds but the
current rate of interest (rc) is 0.02 and the expected rate of interest (re) is
0.04 . Know ;
A) Calculate the expected capital gain or loss (G)?
Solution: It can be computed by subtracting the current investment of
one birr from the ratio of current rate of interest to the expected rate of
interest, or G = rc/ re-l = 0.02/0.04-1 = -0.5 birr(net loss).
Interpretation : The market value of one birr invested today in a bond
yielding 0.02 per year would be expected to decline to 0.5 birr and the
bond holder would suffer a potential capital loss equal to one-half the
value of the holding of bond .
B)Net yield from investing on bond ?
Solution :
Net yield on bonds= rc+ G if it is gain , if loss make it minus ,
Net yield from investing on bonds : rc-G if it is loss . so , net yield from
investing on bonds will be =0.02-0.50
=-0.48 an investor hold money than investing on bond .

Total demand for money(LP) : L1+L2
LP= L1(y) +L2(r)
Lp=(r,y)
• The community over all demand for money depends up on the
level of national income and the rate of interest rate .
Lp=L1+L2
The demand for money
Figure 3.5The rate of interest and total demand for money

=
Implication
• velocity of money is not constant and as interest rate rise,
leads to increase in velocity of money which in turn leads to
reduction in demand for money.
• Change in expectation of future interest rate , change demand
for money and velocity of money too.

Criticism of Keynesian theory of demand for money
1. It is unscientific to separate artificially the demand for money in
to three parts as it has been done by Keynes for the reason the
people do not keep with them three separate purses (money to
spend)in order to use money for three different motives.
2. The transactions demand precautionary demand and speculative
demand for money all depend to some extent on both the level of
income and the rate of interest. Consequently he should consider
only a single unified demand function, and not two separate
demand functions for money, which depends on the level of
income, rate of interest and the wealth variables.
3. Since the speculative demand for money depends on the difference
between the current interest rate and the normal interest rate, it
would disappear if the difference between these two interest
rates disappeared and the difference would disappear if the
current interest rate remained constant fro a long time
• In other words, the critics have argued that any rate of interest,
no matter how low, will tend to be the normal interest rate, if it
prevailed long enough causing elimination of the expectations
of capital loss and consequently disappearance of the
speculative demand for money.
4. Empirically, it has been found that individuals do not hold all
their wealth either in the form of bonds or money but in
some composite form made up of the bonds and money.
5. He made his analysis of liquidity preference based on
expectation concerning the future rate of interest, ignore un
certainty .
• The well known scholar that criticized the Keynesian theory
of money of demand for money are William Baumol, James
Tobin, and Milton Friedman .
3.3 Post Keynesians developments in monetary theory
3.3.1 Baumol’s inventory theoretical approach (Interest elasticity of
transaction demand for money )
• According to Baumol people holds money for convenience
and capability of its being easily used for transaction of
goods and services keeping them in saving deposit which are
quit safe and earns some interest as well .
• Prof.William Baumol explains or analyze the transaction
demand for money from the viewpoint of the inventory
control or inventory management(capital theory) .
• As businessmen keep inventories of goods and materials to
facilitate transactions or exchange in the context of changes
in demand for them, Baumol asserts that individuals also hold
inventory of money because this facilitates transactions (i.e.
purchases) of goods and services.

• Individuals also incur cost when they hold inventories of money for
transactions purposes .
• In view of the cost incurred on holding inventories of goods there is
need for keeping optimal inventory of goods to reduce cost.
• Similarly, individuals have to keep optimum inventory of money for
transaction purposes.
Assumptions
• An individual or a firm receives income payment (y) once per time
period say per month .
• This agent is assumed to spread out his purchased over time ,that is
not at a time .
• There are only two assets cash and bonds and cash earns a nominal
return of zero, bonds earn an interest rate .
• Every time an individual buys or sells bonds to raise cash he incurs at a
fixed brokerage fee.

• The whole of his /her receipt are spent at a constant rate over the
period.
• The firm obtains money in order to carry out the transaction by
selling the bonds .
• The transaction between money and bonds are transparent and
occur in a steady stream say one birr nominal worth of transaction
takes place .
• The bond market is perfect where there is easy conversation of
bonds into cash and vice versa .
• There is a fixed cost in exchanging bond for cash and vise versa .
• A firm has knowledge about the size of its total future transactions.
• The holding of cash involves interest cost and noninterest rate
cost .
• The interest cost is constant over the year and
• The non–interest costs such as brokerage fee, mailing expense etc
are also fixed over the year .
• He pointed out that the transaction demand for money is interest
elastic .
• He also showed that the relationship between, transactional demand
for money and income is neither linear nor proportional .
• Cash balance held by the people, as income and expenditure do not
takes place simultaneously .
• But it is expensive to have large amount of money in the form of
cash balances. That money could otherwise be used profitably
elsewhere , for example in bond .
• When a firm or an individual holds money for transaction purpose ,it
incurs interest cost and non interest cost or conversation cost .

1) Conversion cost (non interest cost)(brokerage cost )i.e the cost of
converting of bond in to money .
• Non interest costs are mailing expenses(postal charge) or brokerage
fee, bookkeeping expense and so on for converting cash for bond .
2) Foregone interest(interest cost)
• The interest cost is an opportunity cost i.e when a firm hold cash for
transaction purpose, it forgoes interest income .
• An individual would always try to keep minimum transaction balance
in order to earn maximum interest income .
• So the interest rate on bond is high ,the lesser the transaction
demand for money .
• He assumes that an individual or a firm has an optimal inventory of
money for transaction purposes .
• In this situation, money balance held to make expenditure are
considered as a kind of inventory and the objective of the individual
is to minimize, the cost associated with the inventory .

• Let r be a rate of interest which is assumed to be constant over a year .
• b is the brokerage cost which is also assumed to be fixed .
• Assume that at the beginning of the year Y is the income of the
firm/individual which equal to the real value of transaction performed by
it .
• K is the size of each cash withdrawal at interval when the bonds are sold
or the average amount of the cash he withdraws each time the
individual goes to the bank .
• Thus Y/K is the number of withdrawal that occur over the year(the
number of times he goes to the bank to withdraw cash ).
• b(Y/K) is the costs of brokerage fee during a year since , the average
cash withdrawal are K/2, the interest cost of holding cash balance is
r(K/2) when, the withdrawal are made twice in a year.
• The total cost of making transaction or Total cost inventory of money :
(C)=r(K/2)+b(Y/K) ,
• The optimal value of K can be found by minimizing the total inventory
cost (C): dC/dk =0

This is known as square root rule .The following points become clear
from the above formula:
• If the brokerage fee increases, the optimal cash balance will
increase ,because the firm will invest on bonds .
• If the rate of interest on bond rise , the firm find it profitable to
invest on bonds and the optimal cash balance will be lower and
vice versa.
• Baumol’s analysis to wards an other important facts about the
behavior of demand for transaction balances .
• When a firm or an individual purchase large number of bonds it
is left with small transaction balance and vice versa.

• The demand for money is the demand for real balance since
the value of average cash holding over the year is K/2 , the
demand for real balance of transaction .
Where , Md is demand for money and p is the price level .

• The demand for real transaction balance ,is proportional to
the square root of the volume of transactions and inversely
proportional to the square root of the rate of interest .
• The pattern of a firm’s purchase remaining unchanged, the
optimal cash balances (y) will increase in exactly the same
proportion as the price level (p) .

• If the price level doubles ,the money value the firms
transaction will also double .
• When all price double, brokerage fee will also double .
• So that large cash balance will be desirable in order to
avoid investment and withdrawals and the brokerage
costs which they incur.
• Thus the increase in money value of transactions and in
brokerage fee lead to a rise in optimal demand for
money in exactly the same proportion as the change in
price level .
• Thus Baumol's analysis of the demand for real balance
implies there is no money illusion in the demand for
money for transaction purpose .

Superiority of Baumol’s analysis over Keynes
• It is realistic, Baumol integrates capital theory(by taking asset and
their cost)with the transactional theory of demand for money.
• He showed interest elasticity of transaction demand for money ,
because, the household some times behave like business man .
• He showed empirically the less than proportionate relation ship
between income increase and the increase in transaction
demand for money because of economies of scale in cash
management .
• His analysis is the analysis of demand for real balances and hence,
money illusion is absent.
• His analysis integrates the transaction demand for money with
the capital theory approach by including assets and their interest
and non interest costs.
• He avoid the dichotomy between transactions and speculative
demand for money of Keynes .
3.3.2Tobin portfolio selection model(The risk aversion theory of liquidity
preference ) or portfolio balance approach .
• He emphasize the role of money as a store of value . He also told that as
we can keep money both in cash and bonds i.e his portfolio selection
model of liquidity preference with the assumption that an individual asset
holder has portfolio comprising both money and bonds.
• His analysis of rational portfolio selection were made under uncertainty.
• This theory predicts that the demand for money depend on the risk and
return associated with money as also on various other assets households
hold can hold instead of money .
Assumptions
1. At the beginning of some given time period initially an individual wealth
holder possesses a wealth portfolio of certain given size .
2. The individual wealth holder prefer more wealth to less wealth.

