SG: Chapter 13, 14

TOPIC 3: MONEY, PRICES, INTEREST RATES

AND MONETARY POLICIES

Zhang Xuyao
Asia Competitiveness Institute
LKY School Of Public Policy

Prepared by
Dr. Xu Le
NUS Business School
MONEY
• Sophocles, the ancient Greek playwright, had
strong opinion about the role of Money. As
he saw it, “Of evils upon earth, the worst is
money. It is money that sacks cities, and
drives men forth from hearth and home;
warps and seduces native intelligence, and
breeds a habit of dishonesty.”

• The purpose of the lecture is to examine the

role of money in the economy today.
QUESTIONS
Money, Money, Money: People slog to get more.

(a)Why don’t the government print money and distribute the money so that
everyone is rich and able to buy anything, and the macro economy will
expand?

(b)How does the government control the money supply and affect the level of
GDP & employment in the economy?

(c)Is it true that inflation is too much money chasing too few goods and
services available?
FINANCIAL INSTITUTIONS IN THE CIRCULAR
FLOW

Function of financial institutions (e.g. banks) is not

to store money but to transfer purchasing power
from savers to spenders and investors. This helps
to maintain desired rate of aggregate spending.
MONEY
• Money is any asset that can be used in making purchases
 Examples include coins and currency, checking account balances, and traveller's
checks
 Shares of stock are not money
• Money has three principal uses
 Medium of exchange: accepted as payment for goods and services.
 Unit of account: serves as a yardstick for measuring the prices of goods and services.
 Store of value: can be held for future purchases.
• Money facilitate Exchange Economy
• Money makes barter unnecessary
 Barter is trading goods directly
 Double coincidence of wants is avoided with use of money
PRIVATE MONEY
• Money is usually issued and controlled by the government
• Private money can develop in certain circumstances
• An Ithaca Hour (Since 1991) is worth $10, the average hourly wage of workers
 1,600 individuals have earned and spent this currency
 Encourages local shopping
• Bitcoin virtual currency
 Obtained through “mining,” or in exchange for other currencies, products, and
services
 The price of Bitcoins is significantly volatile: In a famous episode, in Nov 2013 one
bitcoin traded for more than $1100- more than 10 times its price in dollars a few
months earlier – before sharply declining and trading for less than $300 during 2015.
HOW MONEY IS MEASURED
• Money is usually issued and controlled by the government or the central bank.

• Money can be measured & classified according to liquidity: M1, M2, M3, . . .

• Money can be anything if there is general acceptability that the chosen item performs
the role of money.
THE MONEY SUPPLY 1
• There are many types of money.

• The concept of money includes more than dollar bills and coins.

• Most money consists of balances in transactions accounts, a bank account that

permits direct payments to a third party and is a form of money.

• Credit cards are loans, not money.

• Mobile payments like Apple Pay or PayPal do not qualify as “money.”

THE MONEY SUPPLY 2

• The amount of money in

the economy is referred
to as the money supply.

• The value of coins and

currency plus balances
in transactions accounts
is referred to as M1.

Source:” Money Stock Measures”, Federal Reserve Board of

Governors, 2018
THE MONEY SUPPLY 3
• M2 and M3 are other measures of the money supply.

• There are many assets that are close to being money that expand the definition of
money:

• Savings accounts.

• Certificates of deposit (CDs).

• Money-market mutual funds.

MEASURING MONEY, JULY 2017
• Definitions of money range from narrow to broad
M1 3,528.1
Currency 1,486.4
Demand deposits 1,474.2
Other checkable deposits 565.4
Traveler’s Checks 2.0
M2 13,602.2
M1 3,528.1
Savings deposits 9,028.9
Small-denomination time deposits 364.4
Money market mutual funds 680.8
THE CENTRAL BANKS
• The Fed, Bank of Japan, Monetary Authority of Singapore, and People's Bank of
China are the central banks of the United States, Japan, Singapore and China
respectively.
• Responsible for monetary policy and the oversight and regulation of financial
institutions and financial markets.

The Fed: https://www.federalreserve.gov/aboutthefed.htm

CONTROL OF MONEY SUPPLY
• Monetary policy is deciding and managing the size of the nation's money supply
Money supply is controlled indirectly via…
• Reserve ratio: the ratio of a bank’s reserves to its total transactions deposits.
• Discount rate: the interest rate that the fed charges commercial banks to borrow
reserves.
• Open-market operations: the transactions of government bonds between the
central bank and the public for the purpose of controlling money supply
• Quantitative Easing (QE): an expansionary monetary policy in which a central
bank buys long-term financial assets, thereby lowering the yield or return of those
assets while increasing the money supply.
 MONEY CREATION PROCESS
• Commercial Banks make loans –create demand deposits -a form of money.
• Suppose the required reserve-deposit ratio (θ) is 10%.

