MACROECONOMICS

Le Phuong Thao Quynh

FACULTY OF INTERNATIONAL ECONOMICS
Email:quynhlpt@ftu.edu.vn
Lecture 4
MONEY AND THE MONEY MARKET
THE MEANING OF MONEY

Money is the set of assets in an economy that people

regularly use to buy goods and services from other
people.
The Functions of Money
• Money has three functions in the economy:
– medium of exchange
– unit of account
– store of value.

• Medium of exchange
– A medium of exchange is an item that buyers give to
sellers when they want to purchase goods and services.
– A medium of exchange is anything that is readily
acceptable as payment.
The Functions of Money
• Unit of account
– A unit of account is the yardstick people use
to post prices and record debts.

• Store of value
– A store of value is an item that people can use to transfer
purchasing power from the present to the future.
KINDS OF MONEY

• Commodity money takes the form of a commodity with

intrinsic value.
– Examples: gold, silver, cigarettes.
• Fiat money is used as money because of government
decree.
– It does not have intrinsic value.
– Examples: coins, currency, cheque deposits.
MONEY IN THE VIETNAMESE ECONOMY

• Currency is the plastic notes and metal coins in the hands

of the public.

• Demand deposits are balances in bank accounts that

depositors can access on demand by using a debit card or
writing a cheque.

- Debit: chi tiêu trong số tiền mình có (có bao nhiêu chỉ tiêu
từng đấy)
- Credit: tín dụng tốt  có thể chi tiêu quá số tiền gửi và trả
sau (tiêu trước trả sau)
II. THE MONEY SUPPLY (MS)
1. Monetary base and money supply
a. Monetary base
Basic money is the money issued by the central bank
(High Powered Money).

B = Cu + R

• Cu: Currency hold by the public

• R: Cash reserve of bank
THE MONEY SUPPLY

• The money supply is the quantity of money available in

the economy.
• The money supply is determined by the actions of the
Central Bank and by the banking system.
THE MONEY SUPPLY

Since money can be defined in different ways, there are different ways
of measuring MS

+ M0: Currency - Paper bills and coins in the hands of the public
(highest liquidity)
+ M1: M0 and demand deposit (depositors can access on demand by
writing a check)
+ M2: M1 and timely deposit (depositors in principle can access to the
money as maturity elapses)

The differentiation in measuring money volume bases on the gradual

decrease of liquidity (liquidity is the ease with which an asset can be
converted into the economy’s medium of exchange)
THE MONEY SUPPLY

MS = Cu + D

• Cu: Currency hold by the public

• D: Deposits in banks
 BANKS AND THE MONEY SUPPLY
Banks can influence the quantity of demand deposits in the
economy and the money supply.

• Reserves are deposits that banks have received but have

not loaned out.
• In a fractional-reserve banking system, banks hold a
fraction of the money deposited as reserves and lend out
the rest.
• Reserve ratio is the fraction of deposits that banks hold
as reserves.
Why fractional reserve?
• Banks are only required to keep a small fraction of their
deposits on hand as reserves.
- On any day, withdrawals are small & are offset by
deposits. So banks do not need to keep all deposits on
hand as reserves.
- But if there is a bank run – if all of the bank’s
depositors go to the bank all at once to take out their
money because they fear the bank will collapse – then the
bank will collapse.
Money creation
(Case 1: no excess reserve)

• reserve ratio = required reserve ratio + excess reserve ratio

• ra = rr + re
• No excess reserve: ra = rr (if commercials banks requires 8% then
the central bank will keep that similar level)

• The money supply is affected by the amount deposited in banks

and the amount that banks lend out.
• Deposits into a bank are recorded as both assets and liabilities.
• The fraction of total deposits that a bank has to keep as reserves is
called the reserve ratio.
• Loans become an asset to the bank.
Normally: can have excess reserve
Money creation
(Case 1: no excess reserve)
• This T-Account shows a bank that…
• accepts deposits,
• keeps a portion
as reserves, and
lend out the rest.  Needs to repay
• It assumes a households
reserve ratio
of 10%.

Assume: John borrow $9000 to buy a new car  seller receives

$9000  deposit and go back to the bank  $9000 demand
deposit; required reserve: $900
Money creation
(Case 1: no excess reserve)

• When one bank lends money, that money is generally

deposited into another bank.
• This creates more deposits and more reserves to be lent
out.
• When a bank makes a loan from its reserves, the money
supply increases.
Money creation
(Case 1: no excess reserve)
Money creation
(Case 1: no excess reserve)
Money creation
(Case 1: no excess reserve)
Money creation
(Case 1: no excess reserve)
• Total money created = loans made from the initial deposit
= $9000 + $8100 + $7290 +… = $9000 * (1/0.1) =
$90,000

• MS = $10,000 + $90,000 = $100,000

 Money creation (Case 1: no excess reserve)
• 1st deposit: 1
• Lending1: D-R = 1 – 1.rr = 1.(1-rr)
• Lending 2: 1x(1-rr) – rr.1.(1-rr) = 1.
• Lending 3: 1. - rr. 1.= 1.
• ………………..
• Lending n: 1.- rr. 1. = 1.

n 1 n 1
1  (1  rr ) 1  (1  rr )
MS  1  (1  rr )  (1  rr )  ...  (1  rr )  1
2 n
 1
1  (1  rr ) rr

1 0 1 1
0 < rr < 1 => MS  1  1   10
rr rr 0,1
THE MONEY MULTIPLIER (Case 1: no excess
reserve)

• The money multiplier is the amount of money the banking

system generates with each dollar of reserves.
• assume there is no excess reserve
The money multiplier is the reciprocal of the
required reserve ratio: mM = 1/rr

• Eg: rr = 20% , the multiplier is 5.

