Chapter Two

• The Role of Money in the Macro economy

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• Money is one of the fundamental inventions of
mankind. It has become so important that the
modern economy is described as the money
economy. The modern economy cannot work
without money. Even in the early stages of
economic development, the need for exchange
arose. At first, the family or village was a self-
sufficient unit
2
 Money
• Currency – bills and coins
• Includes demand deposits (checking accounts)
issued by banks Plays a key role in influencing
the behavior of the economy as a whole and the
performance of financial institutions and
markets

3
 Monetary Economy
• Facilitates transactions within the economy
• Principal mechanism through which central
banks attempt to influence aggregate
economic activity
– Economic Growth
– Employment
– Inflation

4
 The lack of money in economics is the root
of all evil.
 What is the right amount of money in
economy?
 Actually those are fairly sophisticated
questions requiring careful consideration
to produce answers that stand the test of
time.
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 The right amount of money in the economy is not
too much and not too little, but it must be enough
in circulation.

 In the good old days money was gold, kept under

lock and key until it was sent by ship or stagecoach
to meet the payroll.
 Nowadays money is paper that we carry around
any where.

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• Sir William Petty (1623–87) wrote in 1651
• “To which I say that there is a certain measure and
proportion of money requisite to drive the trade of
a nation, more or less than which would prejudice
the same”
– Too much money will lead to inflation
– Too little money will result in an inefficient economy

7
• The demand for money is the quantity of
monetary assets people want to hold in their
portfolios
– Money demand depends on expected return, risk, and
liquidity
– Money is the most liquid asset
– Money pays a low return
– People's money-holding decisions depend on how
much they value liquidity against the low return on
money

8
 Liquid Asset
• Something that can be turned into a generally
acceptable medium of exchange, without loss of
value
• Liquidity is a continuum from very liquid to illiquid
• Currency and checking accounts are most liquid
assets

9
 Qualities of good money material
• General acceptability: A good money material must be
generally acceptable. People should not hesitate to
exchange their goods for the material. Precious metals like
gold and silver are always acceptable.
• Portability: A satisfactory money material must be of high
value for its bulk. Since it has to be moved about from
place to place, it must be possible for us to carry it from
one place to another without difficulty, expense, or
inconvenience. Precious metals such as gold and silver are
satisfactory in this regard. Even paper money is ideal in
this regard. Iron, for instance, would not be satisfactory in
this respect.
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• Cognizability: The material used as money
should be easily recognizable. Gold and silver,
for example, can be easily recognized by their
color and heavy weight for small bulk.

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• Durability: The material used as money
should not deteriorate. The early forms of
money such as corn, fish, and skin were
unsuitable in this regard. Gold coins will
last many hundreds of years.

12
• Divisibility: The material must be capable of
division without difficulty and without loss of
value on account of division. Metals have this
advantage.
• Homogeneity: All coins of the material should
be of the same quality. One coin should not be
superior to another.

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• Malleability: A material must be capable of
being moulded without much difficulty. Even if
a material is divided into a number of pieces,
they must be capable of being reunited without
loss. Gold is excellent for such purposes.

14
• Stability of value: This is another important
quality of a good money material. Commodities,
which are subject to violent changes in supply
and demand, are unfit for money. For, the value
of money, like any other thing, is determined by
its supply and demand. If there are violent
changes in its supply and demand, its value is not
likely to be stable.

15
• Since money is used as a store of value and
standard of deferred payments, it cannot perform
these two functions well, if there is no stability
of value for money. If money goes on losing its
stability of value, it will not be accepted as
money.

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 Monetary Base
• A “base” amount of money that serves as the
foundation for a nation’s monetary system.
• Under a gold standard, the amount of gold
bullion.
• In a fiat money system, the sum of currency
in circulation plus reserves of banks and
other depository institutions.

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 The Monetary Base
• Currency:
– Coins and paper money.
• Reserves:
– Cash held by depository institutions in their
deposit with the Federal Reserve System.

• Monetary Base = Currency + Reserves

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• Financial institutions and markets have become
so complex during the second have of twentieth
century that commercial banks are no longer the
only financial institutions that operate.

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 How large a money supply do we have?
 Currency outside banks plus checking accounts is
frequently called M1.
 Since currency and checking accounts are
spendable at face value virtually anywhere, at any
time, they are the most liquid assets a person can
have.