• Given the above two assumption the individual wealth holder faced
with formidable problem of deciding as to what fraction he
should hold in the form of money and in the form of bond .
• Here ,Money neither brings any returns, nor impose any risk i.e ,
the cash balance has fixed monetary value .
• Bond not only bring income in the form of interest rate but also
impose some rise of capital gain or loss.
• An investor can bear this risk, if he is compensated by an
adequate return from bond .
• In the portfolio of an individual ,more bond means more risk and
more income .
• It is worth mentioning that Tobin’s portfolio approach, according
to which liquidity preference(i.e. demand for money) is
determined by the individual’s attitude towards risk, can be
extended to the problem of asset choice when there are several
alternative assets, not just two, of money and bonds.
• He classified investors into three
1. The risk lover: gambler who put all their wealth in to bond to maximize
risk .
• They accept risk of loss in exchange for the income they accept from bond
and they act as gambler .
2. The plungers: They will either put all their wealth in to bond or will keep
it in cash .They either go all the way or not at all.
3. The risk averter or diversifier : majority of the investors belongs to this
category .
• They prefer to avoid risk of loss which is associated with hold of bonds.
• They try to maximize returns and minimize risk .
• Liquidity preference theory is very relevant for the risk averter or
diversifiers .
• They are prepared to bear some additional risk only if they expect to
receive some additional risk only if they expect to receive some additional
returns on bond ,provided every increase in risk born brings with it greater
increase in returns .
• They will, therefore ,diversify their portfolios ,and hold both money and
bond .
• Diversifier generally prefer to hold on a mixed portfolio of some cash and some
bonds .
• Every investor act on the basis of his subjective estimation of probability
distribution of risk and returns .
• In general Tobin demonstrated that for a given uncertainty about the future
interest rate, the wealth holder bears a greater or smaller risk as he holds a
larger or smaller proportion of his total wealth portfolio in the form of bonds.
• A wealth holder who operates under the above assumed condition will maximize
the expected growth of wealth if he holds his total wealth in the form of bonds.
He will, however, simultaneously also bear the maximum risk of a possible
capital gain or loss.
• If, on the other hand, the wealth holder holds his entire wealth in the form of
money he will assume zero risk but his wealth will not grow at all.
• In order to find out risk averter’s preference between risk and expected returns .
• Tobin uses indifference curves(IC) having positive slopes indicating that the risk
averter demands more expected returns in order to take more risk.
• The line OX is the budget line of the risk averter which shows the combination
of risk and expected return on the basis of which he arranges his portfolio of
wealth consisting of money and bonds .
• The Y-axis (OY) measures expected return on portfolio and
• The X-axis (OX) measures risk.
• The investor requires more income to compensate for any increase
in risk.
• As a result the indifference curves (Ic1, Ic2& Ic3)slopes upward to the
right.
• The preference curves are convex downwards as an individual
becomes increasingly reluctant to accept additional risk as the risk of
his portfolio increases.
• Given the rate of interest on bonds, the opportunities(budget line)
open to an individual, with a given amount of funds, is shown by the
straight line through the origin-ox1.
• At ‘O’ the individual holds all his assets in money there is no
income and no risk.
• If the entire money is invested in bonds, the individual is at x1 and
income and risk are bothBY:
12/13/2020
maximized.
Yeshiwas Ewinetu Tegegne 338
• Here, we can draw a set of indifference curves showing the combinations between
money and bonds as shown in figure .
Figure 3.5 Portfolio choice
• The individual attains equilibrium at point P1 the point of tangency between the
indifference curve and the opportunity curve, ox1.
• At p1, the portfolio of the individual consists of both money and bonds.
• If the rate of interest rises, the opportunity curves for the individual
shifts to OX2.
• The equilibrium is at point P2, where a greater proportion of
assets will be in the form of bonds.
• In other words, as the interest rate increases, the increase in the
wealth holder's welfare which has been shown by the movement
on to the higher indifference curves is a accomplished by an
increase in the amount of bonds ( or decrease in the amount of
money held ) and also by increase in the portfolio risk.
• That is From the above graph , when interest rate is r1 and s/he
hold bond s (OP1) and P1M money (cash) .
• When the rate of interest increase from r1 to r2 risk averter , hold
successive units of more bonds (rise from OP1 to OP2) and less on
money (reduce from P1P2 ) in their portfolio
• Thus, Tobin again, like Keynes, proves the negative relationship
between the speculative demand for money and the rate of
interest.
• The figure also shows that, as the rate of interest rate increase,
by equal increment from r1 to r2 by the, risk averter hold bond
by a deceasing increment.
• This means that the demand for money is fall by small
amounts, as the rate of interest increase . This because the total
wealth in the portfolio consists of bond plus money .

Superiority of Tobin over Keynes
• Tobin theory did not depends on inelasticity expectation of
future interest rate ,but proceeds from the assumption that
the expected value of gain or loss from holding interest
bearing asset is always zero which is more logical and
satisfactory foundation .
• His theory explains that individual hold diversified portfolio
of bonds and money .
• He regard the demand for money is as closely related to
interest rate and inversely related to interest rate and provide a
basis for liquidity preference .
• Tobin is more realistic in discussing the perfect elasticity of
demand for money at a very low rate of interest .

3.4. Fried man’s modern quantity theory of money(capital or wealth theory )
• In 1956, Milton Friedman developed a theory of the demand for money
in a famous article, "The Quantity Theory of Money: A Restatement.”
• He considered money as asset or capital good.
• Though, Friedman, like his predecessors, pursued the question of why
people choose to hold money, he did not however, deal with the
specific motives for holding money, as Keynes did.
• He simply applied the general theory of portfolio choice to money.
• He said that the demand for money is affected by the same factors that
affect the demand for any other asset.
• For ultimate wealth holders the demand for money ,in real term ,may be
expected to be a function of primarily total wealth ,the expected rate of
return of money and other assets ,the division of wealth between human
and non human forms ,taste and preference ,etc.

• Friedman considers different forms in which wealth can be
held, namely,
• Money bonds , equities , physical non human goods and
human capital .
• Money is thus one of the several forms of assets in which
wealth may be held.
• Like the theory of consumer choice, the demand for money
depends on:
1. The total wealth to be held indifferent forms;
2. The relative costs and the rates of returns on different forms of
assets in which wealth can be held, and
3. Tastes and preferences of wealth owing units or any other
institutional factors.

• Therefore, according to Friedman, the main determinants of the
individual’s demand for real balances were the real yields on other
assets(bonds, equities and physical assets),the rate of inﬂation, real
wealth and the ratio of human to non-human wealth. Writing this
demand function in symbols,
Md/P = f(W, h, -rm, -rb, -re, P, -π, U) .
• Where Md stands for nominal demand for money and Md/P for
demand for real money balances, W stands for wealth of the
individuals in real term, h(HW/NHW) i.e the proportion of human
wealth to the non human wealth held by the individuals.
• Human wealth(HW) is the present discounted value of labor
income while, non human wealth(NHW) the individual’s ﬁnancial
and physical assets. rm for rate of return or interest on money, rb for
rate of return on bonds, and re for rate of return on equities in real
terms , P for the price level, π rate of inflation), and U for the
institutional factors or taste and preference .
Simplifying Friedman’s Demand for Money Function
• A major problem faced in using Friedman’s demand for
money function has been that due to the non-existence of
reliable data about the value of wealth (W). It is difficult to
estimate the demand for money. To overcome this difficulty,
Friedman suggested that since the present value of wealth or
W=YP/r (where Yp is the permanent income and r is the rate of
interest on money.), permanent income Yp can be used as a
proxy variable for wealth.
• Incorporating this in Friedman’s demand for real money
balance function we have:
Md/p =(Yp,h,-rm,-rb,-re p,-π,U).

1)Wealth (W): analogue of budget constrained.
• The major factor determining the demand for money is the
wealth of the individual (W). In wealth Friedman includes not
only non human wealth such as bonds, shares, money which
yield various rates of return but also human wealth or human
capital. By human wealth Friedman means the value of an
individual’s present and future earnings.
• Whereas non human wealth can be easily converted into money,
that is, can be made liquid. Such substitution of human wealth is
not easily possible.
• Thus human wealth represents illiquid component of wealth
and, therefore, the proportion of human wealth to the non
human wealth has been included in the demand for money
function as an independent variable.
• Income is the surrogate of wealth .

• Individual’s demand for money directly depends on his total
wealth. Indeed, the total wealth of an individual represents an
upper limit of holding money by an individual and is
similar to the budget constraint of the consumer in the
theory of demand.
• The greater the wealth of an individual, the more money he
will demand for transactions and other purposes. As a
country, becomes richer, its demand for money for transaction
and other purposes will increase.
• Since as compared to non- human wealth, human wealth is
much less liquid, Friedman has argued that as the proportion
of human wealth in the total wealth increases, there will be
a greater demand for money to make up for the illiquidity of
human wealth.

2)Rates of Interest or Return (rm, rb, re
• Friedman considers three rates of interest, namely, rb(rate of interest on
bond ) , re(rate of interest on equity) and which determine the demand for money,
rm is the own rate of interest on money.
• Note that money kept in the form of currency and demand

deposits does not earn any interest.
• But money held as saving deposits and fixed deposits earns certain
rates of interest and it is this rate of interest which is designated by
rm in the money demand function. Given the other rates of interest
or return, the higher the own rate of interest, the slower the
demand for money.
• In deciding how large a part of his wealth to hold in the form of
money the individual will compare the rate of interest on money
with rates of interest (or return) on bonds and other assets.
• As mentioned earlier, the opportunity cost of holding money is
the interest or return given up by not holding these other forms of
assets. As rates of return on bond (rb) and equities (re) rise, the
opportunity cost of holding money will increase which will
reduce the demand for money holdings.
• Thus, the demand for money is negatively related to the rate of
interest (or return) on bonds, equities and other such non money
assets.
3)Price Level (P)
• Price level also determines the demand for money balances. A
higher price level means people will require a larger
nominal money balances in order to do the same amount of
transactions, that is, to purchase the same amount of goods and
services.
• If income (Y) is used as proxy for wealth (W) which, as stated
above, is the most important determinant of demand for
money, then nominal income is given by YP which becomes a
crucial determinant of demand for money.
• Here Y stands for real income (i.e. in terms of goods and
services) and P for price level. As the price level goes up, the
demand for money will rise and, on the other hand, if price
level falls, the demand for money will decline. As a matter of
fact, people adjust the nominal money balances (M) to achieve
their desired level of real money balances (M/P).
4. The Expected Rate of Inflation ( π):
• If people expect a higher rate of inflation, they will reduce their
demand for money holdings. This is because inflation reduces the
value of their money balances in terms of its power to purchase
goods and services.
• If the rate of inflation exceeds the nominal rate of interest, there
will be negative rate of return on money. Therefore, when people
expect a higher rate of inflation they will tend to convert their
money holdings into goods or other assets which are not affected
by inflation. On the other hand, if people expect a fall in the price
level, their demand for money holdings will increase.
5. Institutional Factors (U)
• Institutional factors such as mode of wage payments and bill payments
also affect the demand for money. Several other factors which influence
the overall economic environment affect the demand for money. For
example, if recession or war is anticipated, the demand for money
balances will increase.
• Besides, instability in capital markets, which erodes the confidence of
the people in making profits from investment in bonds and equity shares
will also raise the demand for money. Even political instability in the
country influences the demand for money. To account for these
institutional factors Friedman includes the variable U in his demand for
money function.
• Empirical evidence, suggests that the income elasticity of demand for
money is greater than unity which means that the income velocity is failing
over the long run .This means that the long run demand for money function
is stable and is relatively interest inelastic .
Md
Money balance
Superiority of Friedman over Keynesian theory
• Friedman use broader definition of money i.e money is an
asset or capital goods capable of serving a temporary abode of
purchasing power than demand deposit and non interest
bearing dept of the government .
• Demand for money is a function of many variables like
bond ,security ,yield of money and yield on physical assets
rather and other variables i.e taste and preference of the
consumers than confined to bond only .
• Monetary disturbance directly affects price and production of
all actives un like Keynes .
• Friedman did not divide the motive of holding cash in active
and idle balance .
• Friedman introduce permanent income and nominal income to
explain his theory but Keynesian did not doing so .
Criticism
1. Very Broad Definition of Money:
• Friedman has been criticized for using the broad definition of
money which not only includes currency and demand deposits (М 1)
but also time deposits with commercial banks (M2). This broad
definition leads to the obvious conclusion that the interest elasticity
of the demand for money is negligible. If the rate of interest
increases on time deposits, the demand for them (M2) rises. But the
demand for currency and demand deposits (M1) falls.
• So the overall effect of the rate of interest will be negligible on the
demand for money. But Friedman’s analysis is weak in that he does
not make a choice between long-term and short-term interest rates.
In fact, if demand deposits (M1) are used a short-term rate is
preferable, while a long-term rate is better with time deposits (M2).
Such an interest rate structure is bound to influence the demand for
money.
2. Money not a Luxury Good: Friedman regards money as a luxury
good because of the inclusion of time deposits in money. This is
based on his finding that there is higher trend rate of the money
supply than income in the United States. But no such ‘luxury
effect’ has been found in the case of England.
3. More Importance to Wealth Variables:
• In Friedman’s demand for money function, wealth variables are
preferable to income and the operation of wealth and income
variables simultaneously does not seem to be justified. As pointed
out by Johnson, income is the return on wealth, and wealth is
the present value of income. The presence of the rate of interest
and one of these variables in the demand for money function
would appear to make the other superfluous.
4. Does not consider Time Factor:
• Friedman does not tell about the timing and speed of adjustment or
the length of time to which his theory applies.
1.5Empirical evidence on money demand
• Empirical finding shows that interest sensitivity of money
demand but no liquidity trap .
• It is also observed that transactional demand was stable till
1973, unstable after; most likely, source of instability is
financial innovation and cast doubts on money targets.
• There is a broader agreement that income is positively related
with money demand and interest rate is negatively related with
money demand ,but considerable variation in value of
regression coefficient .