• The actual money multiplier is smaller than these

examples suggest because people hold a lot of cash.
Also, lenders may not be willing to lend & borrowers may
not be willing to borrow.
THE MONEY MULTIPLIER (Case 1: no excess
reserve)

assume there is no excess reserve (ra = rr)

MS = H * 1/rr

H or B: monetary base
rr: reserved ratio (equivalent to required reserve ratio)
(mM = 1/rr) is the money multiplier
 THE MONEY MULTIPLIER (Case 2: with excess reserve)

Money supply model

+) Money supply: money as the most wide scope of
understanding (M2)
MS(M) = Cu + D
where Cu currency circulated outside banks and D deposits in
bank
+) Monetary base (basic money, high powered money):
money as cash printed by central bank (M0)
B (Ho) = Cu + R
where Cu currency circulated outside banks and R currency
reserved by banks
 THE MONEY MULTIPLIER
Money supply model
Monetary multiplier (mM) is the fraction between MS and B

Denote Cu/D = s (currency over deposit ratio) (tỉ lệ tiền

ngoài ngân hàng)
R/D = ra (reserve ratio)
→ 𝑀𝑆 𝑠 +1 𝑠 +1
𝑚𝑀 = = =
𝐵 𝑠+𝑟𝑎 𝑠+(𝑟𝑟 +𝑟𝑒)
 Maths problems
1) Data have given as follows s = 20% ra = 10% MS = 2000. Find
B?
2) Data have given as follows ra = 15%, MS = 3000, B = 500.
Find s ?
3) Data have given as follows s/ra = 4, MS = 2000, B = 200. Find
s, ra ?
4) Data have given as follows s + ra = 40%, MS = 1500, B = 500.
Find s, ra ?
5) State bank of Vietnam (SBV) printed more cash of 1000, given
that s = 0% ra = 10%. How much money supply increase ?
II Banking system and money supply
Money supply model
Conclusions
- Central bank cannot control entirely money supply due to
s (decided by payment behavior of people) and re
(decided by each bank)
- Monetary multiplier has negative relationship with both ra
(rr) and s

Period 1996-1997 2000-2001 2006-2007 2009-2010

mM of 1,6-1,7 2,3-2,5 3-3,5 5-5,2

Vietnam
The central bank and tools of monetary control
• The Central Bank:
• It is designed to oversee the banking system.
• It regulates the quantity of money in the economy.
• The Central Bank has three tools in its monetary toolbox:
• Open-market operations
• Changing the reserve requirement
• Changing the discount rate
The central bank and tools of monetary control
• Open-Market Operations:

• The Central Bank conducts open-market operations when it buys

government bonds from or sells government bonds to the public:
 Increase monetary base  Increase money supply
• When the Central Bank buys government bonds, the money supply
increases.
• The money supply decreases when the Central Bank sells government
bonds.
The central bank and tools of monetary control
• Reserve Requirements
• The central bank also influences the money supply with
reserve requirements.
• rr increases =>mM reduces => MS reduces.
• rr decreases  MS increase
• (reserve less  lend more and vice versa)
The central bank and tools of monetary control
• Changing the Discount Rate
• The discount rate is the interest rate the Central Bank charges
banks for loans.
• Increasing the discount rate decreases the money supply.
• Decreasing the discount rate increases the money supply.
III. THE MONEY MARKET
1. MONEY DEMAND
a. Money demand: the demand for liquidity, i.e., for an asset
to have purchasing power
b. Types of money demand
• 1) Transactions demand for money (primary): to conduct
purchases
• 2) Precautionary demand for money: to protect against
unexpected needs for liquidity
• 3) Speculative demand for money: to take advantage of
unexpected speculative opportunities
Costs of MD
a. The opportunity cost of holding money is the foregone
interest income from the alternative of holding bonds (real
interest rate)
b. Foregone purchasing power caused by inflation
c. Total cost of MD = nominal interest rate (i)
• 1) Real interest rate = nominal interest rate – inflation
rate
• 2) Real interest rate + inflation rate = nominal interest
rate
The MD Curve
Dynamics of MD