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 A liquid asset is something you can turn
into the generally acceptable medium of
exchange quickly without taking a loss, as
compared with illiquid assets.
 Currency and checking accounts are the
most liquid assets you can have simply
because these are used as medium of
exchange.

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 but currency and checking accounts are not
the only liquid assets around us, savings
deposits and government bonds are rather
liquid, although you can`t spend them
directly.
 To spend them, you first have to exchange
them for money.

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Table 2.1 summarizes the three different
definitions of the money supply.
 M1 refers to the most liquid of all assets,
currency plus all types of checking accounts
at a financial institution, in addition to
commercial banks, in so called thrift
institutions –(the careful use of money,
especially by avoiding waste )
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Saving banks, saving and loan associations, and
credit unions can also issue checking accounts
How ever demand deposits(non interest-bearing
checking accounts) are still in commercial banks.

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Three definitions of money supply (dec31,1995)
 M1 currency outside banks ($373 billion)
plus demand deposit at banks ($390 billion)
plus other checkable deposits at banks and at all
thrift institutions ($353billion)
plus traveler`s checks ($9billion)
= $1125billion

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• M2 Add small denomination time deposits ($936billion)
• plus money market deposit accounts and savings deposits at
all depository institutions ($1,135 billion)
• plus retail money market mutual funds shares ($465
billion) = =
$3661 billion

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 M3 Add large –denomination ($100,000 and over)
at all depository institutions ($417
billion)
plus institutional money market mutual funds shares
($227 billion)
plus bank repurchase agreements and Eurodollars
($269billion)
= $4574billion
 Source: Federal Reserve Bulletin. 27
The monetary authority in most countries is called
central bank. A central bank does not deal directly
with the public; it is rather a bank for banks, and it
is possible for the implementation of national
monetary policy. In the united states the central
banking function is carried out by the federal
Reserve System created by congress in 1913.

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For the most part it enters circulation when people
and business firms cash checks at their local
banks. Thus it is the public that ultimately decides
what proportion of the money supply will be in
the form of currency.

29
• Central bank influences the total money
supply, but not the fraction of money between
currency and demand deposits which is
determined by public preferences
• Central bank implements monetary policy by
altering the money supply and influencing
bank behavior

30
• For one thing, without money individual in the
economy would have to devote more time to
buying what they want and selling what they
don`t. just as it was in a barter trade, that there is
no money in exchanging goods and services. More
time is needed at that era to be satisfied both parts
of seller and payer.

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• Take a case study of ellen the economics
professor, who can do just one thing well: give
brilliant economics lectures, in barter economy, if
ellen wants to eat, she must find a farmer who not
only produces the food she likes but also wants to
learn economics. As you may expect this search
will be difficult and time consuming, and ellen
may spend more time looking for such an
economics hungry farmer than she will teaching.
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• The most important thing about the medium of
exchange is that every one must be confident that
it can be passed on, that it is generally acceptable
in trade. People will accept the medium of
exchange only when they are certain that it can
be passed on to someone else, one key
characteristic is that the uncertainty over its
value in trade must be very low.
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• Money is good thing. It frees people from
spending too much time running around in your
brain, freeing that limited space for creative
speculation.
It is important to emphasize, once again, that
people use the medium of exchange, money not
because it has any intrinsic value but because it
can be exchanged for things to eat
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Drink, wear, etc. The value of a unit of money is
determined, there fore, by the prices of each and
every thing more accurately. If prices go up, a unit
of money is worth less because it will buy less; and
vice versa is true.

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 Four Players in the Money Supply Process
• There are four types of individuals and institutions
that are involved in the process of creating deposits
and hence in the money supply process more
generally.
• 1. Central Bank = The government agency that
oversees the banking system and is responsible for
the conduct of monetary policy. The central bank in
the US is the Federal Reserve System.

Copyright © 2007 Pearson Addison-Wesley. 14-36 36

• 2. Banks (depository institutions) = The financial
institutions that accept deposits from
individuals and corporations and make loans , these
include commercial banks, savings and loan
associations,, and credit unions.

Copyright © 2007 Pearson Addison-Wesley. 14-37 37

3. Depositors = The individuals and corporations
that hold deposits in banks.
4. Borrowers from banks = Individuals and
corporations that borrow from banks, along with
Federal, State, and Local governments that issue
bonds that are purchased by banks.