Chapter review questions
1) Compare and contrast the transaction balance and cash
balance approach of demand for money ?
2) What are the motives for holding cash balance according to
Keynes ? Give the modifications made by modern economists
3) Analyze the investor approach to the transaction for money .
What is the relation ship with the rate of interest ?
4) Discuss the portfolio selection approach to the speculative
demand for money ?How it is superior to the Keynesian
liquidity preference theory ?
5) Explain the Friedman demand for money ? and How it is
superior to the Keynesian ?

Chapter 4: The Money supply Process (12hrs)
4.1 Meaning and constitutes of money supply
4.1.1 Meaning of money supply
4.1.2 Constitutes of money supply
4.2 Multiple Deposit Creation and money supply process
4.2.1 Players in the Money Supply Process
4.2.2 Central Bank Balance Sheet
4.3 Money supply Multiplier
4.4 The determinates of money supply .

4.1 Meaning and constitutes of money supply
• Generally, Money supply the total amount of monetary
assets available in an economy at a specific time .It
refers to the stock of money held by the public in spend
able form only.
• The term, money supply means the total stock of money
held by the public in expenditure form.
• The term ‘public’ here, refers to the individuals and
the business firms in the economy, excluding the central
government, the central bank and the commercial banks.

• The cash balances held by the central government, the
central bank and the commercial bank do not form money
supply because they are not in actual circulation.
• Money supply is a stock as well as a flow concept. When
money supply is viewed at a point of time, it is a stock,
and when viewed over a period of time, it is a flow.
• Money supply at a particular moment of time is the stock
of money held by the public at a moment of time. It refers
to the total currency notes, coins and demand deposits with
the banks held by the public.
• Over a period of time, money supply becomes a
flow concept. Money may be spent several times during
a period of time.

• There is no agreement among Economists on the definition of
money supply.
• There are four broad approaches of money supply.
4.1.1 Meaning of money supply
1.Traditional Approach
• The traditional approach emphasizes the medium of exchange
function of money.
• According to this approach, money supply is defined as currency
with public and demand deposits with commercial banks.
• Demand deposits are the current accounts and saving account of
depositors in a commercial bank .They are the liquid form of
money because depositors can draw cheque at any amount lying in
their account in their accounts and the bank has to make immediate
payment on demand .
• Demand deposit with the commercial bank plus currency with
the public are together denotes as M1 ,the money supply.

• The traditional approach is analytically superior because
it provides the most liquid and exact measure of money
supply.
• The central bank can have better control over the money
supply, if it includes currency and demand deposits of banks
alone. But, this regarded as the narrow definition of the
money supply.
2)Monetarist approach (Friedman modern quantity theory of
money)
• This approach defines money supply to include currency plus
demand deposits plus commercial bank time deposits i.e.
(M2=M1 + time deposit of commercial bank)
• Time deposits are fixed deposits of the banks and posses
liquidity which earn a fixed rate of interest depending on the
period for which the amount is deposited.
M2 of Ethiopia from 1974-2017
.

• According to Friedman money is defined as "anything that serves
the function of providing a temporary abode of purchasing power".
• Money can act as a temporary abode of purchasing power, if it is kept
in the form of cash, demand deposits or any other asset which is close
to currency, i.e., time deposits.
• This approach lays emphasis on the store of value function of
money and provides a broader measure of money.
• M2 is the wider definition of money supply in Amercia and M3 in
British and India .
3) Gurley and Shaw Approach:
• Gurley and Shaw further widened the scope of money supply by
including in its constituents currency plus demand and time
deposits of banks plus the liabilities of non-banking
intermediaries.

• M3 is the sum of M2 plus deposit of saving bank ,building
societies , loan associations , deposit of other credit and financial
institutions .
4)Radcliffe Committee Approach:
• Radcliffe Committee approach or liquidity approach provides a
much wider view of the concept of money supply(M4).
• As per this approach, the supply of money is a meaningless
number in presence of other financial assets substitutable for
money.
• The spending decisions by households and corporate bodies are not
determined by money, i.e. the quantity of means of payment, but
by the whole structure of liquidity in the economy.
• The spending here is not limited to the amount of money in
existence. It is related to the amount of money people think they
can get hold of whether by receipts of income, disposal of
assets or by borrowing.
• Thus, according to the approach, money supply includes cash, all kinds of bank
deposits, the deposits with other institutions, near-money assets and the
borrowing facilities available to the people.
• The practical difficulty with this liquidity approach is that the money supply in
this wider sense cannot be successfully measured because the degree of
liquidity of different constituents of money supply varies considerably.
Moreover, most of the constituents remain outside the control of the Central
Bank and thus restrict the effective implementation of monetary policy.
• Hence, the choice between these alternative definitions of the money supply
depends two considerations ;
1) A particular definition of money supply facilitate or blur the analysis of various
motives for holding cash .
2) From the point of view of monetary policy an appropriate definition include the
area over which the monetary authority have direct influence .
• If the these two criteria's are applied ,none of four definition is wholly
satisfactory .
• The first definition may be analytically better ,because M1 is a sure medium of
exchange but M1 is inferior store of value because it earns zero rate of interest
as is earned by time deposit .
• Further, the central bank can have direct control over a narrow
area if only demand deposit is included in the money supply.
• M2 includes time deposits in the supply of money is less
satisfactory analytically because in a highly developed financial
structure ,it is important to consider separately the motive for
holding means of payment and time deposits .
• Unlike ,the demand deposit ,time deposits are not a perfect liquid
form of money . This is because the amount lying in them can be
withdrawal immediately by cheques.
• Normally it can not be withdrawal before the due date of expire
of deposit .
• In case a depositor wants his money earlier ,he has to give a
notice ,to the bank which allows the withdrawal after changing a
penal interest rate form the depositor .
• Thus the time deposit lack perfect liquidity and can not be
included in the money supply
12/13/2020
.
• But this definition is more appropriate from the point of view
of monetary policy because the central bank can exercise
control over a wide area that includes a wide area that
includes both demand and time deposits held by the
commercial bank .
• The third definition(M3) which equal to ,M2 plus deposit of
non-bank financial institution and the fourth definition (M4)
which equal,M3 plus meaningless number in presence of other
financial assets substitutable for money are unsatisfactory in
both criteria.
Measuring the value of money supply
We can measure the value of money or total money supply in
the economy with
M1 =currency + demand deposit.
M2= currency +demand deposit + time deposit .
M3 = currency +demand deposit + time deposit+ deposit by
other depository institutions rather than banks .
M4= currency +demand deposit + time deposit+ deposit by other
depository institutions rather than banks + near assets .

Money supply in Ethiopia 1979/80-2017/18 G.C based on NBE data

4.1.2. Constitutes of money supply
• Monetary economists hold different views regarding the constituents of
money supply. Broadly, there are two views: the traditional view and the
modern view.
1. Traditional View. According to the traditional view, money
supply is composed of : Currency money and legal tender, i.e. coins and
currency notes, and Bank money, i.e. demand deposits with the
commercial banks.like Chq able .
2. Modern View. According to the modem view, the phenomenon of money
supply refers to the whole spectrum of liquidity in the asset portfolio of
the individual.
• Thus, in the modern approach, money supply is a wider concept which
includes: Coins ,Currency notes , Demand deposits with the banks ,
Financial assets, such as deposits with time the non-banking financial
intermediaries, like the post-office saving banks, building societies, etc. ,
Treasury and exchange bills and Bonds and equities.

• The basic difference between the traditional and modern views
is due to their emphasis on the medium of exchange function
of money and the store of value function of money
respectively.
• While the acceptance of medium of exchange function of money
supply gives a narrow view of money supply, the recognition of
the store of value function of money provides a broader concept
of money supply and allows for the substitutability between
money (which is traditionally defined as a medium of
exchange) and the whole spectrum of financial assets.

4.2 Multiple Deposit Creation and money supply process
4.2.1. Players in the Money Supply Process . The four players in the money supply
process.
1) The central bank – the government agency that oversees the banking system and is
responsible for the conduct of monetary policy. This bank takes different names in
different countries; the Federal reserve system in the United states and National Bank
in Ethiopia, for instance . central bank is the most important. Its actions largely
determine the money supply.
2)Banks (depository institutions) – the financial intermediaries that accept deposits
from individuals and institutions and make loans: commercial banks, savings and loan
associations, mutual savings banks, and credit unions.
3) Depositors – individuals and institutions that hold deposits in banks.
4) Borrowers from banks – individuals and institutions that borrow from the
depository institutions and institutions that issue bonds that are purchased by the
depository institutions.
4.2.2. Central Bank Balance Sheet and Control of the monetary base

.