Money multiplier
is 1/θ= 10. The
max amount of
loan created is
1,000,000.
MONEY SUPPLY WITH CURRENCY AND
DEPOSITS
 Suppose that the residents in the country hold 400,000 as currency (currency at hand)
and deposit 500,000 ( Total Reserve) in the banks
 Required Reserve-deposit ratio = 10%
 Money Multiplier = 10
 Created Bank Deposits (Total Bank Deposits) = 500,000 *10 = 5,000,000
 Money supply = 400,000 cash + 5,000,000 deposits = 5,400,000

Total Bank Deposits = Total Reserve * Money Multiplier

Money Supply = Currency at hand + Total Bank Deposits
CONTROLLING THE MONEY SUPPLY: OPEN-
MARKET OPERATIONS
• Suppose that the Fed wants to increase bank reserves, with the ultimate goal of
increasing bank deposits and money supply

• When the Fed purchases a bond from the public

 Fed pays bond holder with new money
 The new money enters the economy
 The bond, which wasn’t money, leaves the economy
 Receipts are deposited and this leads to a multiple expansion of the money supply

• When the Fed sells a bond to the public

 Bondholder pays with checking funds
 The checking funds, which were money, leave the economy
 The bond, which is not money, enters the economy
 Bank reserves decrease and this leads to a multiple contraction of the money supply
MONEY AND PRICES
• In the long run, the amount of money circulating and the level of prices are
closely linked. Sustained high inflation rates occur with a comparably high
growth rate of the money supply
VELOCITY OF MONEY (V)
• Velocity is a measure of the speed money changes hands in transactions for final
goods and services.

Nominal GDP
Velocity 
Money stock
• Nominal GDP is the price level (P) times real output (Y) and M is the money
stock
PY
V
M
M×V=P×Y
MONEY AND INFLATION IN THE LONG RUN
• Recall the quantity equation: it states that money times velocity equals nominal
GDP.
M×V=P×Y
 Suppose velocity and real output are constant
V and Y, respectively
 An increase in the money supply, M, by a given percentage would increase the price
level, P, by the same percentage
THE CENTRAL BANK AND INTEREST RATES
• Controlling the money supply is the primary task of a central bank
 Money supply and demand determine the interest rate
 The central bank manipulates money supply to achieve its desired interest rate

• The demand for money is the amount of wealth an individual or firm chooses to
hold in the form of money.
• Example: If Louis decided to hold $1000 in cash, $2000 in a checking account,
$2000 in government bonds, and $5000 in rare stamps, his demand for money would
be only $3000 - that is $1000 in cash plus $2000 in his checking account.
DEMAND FOR MONEY: KEYNESIAN THEORY
THE MONEY DEMAND CURVE
• Interaction of the aggregate demand for money and the supply of money
determines the nominal interest rate
• The money demand curve shows the relationship between the aggregate quantity
of money demanded, M, and the nominal interest rate

 An increase in the
nominal interest rate
increases the
opportunity cost of
holding money
 Negative slope
THE MONEY DEMAND CURVE
• Changes in factors other than the nominal interest rate cause a shift in the
money demand curve
• The demand curve shift to the right indicates an increase in demand for money
resulting from:
 An increase in output
 Higher price levels
 Increase in wealth
 Foreign demand for
dollars
• An improvement in payment
technology less need for
money in transaction
will shift the demand curve to
the left
THE CENTRAL BANK MANIPULATES THE
SUPPLY OF MONEY TO TARGET THE
NOMINAL INTEREST RATE
• Central bank policy is stated in terms of interest rates
 The tool they use is the supply of money
• Initial equilibrium at E
• The central bank increases
the money supply to MS'
 Open market operation:
Buy bonds from public
 New equilibrium at F
 Interest rates decrease to i’
to convince the market to
hold the new, larger amount of money.
THE CENTRAL BANK (CB) CONTROLS THE
NOMINAL INTEREST RATE
To Decrease the Money Supply

To Increase the Money Supply

THE CENTRAL BANK TARGETS THE
INTEREST RATE
• The central bank cannot set the interest rate and the money supply independently
• Central bank policy is announced in terms of interest rates because
 Public is not familiar with the size of the money supply
 Interest rate changes affect planned spending and the level of economic activity
 Interest rates are easier to monitor than the money supply
FEDERAL FUNDS RATE
• The federal funds rate is the interest rate that banks in the United States charge
each other for very short-term loans
 Closely watched in financial markets
• The Fed targets this interest rate because it is closely tied to the level of bank reserves
 Changes in the federal funds rate indicate the Fed's plans for monetary policy
 Other interest rates could be used to indicate the Fed's intentions; e.g. interest rate for
Treasury bills with long maturity date.
MONEY SUPPLY AND PLANNED AGGREGATE
EXPENDITURE

Suppose inflation rate is zero. Nominal interest rate is the

same as the real interest rate.
MONETARY POLICY: REGULATING THE
ECONOMY BY CHANGING THE INTEREST RATES
Recessionary Gap

Inflationary Gap
TRANSMISSION MECHANISM
• Increase Money supply Lower interest rate stimulates investment & consumption;
• AD curve shifts to the right; PAE shifts up; equilibrium output increases.
SUMMARY
CONSTRAINTS ON MONETARY POLICY
• Though MP is usually implemented faster than FP, the change in monetary policy must percolate
through the banking system, changing the quantity of loans and affecting interest rates. it takes time
for these changes to filter through the rest of the economy.
• Excess reserve: When many banks are choosing to hold excess reserves, expansionary monetary
policy may not work well.
• Unpredictable Movements of Velocity: Velocity describe how quickly money circulates through the
economy. From quantity equation of money: MV = PY.
%ΔM + %ΔV = %Δ(PY).
• If velocity changes unpredictably over time, however, then the effect of changes in the money supply
on nominal GDP becomes unpredictable.
• What happens during episodes of deflation? Deflation tends to push up real interest rate,
discourages investment and consumption. Deflation can make it very difficult for monetary policy to
address a recession.
• Liquidity Trap: expansion of money supply has no effect on interest rate. The horizontal section of
the money demand curve portrays this this situation.
• Interest rate hit zero in financial crisis –quantitative easing (QE)
• Inelastic Investment demand: lower interest rate won’t stimulate investment.