a) Movement along MD curve due to change in interest

rate
b) Shifts between MD curves due to any other factor that
causes a change in MD
• ∆price level (↑PL  ↑MD)
• ∆real GDP (↑sales  ↑MD)
• ∆technology (e.g., ATMs)
• ∆institutions (e.g., laws affecting checking accounts)
The MONEY SUPPLY (MS)
a. For simplicity assume that money supply (MS) is
completely determined by the Central Bank, which can set
it at any level it wants.
b. Then the MS curve is vertical
c. MS curve will shift due to actions by the Central Bank
- Expansionary monetary policy shifts the MS curve out
- Contractionary monetary policy shifts the MS curve in
The theory of liquidity preference and
monetary policy
The theory of liquidity preference (money market)
This is Keynes’s theory which indicates that interest rate will
adjust to bring money supply and money demand into
balance (we see nominal interest rate instead of real interest
rate; moreover in short run due to fixed price, nominal and real
interest rate are not different )
Money supply Money demand
Controlled by central bank Money – most liquid asset (liquidity
Quantity of money supplied fixed by preference)
central bank therefore doesn’t vary Interest rate (i) – opportunity cost of
with interest rate holding money. Income (Y) is the most
Money supply curve - vertical determinant of money demand
Money demand curve – downward
sloping
MS = mM . B MD = f(Y, i)
 The theory of liquidity preference and monetary
policy

The theory of liquidity preference (money market)

• If interest rate > equilibrium: Quantity of money people
want to hold less than quantity supplied → People holding
the surplus buy other assets → Lowers the interest rate →
until equilibrium

• If interest rate < equilibrium: Quantity of money people

want to hold more than quantity supplied → People -
increase their holdings of money by selling other assets
→ Increase interest rates until equilibrium
EQUILIBRIUM IN THE MONEY MARKET
 The theory of liquidity preference and monetary policy
(a) The Money Market (b) The Aggregate-Demand Curve
Interest 2. . . . the increase in Price
rate Money 1. When an increase in government purchases
level
supply spending increases increases aggregate demand . . .
money demand . . .
4. . . which in turn
3. . . . which increases partly offsets the
r2 $20 billion
the equilibrium interest initial increase in
rate . . . aggregate demand.

r1
MD2

AD2
AD3
Money demand, MD1 Aggregate demand, AD1

0 Quantity fixed Quantity 0 Quantity

by the Fed of money of output
Panel (a) shows the money market. When the government increases its purchases of goods and services,
the resulting increase in income raises the demand for money from MD 1 to MD2, and this causes the
equilibrium interest rate to rise from r 1 to r2. Panel (b) shows the effects on aggregate demand. The initial
impact of the increase in government purchases shifts the aggregate-demand curve from AD 1 to AD2. Yet
because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the
quantity of goods and services demanded, particularly for investment goods. This crowding out of
investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the
aggregate-demand curve shifts only to AD .
Monetary Policy
• Monetary policy is the process by which the monetary
authority of a country controls the supply of money,
often targeting a rate of interest for the purpose of
promoting economic growth and stability.
• 2 instruments: money supply and interest rate.
• 2 types: expansionary and contractionary:
- expansionary policy increases MS, reduces i => increase
AD
- contractionary policy reduces MS, increases i => reduce
AD and slow inflation
The impact of monetary policy
Mechanism of monetary policy on AD and Y:
Increase MS => reduce i => increase investment => AD
and Y increase.
 Expansionary monetary policy

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
rate Money supply, level
MS1 MS2
1. When the Fed
increases the
r1 money supply . . .
P

r2

AD2
Money demand Aggregate
at price level P demand, AD1
0 Quantity 0 Y1 Y2 Quantity of output
2. . . . the equilibrium of money 3. . . . which increases the quantity of goods and
interest rate falls . . . services demanded at a given price level.

In panel (a), an increase in the money supply from MS 1 to MS2 reduces the equilibrium interest
rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate
raises the quantity of goods and services demanded at a given price level from Y 1 to Y2. Thus, in45
panel (b), the aggregate-demand curve shifts to the right from AD to AD .
Problems and applications
1. Which of the following are money in the U.S. economy? Which are not?
Explain your answers by discussing each of the three functions of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card

2. Beleaguered State Bank (BSB) holds $250 million in deposits and

maintains a reserve ratio of 10 percent.
e. Show a T-account for BSB.
f. Now suppose that BSB’s largest depositor withdraws $10 million in cash
from her account. If BSB decides to restore its reserve ratio by reducing
the amount of loans outstanding, show its new T-account.
g. Explain what effect BSB’s action will have on other banks.

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Problems and applications
3. Assume that the banking system has total reserves of $100 billion. Assume also
that required reserves are 10 percent of checking deposits and that banks hold no
excess reserves and households hold no currency.
a. What is the money multiplier? What is the money supply?
b. If the Fed now raises required reserves to 20 percent of deposits, what are the
changes in reserves and in the money supply?
c. Assume that the reserve requirement is 20 percent. Also assume that banks
do not hold excess reserves and there is no cash held by the public. The
Federal Reserve decides that it wants to expand the money supply by $40
million dollars.
- If the Fed is using open-market operations, will it buy or sell bonds?
- What quantity of bonds does the Fed need to buy or sell to accomplish the
goal? Explain your reasoning.

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