Assets:- government securities holdings by the central bank that affect money supply
and earn interest and discount loans provide reserves to banks and earn the discount
rate.
1) Securities:– these are the central banks holdings of securities, which consist primarily of
treasury securities.
• The total amount of securities is controlled by open market operations (the central bank’s
purchase and sale of these securities). Securities are by far the largest category of assets
in the central banks’ balance sheet.
2) Discount loans- these are loans the Central Bank (Fed) makes to banks, and the amount is
affected by the Central bank's setting the discount rate, the interest rate the Central bank
charges banks for these loans.
• These first two Central bank assets are important because they earn interest. Because the
liabilities of the Central bank do not pay interest, the Central bank makes billions of
dollars every year. Its assets earn income and its liabilities cost nothing. Although it
returns most of its earnings to the federal government, the Central bank does spend some
of it on “worthy causes”, such as supporting economic research.
3) Gold and SDR certificate accounts. Special drawing rights (SDRS) are issued to
governments by the International Monetary Fund (IMF) to settle international debts and
have replaced gold in international financial transactions. When the treasury acquires
gold or SDRs, it issues certificates to the Central bank that are claims on the gold or
SDRS and is in turn credited with deposit balances at the Central bank. The gold and
SDR accounts are made up of these certificates issued by the Treasury.
4) Coin- this is the smallest item in the balance sheet, and it
consists of treasury currency (mostly coins) held by the
Central bank.
5) Cash items in process of collection- These arise from the
Central bank’s check-clearing process. When a check is given
to the Central bank for clearing, the Central bank will present
it to the bank on which it is written and will collect funds by
deducting the amount of the check from the bank’s deposits
(reserves) with the Central bank. Before these funds are
collected, the check is a cash item in process of collection and
is a Central bank asset.
6) Other Federal Reserve assets. These include deposits and
bonds denominated in foreign currencies as well as physical
goods such as computers, office equipment, and buildings
owned by the Central bank.
Liabilities:- monetary liabilities are currency in circulation in the hands of the
public and Reserves bank deposits at the central bank and vault cash
1) Central bank notes (currency) outstanding. The Central bank issues
currency (those pieces of paper in your wallet).
• The Central bank notes outstanding are the amount of this currency that is in
the hands of the public. (Currency held by depository institutions is also a
liability of the Central bank but is counted as part of the reserves liability.)
2) Reserves. All banks have an account at the Central bank in which they hold
deposits.
• Reserves consist of deposits at the Central bank plus currency that is physically
held by banks (called vault cash because it is stored in bank vaults).
• Reserves are assets for the banks but liabilities for the Central bank because the
banks can demand payment on them at any time and the Central bank is
required to satisfy its obligation by paying Central bank notes.
• As you will see, an increase in reserves leads to an increase in the level of
deposits and hence in the money supply.

• Total reserves can be divided in to two categories: reserves that the Central
bank requires banks to hold (required reserves) and any additional
reserves the banks choose to hold (excess reserves).
• For example, the Central bank might require that for every dollar of
deposits at a depository institution, a certain fraction (say, 10 cents) must be
held as reserves. This fraction (10 percent) is called the required reserve
ratio.
3)Treasury deposits. The Treasury keeps deposits at the Central bank, against
which it writes all its checks.
4) Foreign and other deposits, these include the deposits with the Central
bank owned by foreign governments, foreign central banks, international
agencies (such as the World Bank and the United Nations)
4) Deferred-availability cash items. Like cash items in process of collection,
these also arise from the Central bank’s check–clearing process.
5) Other liabilities and capital accounts: this item includes all the remaining
liabilities not included elsewhere on the balance sheet. For example, stock
in the Central bank purchased by member banks is included here.

4.3. Money supply multiplier
•The process of money multiplier will be as follows;
 Monetary base or high powered money (B or H).
•The sum of the currency in circulation and reserves is called the
monetary base.
 Currency in circulation is the amount of currency in the hands
of the public.
The currency component of the money supply, no matter how it
is defined, includes only currency in circulation.
It does not include any additional currency that is not yet in the
hands of the public.
Currency held by depository institutions is a liability of the
central bank, but is counted as part of the reserves.

• Reserves consist of banks’ deposits at the central bank plus currency that is
physically held by banks (called vault cash because it is stored in bank vaults).
• Reserves are assets for the banks but liabilities for the central bank, because the
banks can demand payment on them at any time and the central bank is required
to satisfy its obligation (by paying notes).
 Money multiplier (m)
• The ratio of money supply to the monetary bases .
• m tell as by how much will change money supply with a given change in high
powered money or base money .
• Let us the two stock concept for our discussion first .
1)Take M1
• Monetary base or high powered money or reserve money(H): C+RR(bank
deposit of banks at NBE) where RR is required reserve of commercial bank
and C currency with the public .
• Money supply (M):M1=C+DD Where, D is the demand deposit of commercial
bank and C is currency with BY:
12/13/2020
theYeshiwas
public.Ewinetu Tegegne 383
• At any particular time there should be a monetary base of a given value and
similarly a given quantity of a broader money and it’s a simple task to create ratio
of money supply to a monetary base .
• As we see from above ,the volume of abroad based money relation to the base
depend up on the two ratio ;
Currency to deposited ratio (Cr) or the public cash ratio .
Reserve to bank deposit ratio (Rr ) or bank ratio.
• The higher the value of m1 multiplier, the lower will be the reserve ratio(Rr)
and currency deposit ratio (Cr) .
• Note : In fractional reserve system Rr will have a value less than 1. Then, the
above term is greater than 1. Consequently , 1 birr increase in money base will
leads to more than 1 birr increase
12/13/2020 in money
BY: Yeshiwas supply(M1) .
Ewinetu Tegegne 384
Example1: Suppose that the monetary base B is
Birr 800 billion, the reserve–deposit ratio rr is
0.1, and the currency–deposit ratio cr is 0.8.
A)find the money multiplier ?
Solution :m2=Cr+1/Cr+Rr =2
B) Find the money supply ?
Solution:
M1= m1XB= 2xBirr 800= Birr 1,600

Example 2 : Given hypothetical data as follows
The Required reserve ratio(Rr) determined by
law of a given country is = 0.10 .
Currency in circulation(C) = Birr400 billion.
Checkable deposits(D) = Birr800 billion
A)Calculate currency ratio(Cr)?
B)The money multiplier ?
C)Interpret the result ?

Solution:
A)Cr=C/D=Birr 400billion/Birr800 billion =0.50.
B)
= m1=1+Cr/Rr +Cr
1+0.50/0.10+0.50=1.50/0.600=2.50
Interpretation: The money multiplier of 2.5 tells us that given the
required reserve ratio of 10 percent on checkable deposits and
the behavior of depositors as represented by Cr 0.5,a Birr1
increase in the monetary base leads to a birr2.50 increase in the
money supply M1.

2)Take M2=M1+ Time deposit
M2=D+C+TD .
• The high powered money include required reserve ,currency held by the
public and excess reserve of commercial bank(ER) . H=RR+ER+C
M2=m2H
• Where Rr is required reserve ratio, Cr is currency ratio and Td time
deposit ratio.
• The value of m2 is higher than m1 multiplier because , because it leads to
greater increase in the monetary base .

Example2: Given hypothetical data as follows ;
The Required reserve ratio(Rr) determined by law of a given
country is = 0.10 .
Currency in circulation(C) = Birr400 billion.
Checkable deposits(D) = Birr800 billion.
Time deposit (TD) = birr 200 billion
Excess reserves(ER) = birr0.8 billion then,
A)Calculate currency ratio(Cr)?
B) Calculate excess reserve ratio (Er) ?
C) The money multiplier ?
D)Interpret the result ?
Other ratio: The ratio of M2 to GDP, an indicator of financial
deepening.

• The higher m2 , the lower will be the rate of Cr, Er, and Rr .
• The above formula define money supply in terms of high
powered money .
• It express the money supply in terms of four determinates, H
Cr,Rr and Er .
• The equation states that ,the higher the supply of high-powered
money(H) ,the higher the money supply .
• Further, the lower , Cr ,Rr and Er , then money supply will be
higher .
• The higher the money supplier (m2) will leads to higher money
supply but the amount of m2 is determined by currency ratio
(Cr), required reserve ratio (Rr) at the central bank and Excess
reserve ratio(Er) of the commercial bank .
• The lower these ratio are ,the larger the multiplier is(m2) and
hence the stability of m2 is determined by them .
• If money multiplier(m2) if fairly stable (cr,Rr and Er constant) ,
the central bank by manipulating H to manipulate the money
supply .
Hd
Hs’
Figure 1. Figure 2.
• In figure1,Hs is the supply of high powered money
• Hd is the demand for high powered money associated with each
level of money supply (Hd=Cr+Rr+Er)/1+Cr.
• Given the Cr,Rr and Er and the high powered money Hs, the
equilibrium money supply is OM . If the money supply is larger
than this like OM1,there will be excess demand for high powered
money and vice versa.
• If there is an increase in any one of the ratio Cr,or Rr or Er, there
would be an increase in demand for high powered money. This
is shown by Hd’ curve in figure. Where the increase in the
demand for high powered money lead to decline in the money
supply to OM’ .
M2=m2H
• Thus money supply is a function of m and H.
• The size of money multiplier (m) is determined by Cr, Rr,and Er .
• If these multiplier is low , m2 will be larger .
• Given the supply of high powered money, the money supply varies
inversely, with Cr,Rr and Er of the commercial bank.
• But the supply of money varies directly with the change in high
powered money as shown in figure 2.