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• Economists have identified three primary motives
for holding money:
• To settle transactions, since money is the
medium of exchange.
• • As a precautionary store of liquidity, in the
event of unexpected need.
• To reduce the riskiness of a portfolio of assets
by including some money in the portfolio, since
the value of

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• money is very stable compared with that of
stocks, bonds, or real estate.
• These three motives for holding money are often
referred to as the transactions motive, the
precautionary motive, and the speculative
motive
• respectively. Together they provide good reasons
for the Joneses to hold some money in their
portfolio in spite of the opportunity cost of
foregone interest
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 Importance of money in financial
institutions and markets
• Money also contributes to economic development
and growth. It does this by stimulating both saving
and investment and facilitating transfers of funds
out of the hoards of savers and into the hands of
borrowers, who want to undertake investment
projects but do not have enough money to do so.

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• The introduction of money, how ever, permits the
separation of the act of investment from act of
saving:
• In a monetary economy, a person simply
accumulates savings in cash because money is a
store of value.
• Through financial markets, this surplus cash can
be lent to a business firm borrowing the funds to
invest in new equipment for production 42
• The savers receive an interest and the business
firm expects to earn a return over and above the
interest cost.
• Financial institutions have sprung up such as
commercial banks, savings and loans associations,
credit unions, insurance companies and pension
funds that act as an intermediaries in transferring
funds from ultimate lenders to ultimate borrowers.
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• Uncontrolled money may cause hyperinflation or
disastrous depression and thereby cancel its
blessings. If price inflation gets out of hand, for
example, money ceases to be a reliable store of
value and therefore becomes a less efficient
medium of exchange.

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• The higher the prices, the more dollars one has to
give up real good or buy services.
Inflation (rising prices) reduces the value of money.
Hyperinflation (prices rising at fast and fast)
reduces the value of money by a lot with in a
short time span.
Hence people do not want to hold a lot of cash on
hand and they want to exchange for goods or
services quickly.
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The Importance of Money: Money Versus Barter
• Barter—direct exchange of goods/services for
other goods/services
– Very inefficient and limited economy
– No medium of exchange or unit of account
– Requires double coincidence of wants—“I have
something you want and you have something I
want”
– Items must have approximate equal value
– Need to determine the “exchange rate” between
different goods/services
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• Absence of double coincidence of wants: Barter
requires a double coincidence of wants. That is,
one must have what the other man wants, and vice
versa. This is not always possible. For example,
say I want a cow. You must have it. If you want a
horse in return, I must have it. But if I do not have
it, exchange cannot take place.

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• So, I should go to a person who has a horse, and I
must have what he wants. All of this means a lot
of inconvenience. But money overcomes these
difficulties. If I have an object, I can sell it for
some price. I get the price in money. With that, I
can buy whatever I want.

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• No standard of measurement: Barter
provides no standard of measurement. In
other words, it provides no measure of
value. It does not provide a method for
estimating the relative value of two goods.

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• Absence of subdivision: Sometimes it will be
difficult to split up commodities into parts. They
will lose their value if they are subdivided. For
example, say a man wants to sell his house and
buy some land, some cows, and some cloth. In
this case, it is almost impossible for him to
divide his house and barter it for all the above
things. Again, suppose a man has diamonds. If
he divides them, he will make a great loss.

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• Difficulty of storage: Money serves as a store of
value. In the absence of money, a person has to
store his wealth in the form of commodities, and
they cannot be stored for a long period. Some
commodities are perishable, and some will lose
their value.

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Money
– Any commodity accepted as medium of exchange can be used as
money (commodity money)
– Certainty of exchange
– Frees people from need to barter
– Makes exchange more efficient
– Prices, expressed in money terms, permit comparison of
values between different goods
– Must retain its value—the value of money varies inversely
with the price level (inflation)
– Rely on the central bank to control the supply of money to
preserve the value of money
– If money breaks down as a store of value (hyperinflation),
economy resorts to barter
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 The Importance of Money Financial Institutions and
Markets
For an economy to grow, it must forgo present
consumption (save) and invest in new capital assets
Money contributes to economic development and
growth by stimulating savings and investing
Money separates the act of saving from investing
Savers receive interest payments and investors expect
to earn a return over the cost of borrowing
Financial institutions and markets act as
intermediaries between savers and borrowers
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 Money, The Economy, and Inflation
• Money has value because people believe it will be accepted
as a means of payment, as a store of value, and as a standard
of value
• Bank Reserves and the Money Supply
– Demand deposits (money) are created when banks extend loans
through the issuance of credit
– Banks are required by the central bank to hold reserves in the form
of vault cash or on deposit with the central bank against checking
account liabilities (demand deposits).
– Current the reserve requirement is approximately 10% of demand
deposits