• An increase in the supply of high-powered money by ∆H shifts the
Hs curve up ward to Hs’ .
• At E, the demand and supply of high powered money are in
equilibrium and money supply is OM.
• With the increase in the supply of high powered money to Hs’ ,the
supply of money also increase to OM1 at the new equilibrium point
E1.
• further , figure 2, reveal the operation of money multiplier ,with the
increase in high powered money by ∆H ,the money supply increase
by ∆M. An increase in the high powered money by birr 1
increases by multiple of birr 1.
• Some economists do not take into consideration excess reserve in
determining high powered money .But the monetarist give more
importance for excess reserve. According to them, due to
uncertainties ,prevailing in the banking operation as in business
,banks always keep excess reserve .
4.4. The determinants of money supply
• There are two theories or views on the determination of
money supply .
1) The money supply is exogenously determined by the
central bank .
2) The money supply is endogenously determined by change
in economic activity which affects peoples desire to hold
currency relative to deposits, the rate of interest, income and
other factors .
• Thus the determinates of money supply are both endogenous
and exogenous which can be broadly described as follows ;
• But it clear that ,there are two major determinants of money
supply endogenously are; monetary base and money
multiplier .
1) Monetary Base or high powered money:
• Magnitude of the monetary base (B) is the significant determinant of
the size of money supply.
• Money supply varies directly in relation to the changes in the monetary
base.
• High powered money is the base for the expansion of bank deposits
and creation of the money supply .
• Monetary base changes due to the policy of the government and
is also influenced by the value of money.
2) Money Multiplier: Money multiplier (m) has a positive influence on the
money supply. An increase in the size of m will increase the money
supply and vice versa.
3) Reserve Ratio: Reserve ratio (Rr) is also an important determinant of
money supply.
• The smaller cash-reserve ratio enables greater expansion in the credit
by the banks and thus increases the money supply and vice versa .
• Reserve ratio is often broken down into its two component parts or

A) Required reserve
• It is determined by the required reserve ratio and the level of
deposit of commercial bank RR=RrxD .
• Required reserve increase , reduce money supply .
B) Excess reserve: It is the difference between total reserve minus
required reserve (ER=TR-RR) .
• It is the amount of excess reserve of a commercial bank, which
influence the size of its deposit liability . A commercial bank
advance loan equal to its excess reserve which are important
components of the money supply . To determine the supply of
money with the commercial bank , the central bank influence its
reserve by adopting open market operation (selling and buying
of bond government security ) and discount rate policy .
• To expand bank reserve ,commercial bank buy bond, money
supply reduced .So that , excess reserve increase , money
supply reduced.
C) Time-Deposit Ratio: Time-deposit ratio (t), which represents the ratio of time
deposits to the demand deposits is a behavioral parameter having a
negative effect on the money multiplier (m) and thus on the money supply.
• A increase in Td reduces m and thereby the supply of money decreases.
4) Confidence in Bank Money:
• General economic conditions affect the confidence of the public in bank money
and, there by, influence the currency ratio (Cr) and the reserve ratio (Rr).
• During recession, confidence in bank money is low and, as a result, Cr and Rr
ratios rise and their by money supply reduced.
• Conversely, during prosperity, Cr and Rr ratios tend to be low when confidence
in banks is high and money multiplier is high, and money supply will be high.

6) Value of Money: The value of money (1/P) in terms of
other goods and services has a positive influence on the
monetary base (B) and hence on the money stock.
• Value of money increase, monetary base increase leads to
an increase in money supply.
7) Real Income: Real income (Y) has a positive influence on the
money multiplier and hence on the money supply.
• A rise in real income will tend to increase the money
multiplier and thus and vice versa. increase the money
supply

8) Interest Rate: Interest rate has a positive effect on the money
multiplier and hence on the money supply.
• A rise in the interest rate will reduce the reserve ratio (Rr),
which raises the money multiplier(m) and hence increases
the money supply and vice versa .
• Borrowers from banks and the government, household and
firm ,reason, Er, so more reserves to support D;TD so more
MB to support D and C.
9) Discount rate police or bank rate: The rate at which the
commercial bank borrow from the central bank .
• The bank rate policy affects the money supply by influencing
the cost and supply of bank credit to commercial bank .
• A higher discount rate means commercial bank gets less
amount by selling securities to the central bank
• Higher discount rate =>Low money supply
• The commercial bank rise their lending rate to the public there by
making adverse dearer for them and then, there will be contraction
of credit and the level of commercial bank reserve .
• It should be noted that the commercial bank reserve are affecting
significantly only when open market operation and discount rate
policy supplement each other .
• Other wise, their effectiveness as determinates of bank reserve and
consequently of money supply will be limited .
10) Monetary Policy objective
• Expansionary policy objective =increase money supply .
• Monetary policy has a positive or negative influence on the
money multiplier and hence on the money supply, depending upon
whether reserve requirements are lowered or raised.
• If reserve requirements are raised, the value of reserve ratio (Rr)
will rise, reducing the money multiplier and thus the money
supply and vice versa.

11) Seasonal Factors: Seasonal factors have a negative effect on
the money multiplier, and hence on the money stock.
• During holiday periods, the currency ratio (Cr) will tend to rise,
thus, reducing the money multiplier and, thereby, reduce the
money supply.
12) Public desire to hold currency and deposit

• If people desire is less to hold currency or cash relative to
deposit in commercial bank, the money supply will be large .
• This is because bank create more money(more credit
creation)with large deposit and the money supply will be large .
Chapter review questions
1) Define money supply ?
2) What are the constitute of money supply .
3) What are the four players in the money supply process.
4) Discuss the Multiple Deposit Creation and money supply
process.
5) Explain in the various components of money supply .
6) Discuss the determinates of money supply .
7) Discuss the various measures of money supply in Ethiopia .
8) Write a short note on money multipliers and show the
derivation of money multiplier .

Chapter 5: Central Banking and Monetary Policy
5.1. Functions, Structure and Independence of Central Banks
5.2. Tools of Monetary Policy
5.3. Conduct of Monetary Policy: Goals and targets .
5.4. Central Bank Strategy
5.5. Monetary targeting and Empirical Evidence
5.6. Transmission Mechanism of Monetary Policy

5. Meaning of bank
• There are different assumption to the origin of banking .
• This is derived from past experience of Greek and Rome .
• Some side that banking comes from a German word “bench”
• An Italian word “ banco” and;
• French word “Banque” which means in English a bench over
which people site it in the center of the market to exchange.
• They used to sit on a bench in the center of the market and
receive deposit from the public and pay to the public from the
deposit .
• The were referred as “benchers” .
• Banking that time was mainly concerned with the service of
currency exchange .
• The gold smiths, money lenders and merchants have contribute to
the emergence of banking and regard as ancestor of the present day
bank .
• The origin of commercial banking can be traced back to around 2000
B.C .by Babylonians who was performing the safe keeping and
saving functions in its oldest form.
• In a African the first black bank is bank of Abyssinia in march 1905
with the promise of Ras Mekonnen (presently main compass of AAU)
owned by national bank of Egypt an affiliate of the bank of England
which was given monopoly position .
• A bank is financial institution organized in a form of joint
company basis so as to create value to the society and profit
to share holder in a form of dividends .
• It is an institution , which deals with money and credit .
• In modern times the term bank refers to an institution which;
 Deals with money ;it accept deposit and advance loans.
 Deals with credit ;it has the ability to create credit .
 Is a commercial institution ;it aims at earning profit.
 Creates a demand deposits which serve as a medium of
exchange , and as a result manage the payment system of a
country .
Types of banks
i. Based on structure
1. Branch bank system: a big bank as a single institution and
under single ownership operates through a network of braches
spread all over the country or out side the country .
2. The unit banking system: an individual bank operates
through a single office or few branches with in a strictly
limited area .
ii. Based on owner ship
1. Public sector bank: Owned and controlled by the government
like commercial bank of Ethiopia .
2. Private sector bank: Owned and controlled by private
individuals or corporations Like Dashen ,Buna Bank
3. Cooperative bank: They are operated on the cooperative line
to some sort cooperative bank of Oromia .
iii. Based on function
1. Commercial bank : A type of bank which finance trade and
commerce and perform all kinds of banking business .
2. Industrial bank /investment bank: They are banks that meet
the medium and long term financial need of industries .
3. Agricultural bank : They are banks that finance agriculture .
4. Saving bank :The main purpose is to rise saving habit among the
general public and mobilize their small savings .
5. Central bank : It is the apex bank which control ,regulates and
supervise the monitoring and credit system of a country .
6. Exchange banks : They deal in foreign exchange and specialize
in financing foreign trade .
7. World bank : It is an institution which provide financial
assistance to the member country of world bank .

5.1. Functions, Structure and Independence of Central Banks
• The functions performed by the central bank are entirely different
than the functions performed by the other banks.
• A central bank is at the top of all banking institutions in the country.
• It acts as the guardian of the money market.
• It controls and guides the money mechanism of the country.
• Each country has its own central bank. For example the National
Bank of (Ethiopia, Belgium, Denmarketc),Federal Reserve bank of
(India, USA ect),The bank of (Italy, Russia ,Japan) and risk bank of
Sweden .
• The first central banks were created in Sweden and England in
1894 and their main task was to finance the budget deficits.
Function of central bank
•Monopoly power on issue of currency.
•Lender of the last resort .
•Bankers bank to all other banks in the country .
•Central clearance, settlement and transfer.
• Custodian of foreign balance of the country .
•Control of credit .
•Determine the interest rate of a nation .
•Fiscal agent which makes short term loan to the government .
•Economic advisor of the government on economy and money
matters .

• Clear checks.
• Withdraw damaged currency from circulation.
• Administer and make discount loans to banks in their
districts.
• Evaluate proposed mergers and applications for banks to
expand their activities.
• Act as liaisons between the business community and the
Federal reserve system .
• Examine bank holding companies and state chartered member
banks .
• Collect data on local business conditions.
• Use their staffs of professional economists to research topics
related to the conduct of monetary policy
• Custodian of commercial bank cash reserve .
Structure of central banks of Ethiopia
• The structure of the central bank different from country to country
hence, it is better to the structure of central bank of Ethiopia as follows;
1. Board of director: It is the apex and central part of the highest

admistartive part of NBE . It consists of one chair person ,4 members
and one secretary ( Chair person: Ambasader Girma Biru) .
2. Governor: It is a members of the board and one chair person and having
three vice governors (vice-governor of corporate service cluster, Vice
governor and financial stability cluster ,senior advisor to the
governor financial institution supervision cluster, monetary stability
cluster) listed detail sub directorates below .
(Chair person : Dr Yinager Dessie ,2013 E.C )

3. There is also Board of audit committee and Monetary
policy committee
1. Vice governor (chief economists), monetary
stability
• Monetary policy committee
• Monetary and fiscal policy analysis’s directorate
• Economic modeling and policy analysis directorate
• Foreign exchange monitoring and reserve
management directorate
• External sector analysis and international relation
directorate

2. Vice governor and financial stability
• Risk supervisions directorate
• Insurance supervisions directorate
• Micro financial institutions supervision
directorate
• Currency management directorate
• Payment and settlement system directorate

3. Vice governor corporate service
• Corporate planning and financial directorate
• Human resource management directorate
• Ethiopia academics of financial studies
• Property and service management directorate
• Information system management directorate
• Legal service directorate

Structure of central bank (taking national bank of Ethiopia )

• Independence of central bank can be expressed ;
1.Goal independence : The ability to set the goals of monetary policy or
action .
2. Instrumental independence: The ability to choice ,monetary
instruments .
3. Both
• Apart from higher oil prices and other ‘shocks’, there are two particular
threats which bear upon the issue of central bank independence:
1) The tendency for policy makers and politicians to push the economy to
run faster and further than its capacity limits allow; and
2) The temptation that governments have to incur budget deficits and fund
these by borrowings from the central bank.
• To be able to do their job of keeping inflation under control, central
banks have to be able to say ‘no’ to governments when that objective is
threatened. This is why the notion of central bank independence is so
important.

1) National bank governor independence is realized
when ;
• National bank government mandate have to stay more
than 8 years.
• It should be appointed by the national bank board.
• If the national bank law did not permits the national
bank governor to hold other public position.
• National governor could revoke only for the reason
that are not political or his un able to continue his
work.

2) National bank action independence is realized when;
• If the national bank law did not allow the central bank to purchase
government bond or T-bill from the primary market.
• If the national bank is not the development bank for the public and private
sector.
• If the national bank budget is established by national bank of a nation.
• If the national bank profit is distributed according to national bank act.
• If the national bank loan a maturity data of less than 6 years.
• If the national bank may grant short term loan to the state treasury the
maximum loan value is nominal value.
• If the national bank interest rate for short term loans granted to the state
treasury is a market interest rate.
• If there is a conflict between national bank and government, then national
bank decides.
• If the inflation target is fully decided by the national bank of a country.
• If the monetary policy rate is decided by only the national bank of a country.
• If the national bank cannot grant loan to the public institutions.

3)National bank board action independence is
realized when;
• If the national bank board are a pointed by the
parliament.
• If the mandate of national bank board is higher
than the parliament.
• If the national bank board did not additional
held public position.

• National bank degree of independence indicator =Maximum
degree of independence divided by central bank degree of
independence.
• The factors are similar to the ones used by Cukierman (1992).
He give a score for each criterion. The indicator is presented
bellow.
0 – There is no central bank independence considering that

criterion.
1 – Total central bank independence considering the criterion .

• According to the above indicator, national bank has a high
degree of independence.
• The main disadvantage
1) Equal weights to each criterion introduced and this could
negatively affect the final results. Determining optimal
weights could be a very difficult task.
2) Offers a static view regarding the Central bank independence
and does not present how central bank independence
changed in the past years.

The role of central bank for developing economy
•In general the objectives of central banking policy in a
developing economy may be stated as follows:
1.To assist in the mobilization of savings in the community and
promote capital formation.
2.To promote the spread of monetization and monetary
integration through the development of an integrated
commercial banking system.
3.To make adequate provision of credit necessary for
fulfillment of the targets of production and trade .
4.To extend monetary support to the authorities in the central
task of allocation of resources among different sectors in the
economy.
5.To help in maintaining general price stability and preventing
inflationary tendencies from getting out of hand.

5.2 Tools of monetary policy
Monetary policy is the government’s policy relating to the money
supply, bank interest rates and borrowing.
•The tools or instruments of monetary policy are of two types.
1) Quantitative ( general or indirect )
•It includes bank rate variations, open market operation and changing
the reserve requirements or variable reserve .
•They are a meant to regulate the over all level of credit in the economy
through the commercial bank .
2) Qualitative (direct or selective )
• It is aimed at controlling specific type of credit .
•They include changing marginal requirements and regulation of the
customer
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credit . BY: Yeshiwas Ewinetu Tegegne 426
• A Margin Requirement is the percentage of marginable securities that an
investor must pay for with his/her own cash. It can be further broken down
into Initial Margin Requirement and Maintenance Margin Requirement.
• Let us see the various instruments of monetary control which are with in the
hands of the monetary authority clearly as follows ;
1) Open market operations (OMO)
• It refer to the sale and purchase of securities in the monetary market by the
central bank or the selling and buying of bonds and security of the
government and private financial institution by the central in the financial
market .
• To enable open market operations, a central bank must hold foreign
exchange reserves (usually in the form of government bonds) and official
gold reserves.
• The method OMO to control inflation central bank sell
bonds ,securities in the open market to the commercial bank or
the public .
• The reserve of commercial bank is reduced and they are not in a
position to lend more to the business community.
• The method OMO to control depression deflation /recessionary
force ,central bank buy bonds ,securities in the open market
from the commercial bank or the public .
• The reserve of commercial bank is raised and they are in a
position to lend more to the business community.

3. Open market operations are easily reversed. If a mistake is made in
conducting an open market operation, the central bank can
immediately reverse it. If the central bank decides that the federal
funds rate is too low because it has made too many open market
purchases, it can immediately make a correction by conducting open
market sales.
4. Open market operations can be implemented quickly; they involve
no administrative delays. When the Fed decides that it wants to
change the monetary base or reserves, it just places orders with
securities dealers, and the trades are executed immediately.
2)Change in reserve ratio or variable reserve ratio
• Changes in reserve requirements affect the money supply by causing
the money supply multiplier to change.
• It was first suggested by Keynes in 1930 and implemented in USA in
1935.

• Required reserve ratio or legal minimum requirement is required by
law to maintain a minimum percentage of its deposits with in the central
bank . This amount may be a percentage of its time deposit or demand
deposit together or separately
• A rise in required reserve ration reduces the amount of deposits that
can be supported by a given level of the monetary base and will lead to a
contraction of the money supply or reduce the inflation
• Conversely, a decline in reserve requirements leads to an expansion of
the money supply because more multiple deposit creation can take
place.
• When the reserve ratio is lowered, the excess reserve of commercial bank
rise ,They lend more and economic activates is favorably affected i.e
money supply rise .
2) Excess reserve : The excess amount of money over the required
reserves that remains with the commercial bank and it’s the
base for credit creation .
• Excess reserve of commercial bank is the base for credit
creation ,if excess reserve is high ,the higher the power of
bank to create credit .
• There is an inverse relation ship between required reserve and
excess reserve of the commercial bank .

3) Bank rate policy or bank rate
The bank rate is the minimum lending rate of the central bank at
which it rediscounts the first class bill of exchange and
government security held by the commercial bank .
When there is a problem of inflation , the central bank must
raised bank rate to ,it leads to reduction in amount of money
borrowed by the commercial bank from central bank ,which in
turn, leads to contraction of credit and reduce money supply in
the economy and hence , price are checked from rising further
and vice versa .

4) Selective credit control
• They usually take the form of changing margin requirement to
control speculative activities within the economy .
• When there is inflation ,the central bank raising margin
requirement to discourage borrowing and reduce money supply.
• When there is deflation , the central bank lowering margin
requirement to encourage borrowing and rise money supply.
• The degree of success of selective credit controls depends on
several factors.
a) The extent of effective credit restrictions: Since selective credit
controls are generally security oriented and non-purpose oriented,
influential borrowers can mange to escape the bite of these
measures by borrowing against the security of other collaterals
and using the funds so borrowed for indulging in the speculative
holdings of stocks.
• Therefore, the effectiveness of selective credit controls is
likely to improve if they are fully supported by general credit
controls.
b)The availability of non-bank finance: To the extent traders
do not depend up on banks for financing their inventories and
have other sources of finance (their own and of the un
regulated credit markets), they will again escape the
constraints of the selective credit controls.
• Obviously this will depend on the cost and availability of
non-bank finance to the parties concerned.
c)The degree of short fall in supply in relation to normal
demand: the greater this short fall, the more will the
speculative fever rise. In case of acute shortages, credit
controls should be imposed well in time without waiting for
the prices of sensitive commodities to rise actually.

5. Moral Suasion
• This instrument, used by the central bank both for the
quantitative control of credit and money supply as well as for the
qualitative control of credit (i.e., control over the distribution of
bank credit) is moral suasion and it can be defined as follows.
•Moral suasion is a combination of persuasion and pressures
which a central bank is always in a position to use on banks in
general and errant banks kin particular.
•This is exercised via discussions, letters, speeches, and hints
thrown to banks.

• When moral suasion is used for quantitative credit
1. Increased sale of government securities by banks to the central bank
2. Decrease the high powered money and
3. It is supposed to increase the money supply

• To summarize ,for an effective anti cyclical monetary policy ,bank rate,
open market operation, reserve ratio and selective control measure are
required to be adopted simultaneously .
• But it has been accepted by all monetary theorists that
 The success of monetary policy is nil in a depression when business

confidence is at its lowest ebb.
 It is successful against inflation .
Type of monetary policy
1)Expansionary(easy) monetary policy
• It is used to over come a recession ,or depression or deflationary Gap .
• When there is a fall in consumer demand for goods and services, and in
business demand for investment goods a deflationary gap emerge
• To solve the above problems the central bank uses expansionary
monetary policy that eases the credit market conditions and leads to an
upward shift in aggregate demand. For this purpose , the central bank
 Lowers the discount rate .
 Lower the required reserve of central banks .
 The central bank purchase or buy bonds and security's in open market
operations.
 Encourage consumers and business credit through selective credit
measures .
 By such measures ,it decreases, the cost and availability of credit in the
money market ,and improves the economy .
Graph of Expansionary monetary policy

• To explain the graphical illustration . Let us assume ,
• Initially in the recessionary economy is at equilibrium at
interest rate R* and Y* in pane 1 ,p* and Q* in panel 2 at the
existing money supply .
• Suppose the central bank credit policy results an increase in
money supply in the economy .This leads to the right ward
shift of LM curve to LM1 .
• There is an increase in equilibrium level of income from Y*
to Y1* and aggregate demand expand from D to D1 in panel 2.
• With the increase in the demand for goods and services ,output
increase from OQ*to OQ1* at the higher price level P1*.
• If the monetary policy operate smoothly ,the equilibrium at E1
can be at full employment level .But this is not likely to be
attain because of the following limitation .

• In severer contraction or Great world depression during 1930
and 1940’s empirical evidence shows that monetary policy is
ineffective or nil to stabilize the economy due to the presence
of pessimism among business .
• Keynes point out that ,a highly elastic liquidity preference
schedule or liquidity trap render monetary policy impotent in
time of server depression
2) Contractionary or restrictive monetary policy
• A monetary policy designed to curtail aggregate demand in the
economy .
• The economy experience inflationary pressures due to rising
consumer demand for goods and services and there is also
boom in business investment .

• The central bank will adopt restrictive monetary policy to rise
cost and availability of bank credit in order to lower aggregate
consumption and investment by rising reserve requirement
,selling of government security in an open market operation
and rise discount rate and controlling consumer and of credit
in the monetary market and their by control inflationary
pressure
Limitations of monetary policy in controlling inflationary
pressure are ;
• Increase in velocity of money , commercial bank portfolio
adjustment ,the role of non bank financial intermediaries ,time
lag, alternative expectation of borrowers and lenders and
threat to credit market etc.