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(Cont.)
– Banks create money by making loans with excess
reserves, those above the central bank`s required level of
reserves
– Through manipulation (management) of excess reserves,
Fed influences the federal funds rate (rate banks charge
for overnight loans), bank lending, and, therefore
creation of money
• How Large Should the Money Supply Be?
– Purchase goods/services economy can produce, at
current prices
– Generate level of spending on Gross Domestic Product
55
(GDP) that produces high employment and stable prices
 – Increases in money supply alters public’s liquidity and influences
spending through portfolio adjustment
• Direct Impact—excess liquidity is spent on goods/services
• Indirect Impact—purchase financial assets which lowers interest rates
which stimulates business investment and consumer spending
• However, changes in liquidity may alter demand for money and not
influence GDP—people hoard (save) the additional money
• Public’s reaction to changes in liquidity is not consistent, so central bank
cannot always judge impact of a change in money supply
• Money and Inflation
– Inflation—Persistent rise of prices
– Hyperinflation—Prices rising at a fast and furious pace
– Deflation—Falling prices, usually during severe
recessions or depressions
– Inflation reduces the real purchasing power of the
currency—can buy fewer goods/services with the same
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nominal amount of money
– Economists generally agree that, in the long-run,
inflation is a monetary phenomenon—can occur only
with a persistent increase in money supply
– Increase in money supply is a necessary condition for
persistent inflation, but it is probably not a sufficient
condition
• Case 1—Economy in a recession. Expanding money supply
may lead to more employment and higher output
• Case 2—Economy near full employment/output. Expanding
money supply can lead to higher output/employment, but also
higher prices
• Case 3—Economy producing at maximum. Expanding money
supply will most likely lead to increasing inflation.

57
 Bank reserves and the money supply
• Checking accounts come into being when banks
extend credit, that is, when they make loans or buy
securities .
When a bank makes a loan to a consumer or a
business firm, it typically creates a checking
account for the borrower`s use. For example when
you borrow $1000 from the bank, the bank will
take your promissory note and give you a checking
account in return.
Similarly, when a bank buys a corporate or
government bond, it pays for it by opening a
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checking account for the seller.
• Banks cannot always expand its checking
account liabilities by making loans or
buying securities. But Banks are required
by the central bank`s reserve to hold
reserves against their checking accounts.
The current reserve requirement is 10%

59
 How large should the money supply be?
The answer is simple enough. Presumably (likely) the
supply of money affects the rate of spending, and
there fore we should have enough money that we
buy, at current prices, all the goods and services
the economy is able to produce. If we spend less
we will have idle capacity and idle people.
in other words, we need a money supply large enough
to generate a level of spending in a new
domestically produced goods and service the
economy`s gross domestic product (GDP) that
produces high employment at stable price.
60
More money than that would mean too much
spending and inflation, and less money would
mean too little spending and recession or
depression. So that monetary policy is applied
that to manage the movement of money supply.

61
 Increases in the Money Supply Alters Public’s
Liquidity and Influences Spending

• Direct Impact—excess liquidity is spent on

goods/services
• Indirect Impact—purchase financial assets which
lowers interest rates which stimulates business
investment and consumer spending
• However, changes in liquidity may alter demand
for money and not influence GDP—people hoard
the additional money
• Public’s reaction to changes in liquidity is not
consistent, so Fed cannot always judge impact of a
change in money supply
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 The velocity of money
When federal reserve increase money supply, the
recipient of this additional liquidity probably
spend some of it on a domestically produced
goods and services increasing GDP.
GDP then rises further, and the money moves on to
another set of owner`s. This relationship between
the increase in GDP over a period of time and
initial change of the Money supply is important
to have a name: the velocity of money. 63
We can compute the velocity of the total amount of
money in the country by dividing total GDP (not
just the increase in it) by the total money supply.
This gives us the average number of times each
dollar turns over to buy goods and services
during the year.

64
 Questions
1.which definition of money supply, M1 , M2, M3 is
the most appropriate if the most important function
of money is its role as medium of exchange? Why?
2. What are the most characteristics of good medium
of exchange?
3. Explain why the value of money is inversely
related to the price level?

65
4. Without deposit type money the financial sector
would be less developed and the level of
economic activity would be lower.” explain?
5. Assuming the federal reserve can successfully
control the money supply, does this mean that the
fed can also control aggregate spending and GDP?

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