5.3 Conduct of Monetary Policy: Goals and targets
• The problem of central bank is compounded by the fact that their instruments
do not Directly affect these goals.
• These instruments affect variables such as money supply and Interest rates,
which then affect goal variables with lag.
• In addition, these lags may be uncertain. Due to above mentioned problems,
in the conduct of monetary policy distinction is made among.
i) Goals (or objectives),
ii) Targets (or intermediate targets),
iii) Indicators(or operational targets), and ;
iv) Instruments (or tools).

• The conduct of monetary policy can be represented
schematically as follows:
Instruments => Indicators =>Targets => Goals
Monetary Policy Instruments
• Instruments are tools of monetary policy such as ;
1. Open Market Operations
2. Reserve Requirements
3. Operating Band for Overnight Rate
4. Bank Rate

Monetary Indicators
• Monetary Indicators are operational Targets.
• Indicators are set of variables which affects

target variables and link the targets to the goal
of a nation and responsive to the monetary
instruments .
1.Monetary Base or High-Powered Money.
2. Short Run Interest Rate (Rate on Treasury
Bill, Overnight Rate.
Monetary Targets
• Are those monetary Intermediate Targets.
• Target variables such as money supply and interest
rates have direct and predictable impact on goal
variables and can be quickly and more easily observed.
• Target variables lie between goal and instrument
variables .
• Target variables are not directly affected by central
bank instruments .
1.Monetary Aggregates (M1, M2, M3 etc.).
2. Short Run and Long Run Interest Rates.

Three' Criteria for Target
1.Measurability: Quick and accurate measurement of a target

variable is necessary because the target will be useful only if it
signals rapidly when the policy is off track.
• For example, data on monetary aggregates are available after a
two week delay, while interest rate data are available almost
immediately.
• In addition, interest rate data are more precise and rarely revised,
this makes interest rates more desirable than monetary aggregates.

2. Controllability : A central bank must be able to exercise
effective control over a variable. If it is to function as a useful
target.
• If the Central bank cannot control a target, knowing that it is
off track is not useful because the central bank has no way of
getting it on track.
• For example, the central bank has better control over
monetary aggregates and interest rates than over nominal
GDP (which was suggested as an intermediate target). Thus,
nominal GDP is not a good target.
3.Predictable effect on goals
• The most important characteristic a variable must have to be
a good intermediate (operating) target, is that it must have a
predictable impact on (intermediate targets) goals.
• The choice of an operating target can be based on the same
criteria used to evaluate intermediate targets.
• Both the Federal funds rate and Reserve aggregates are
measured accurately and are available daily with almost no
delay; both are easily controllable using the policy tools.

Goals
• Goals are long term macro economic objectives of a
nation .
1. High Employment.
2. Economic Growth.
3. Price Stability.
4. Interest-Rate Stability.
5. Stability of Financial Markets.
6. Stability in Foreign Exchange Markets.

• Although many of the goals mentioned are consistent
with each other high employment with economic
growth, interest rate stability with financial
market stability, this is not always the case.
• The goal of price stability often conflicts with the
goals of interest rate stability and high employment
in the short run (but probably not in the long run).
• For example, when the economy is expanding and
unemployment is falling, both inflation and
interest rates may start to rise.

• If the central bank tries to prevent a rise in interest
rates, this may cause the economy to overheat and
stimulate inflation.
• But if a central bank raises interest rates to prevent
inflation, in the short run unemployment may rise.
• The conflict among goals may thus present central
banks with some hard choices.

5.4 Central Bank Strategy
• Monetary Policy Strategies of major central banks are
the following ;
1)Central bank tend to be highly transparent,
explaining policy decisions and the rationale for those
decisions to the public.
2)Central banks consider not only current economic
conditions, but also the expected evolution of the
economy and the risks around that outlook i.e forward
looking .
3)Publish forecasts of inflation and other
macroeconomic variables .

1) In deliberating about monetary policy and
formulating projections for the economy, central
bank policymakers routinely consult the
prescriptions of policy rules.
2) With regard to the goals of policy, the Federal
Reserve and other major central banks state the
objectives of monetary policy clearly and publicly
and explain how the policy committee pursues those
goals.
3) Central banks around the world regularly announce
their policy decisions to the general public and
explain the rationale for those decisions.

5.6Transmissions Mechanism of Monetary Policy
•The monetary transmission mechanism is the process
by which assets prices and general economic conditions
are affected as a result of monetary policy decisions.
•The effect of change in money demand and change in
money supply and its effect on aggregate economy is
called monetary transmissions.

• To develop a framework for understanding how to
evaluate empirical evidence we need to recognize that
there are two basic types of empirical evidence in
economics and other scientific disciplines.
1) Structural model evidence examines whether one
variable affects another by using data to build a model
that explains the channels through which this variable
affects the other.

• Keynesians typically examine the effect of money on
economic activity by building a structural model, a
description of how the economy operates using a
collection of equations that describe the behavior of
firms and consumers in many sectors of the economy.
• The Keynesians examine the relationship between

Money supply and aggregate demand by looking at
empirical evidence (structural model evidence) on the
specific channels of monetary influence, such as the
link between interest rates and investment spending.

2)Reduced form evidence examines whether one variable has an
effect on another simply by looking directly at the relationship
between the two variables.
• Monetarists tend to focus on reduced form evidence and feel
that changes in the money supply are more important to
economic activity than Keynesians do; Keynesians, for their
part, focus on structural model evidence.
• Monetarists do not describe specific ways in which the money
supply affects aggregate spending.
• Instead, they examine the effect of money on economic activity
by looking at whether movements in aggregate demand are
tightly linked to (have a high correlation with) movements in
Money supply .
• Changes on money supply or changes on money demand impact
on aggregate demand in the economy is called monetary
transmission mechanisms .
• In structural modeling evidence it has three stage of monetary

transmission mechanisms ;
Stage 1. change occurs on money demand or money changes the
equilibrium level of interest rate
Stage 2: Change in equilibrium level of interest rate leads to
change in desires investment.
Stage 3: The change in the desired spending will causes change in
aggregate expenditure .

• Let us suppose the national bank of Ethiopia assume;
1) Money supply increase or decrease in money
demand leads to reducing the equilibrium level of
interest rate.
2) Reduced equilibrium level of interest leads to
increasing desired investment expenditure
3) An increase in the desire investment expenditure
leads to increase in aggregate expenditure.
4) An increase in aggregate expenditure will leads to
leads to right ward shit of aggregate demand curve
.

Structural model of Monetary transmission mechanisms

Reduced model of monetary transmission mechanisms

Potential elements of monetary transmission mechanism
– Monetary base
– Exchange rate
– Credit controls
– Exchange controls
– Prudential controls on banks
– Fiscal policy constraints
• These may have direct and more powerful effect on domestic
demand and net trade
• So lags and scale of impact may be very different in different
countries
• Institutional differences and different inflation history also
create a different response to policy rate changes especially
until credibility of the regime is established.
• No clear cut case can be made that reduced form evidence is
preferable to structural model evidence or vice versa.
• The structural model approach, used primarily by Keynesians, offers
an understanding of how the economy works.
• If the structure is correct, it predicts the effect of monetary policy
more accurately, allows predictions of the effect of monetary policy
when institutions change, and provides more confidence in the
direction of causation between money supply and aggregate demand
or output.
• If the structure of the model is not correctly specified because it
leaves out important transmission mechanisms of monetary policy, it
could be very misleading.
Chapter review Questions
1.Expalin the structure and independence of central bank .
2. What is the meaning of monetary policy ?
2. What are the tools of monetary policy instruments ?
3. State the central bank strategy .
3. What are the goals of monetary policy ?
4. List the monetary policy targets .
5. State the two type of monetary policy ?
6. Discuss transmissions mechanism of monetary policy and the
evidence .

Chapter 6: Monetary Policy in Ethiopia(6hrs)
6.1. Powers and Functions of the National Bank of Ethiopia .
6.2. Conduct of Monetary Policy in Ethiopia

Chapter 6: Monetary Policy in Ethiopia
• Monetary policy, it is a policy involving a change in money supply

as an instrument of achieving a certain given objectives of economic
policy.
•Coming to Ethiopia, it seems likely in line with this intent that
Imperial charter led to the establishment of the State Bank of
Ethiopia, a financial institution designed, in 1942, for the promotion
of productive investment.
•During the Derg Regime, which followed the imperial Regime there
had been a policy of financial repression which took the form of an
outright prohibition, i.e. a severe form of financial repression driven
by12/13/2020
a socialist ideology. BY: Yeshiwas Ewinetu Tegegne 466
• It was immediately following the downfall of the Derg regime that the
Transitional Government of Ethiopia with the belief that the large
repressions of the financial sector during the previous regime had retarded
severely economic growth, it has launched an economic reform program
in which the financial sector reform and liberalization has been included.
6.1 Powers and Functions of the National Bank of Ethiopia
• The name is so called national bank of Ethiopia .
• Established under pro.206/1063 in 1964 with 10 million birr capital .
• It was operated by the government and managed by board .
• A national bank is financial institution established to act on behalves of
the government to control and regulate the activities in the financial
sector .
• They are not established primarily for the sake of profit generation .
• They have much more responsibility and duties than commercial
bank .
• They are not transacting with the general public in the deposit
,borrowing and lending activities .
• Exclusive right to mint coin and print currency note that the
circulate in the national economy.
• Promote balanced and accelerated economic growth.
• Adopt the monetary policy of nation and regulate interest rate
,money supply and creation of credit by the commercial bank .
• Determine the exchange rate and regulate foreign exchange of a
nation.
• Act as the banker of the government deposit government money
and provide direct advance to the government .

• Act as a last resort for commercial bank to borrow money at
the time of shortage .
• Mange and administer the international reserve of the country.
• achieving the macro economic objective of a nation.
• Participates ,in accordance with existing law and regulation in
the formation ,licensing ,consolidation or dissolving financial
institution when deemed necessary .
• Prepare regular report on the money supply ,production of
goods and services and official international economic
transactions carried out by the country .
• Acts in accordance with international monetary and banking
practices rule, regulation to which Ethiopia agree .
• Encourages the formation of micro and other financial
institutions in general and commercial bank in general .
The role and function of commercial bank in Ethiopia
CBE is the biggest lending commercial bank in Ethiopia .
It was incorporated as share company in December 1963 as per the
monetary and banking proclamation 207/1955and began its operation in
January 1964.
Commercial bank is a name given to all banks dealing with the general
public particularly with households and firms .
They are banks established for the purpose of making profit from the
deposited and lending activates .
They usually pay certain amount of interest to the depositor and receive
interest from borrowers.
Revenue for commercial bank(interest differential) =Lending rate –saving
rate .
Regardless of their owner ship and name ,all commercial banks have almost
the same type of objectives , function and role .

 Help to encourage people to save money
 Accept deposit of different kind saving ,time and demand deposit .
 Extend loans ,credit ,overdraft ,advances and other services for individual
and firm .
 Safe keeping or custody of valuable jewels such as diamond ,gold etc.
 Participating in buying and selling of foreign exchanges .
 Issuing of bonds and participate in buying and selling of treasury bill
,bond, and other negotiable instruments .
 Buying and selling of bill of exchange and other promissory notes .
 Accept and issue checks and travel checks .
 Issue letter of credits to facilitate export and import trade .
 Act as agent of business organizations and individual engage in money
market .
 Conduct the transfer of money from one place to another place .
 Prepare regular financial report the national bank .

Similarity
Both the central banks as well as the commercial banks are basically monetary
institutions that are both deal in money in one form or the other.
The central bank creates credit when it issues paper currency without keeping
securities of equivalent value in reserves like wise, the commercial banks also
create credit on the basis of their derivative deposits.
Both the institutions extend short-term loans only because this helps them in
maintaining liquidity in their resources.
The central bank is the apex institution of the country. It controls the
monetary system and the over all credit operations of the banks. The
commercial bank on the contrary is only a constituent unit of the banking
system which is subordinate to the central bank.
The central bank possesses the monopoly of note-issue. issue there was a time
when certain commercial bank also used to issue notes. This right is no longer
held by commercial banks now.
 The central bank is not a profit making institution its main concern is to
promote the general economic policy of the government.

 It acts only in the public interest without regard to profit as a primary
consideration. As against this, the primary objective of commercial banks is
to earn profit for its share holders.
 The central bank maintains the foreign exchange reserves of the country and
attempts to maintain stability in the exchange rate
 The commercial banks only deal in foreign exchange under the directions of
the central bank they do not have the responsibility of maintaining the
foreign exchange reserves and stability in exchange rates.
 The central bank is normally owned by the state, while commercial banks
are mostly privately owned.
 State ownership of commercial banks is not considered to be as much
essential as that of the central bank.
 The central bank does not deal directly with the public, while commercial
banks deal directly with the general public.
 The central bank mainly deals with the government and the banking
institutions. Hence, it cannot undertake the functions normally performed
by the commercial banks. BY: Yeshiwas Ewinetu Tegegne
12/13/2020 473
 The central bank is closely related to the government as its
banker and the financial adviser.
 It is generally an organ of the government and its actions are
closely coordinated with those of the other departments,
particularly with the department of finance or the Treasury.
 Commercial banks, on the other hand, act as bankers and
advisers to the general public only.
 The central bank has a special relation with the commercial
banking system of the country.
 It is given special powers to control, supervise and regulate the
working of the latter. The commercial banks are required to
act in accordance with the directives issued by the central
bank.
 The central bank functions as a banker's bank.

6.2 Conduct of Monetary Policy in Ethiopia
• The final targets of monetary policy in Ethiopia are to

maintain price and exchange rate stability and support sustainable
economic growth .
• In achieving these objectives, the NBE sets money supply as an
intermediate target .
• Narrow money (M1) is a measure of money stock intended
primarily for use in transactions.

Objective of monetary policy in Ethiopia
 Foster monetary, credit and financial conditions conducive to orderly,
balanced and sustained economic growth and development.
 Preserve the purchasing power of the national currency ensuring that the
level of money supply is generally consistent with developments in the
macro economy and intervening in the foreign exchange rate market for
the purpose of stabilizing the rate when conditions necessitate.
 Encourage the mobilization of domestic and foreign savings and their
efficient allocation for productive economic activities through the
implementation of a prudent market driven interest rate policy.
 Facilitate the emergence of financial and capital markets that are capable of
responding to the needs of the economy through appropriate policy
measures. These measures would ensure the gradual introduction of
trading instruments on a short-term basis.

Monetary policy instruments
• The introduction of a wide range of monetary instruments by
central banks engenders competition, efficiency and
transparency and broadens financial intermediation in the
banking system.
• It also promotes liquidity management of commercial banks and
gradually leads to the development of well functioning money
and financial markets which could serve as catalysts for
economic growth and development.
• So far, the use of such instruments has been extremely limited
in Ethiopia due to the underdevelopment of the money
market and the virtual non-existence of a financial market.
Thus, it is envisaged to use a mix of diversified monetary policy
instruments so as to effectively carry out the monetary
management function of the NBE.

1) Open Market Operation (Sale & purchase of bonds or
securities issued by governments) has generally been used by
countries as one of the main instruments for the development of
money markets.
• Trading in these instruments liquefies the financial system in
particular and the national economy in general and increases
financial intermediation among market participants.
• In light of this, the NBE will use open market operations (sale
and purchase of government securities) as one of its monetary
policy instruments. In the absence of its own securities, certain
amount of government treasury bills needs to be allocated to
NBE by the government for its monetary policy purpose.
• To prepare the ground for enhanced open market operations, the
yield on government securities should be at least close to the
minimum interest rate. As a next step, secondary market for
government securities needs to be established.
2) A standing central bank credit facility is another instrument
used to enhance the financial capacity of commercial banks
and to promote financial intermediation and efficiency.
• The key advantages of such standing credit facility are
transparency and predictability of accessing central banks’
resources to cover short-term needs.
• This credit facility gives banks an assurance that, when
confronted with problems of shortfall in the clearing and a
lack of alternatives for raising immediate funds in the inter-
bank market, they can settle the clearing with the central
bank’s funds at a reasonable interest rate which has a clear
relationship with short term market interest rates.
• The NBE will use this facility as one of its monetary policy
instrument.

Other monetary policy instruments used and to be used
include:
• Reserve requirement
• Setting of floor deposit interest rate (until interest rate
is fully deregulated)
• Direct borrowing/lending in the inter-bank money
market and introducing re-purchase agreement
(repo/reverse repo operations),
• Use of selected credit control when necessary, and
• Moral Suasion etc.

Monetary policy target in Ethiopia
• The final targets of monetary policy in Ethiopia are to
maintain price and exchange rate stability and support
sustainable economic growth.
• In achieving these objectives, the NBE sets money
supply as an intermediate target.
• It should be noted that intermediate targets are not
directly controlled by the central bank.
• Traditionally, money supply is defined from its narrow
and broader sense. Narrow money (M1) is a measure of
money stock intended primarily for use in transactions.

• It consists of currency held by the public, traveler’s
checks, demand deposits and other checkable
deposits.
• Broad Money (M2) is a measure of the domestic
money supply that includes M1 plus Quasi-money
(savings and time deposits), overnight repurchase
agreements, and personal balances in money market
accounts.
• Basically, M2 includes money that can be used for
spending (M1) plus items that can be quickly
converted to M1.

Reference
Hard copy available in your library
• M.L. Jhingan. Monetary economics. 7th edition .Vrinda publication (P) LTD.
• R.Cauvery,n.Kruparani,u.K.Sundhanayak,a.Manimekalai (2003).Monetary economics (for
undergraduate student of economics ) .S.CHANDA AND COMPANY LTD. NEW DELHI
• MC VAISH (2005) .Monetary theory, 6th edition ,Vikas publishing house PVT LTD .
• MC Vaish (1993) .Money Banking and international trade .8thedition ,Wiley Eastern
Limited company, New Delihi .
• D.M.Mithani (2007).Money , Banking and international trade and public finance .Himalaya
publishing house. New Delihi.
• M.L. JHINGAN (2007) .Money, Banking and international trade and public finance 6 th
edition, .Himalaya publishing house. New Delhi.
Soft Copy Accessible from Web
• Frederic S. Mishkin (2004) .The economics of money, banking and financial markets, 7 th
edition,Columbia University (Addison-Wesley series in economics). (On line accessible).
• Jagdish Handa (2009). Monetary Economics,2 ndEdition ,by Routledg(On line accessible)
2Park Square,MiltonPark, Abingdon, OxonOX144RN. Simultaneously published in the USA
and Canada
• Chandler,L.V. &Goldfeld,S.M. (1998); The Economics of Money and Banking(On line
accessible)etc..

Thanks a lot !!
Wishes you All the Best !!
Let us “Avoid acute angel”

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Debre Markos University College of Business and Economics Department of Economics

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Debre Markos University

College of Business and Economics

Monetary Economics (Econ 3121)

prepared by : Yeshiwas Ewinetu(MSC)

“Take the job mentality to make the job”.

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 2

Where R is exchange rate and N is number of item .

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 8

•For a commodity to function effectively as money, it has to meet the

1.It must be easily standardized, making it simple to ascertain its

3.It must be divisible, so that it is easy to make change . The material

not deteriorate quickly i.e Durability .

6. The material with which money is made should be easily

7. Money should be stable in value because it has to serve as a

8. The material with which the money should be of the same

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 14

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 16

Example:- Birr notes issued by the central bank of Ethiopia, issued

There is a sentence “Payable to the bearer on demand” to show

ii) Based on acceptable criteria

1)Legal tender money

2) Non - legal tender money

1) Legal tender money:-It is a money in which the state and the

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 20

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1)As a store of value(asset function):

• It means help to meet unforeseen emergency and to pay debt .

1. They sometimes involve storage costs.

2. They may depreciate in terms of money; and

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 28

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 29

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 34

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 38

•These change are brought about by increasing or decreasing in the supply

2) Unequal distribution of income and wealth due to inflation (income

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 39

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5) Money leads to trade cycle or economic fluctuation : The nature of the

6) Growth of monopolies (tendency to exploitation) :Too much money and the

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 41

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• Money has made more people mad than love.

• So the best way is to keep money under control like a faithful

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 43

•It means the purchasing power of money over goods and

1)Internal value of money: It refers to the purchasing power of

2)External value of money: It refers to the purchasing power of

“Think good and do good to others.”

• No individual is interested in general price level .

• Generally individual interested only in the price of those

12/13/2020 BY: Yeshiwas Ewinetu Tegegne 47

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1) As consumption pattern differ from family to family ,depending

1) There are no standard retail price quotations available, the

8/7/2021 BY: Yeshiwas Ewinetu Tegegne 50

•Here again difficulty is arise due to lack of homogeneity of

• The value of money changes in inversely proportional to the