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Functions of money
1. Medium of exchange - accepted in exchange for goods and services.
2. Store of value allows purchasing power to be transferred from one period to the
next. Therefore current income can be set aside as savings.
3. Unit of account a standard unit in which relative prices of goods and services
can be quoted and compared. This makes the accounting system possible.
4. Standard of deferred payment allows payment for goods and services consumed
today in a future time period. It makes the credit system possible.
Demand for money
This refers to peoples desire to hold money ie to keep wealth in the form of money
(cash) rather than spending it an goods and services or using it to purchase financial
assets such as bonds and shares. Money is the most liquid form of wealth. Only money
can be changed into some other form without cost or delay.
Liquidity preference theory
Keynes identified 3 motives for holding money:
Transaction motives money is held to carry out ordinary everyday transactions for
instance buying lunch. As income increases transactionary balances increases and vice
versa. Transaction motive is not affected by Interest rate.
Speculative/ Asset motives used as an asset or provide funds for borrowers. Speculating
means foregoing present opportunities to earn interest. Interest rate plays an important
role in this motive. Bond prices and interest are inversely related as IR falls demand for
holding money balances increases. High IR reduces the desire to hold money.
Curve
increase in the MS does not result in an excess supply of money at a low IR is that
individuals believe bond prices are so high that an investment in bonds is likely to be a
bad investment.
Transaction motives and Precautionary motives are active money balances while
speculative/ Asset motives are idle money balances.
The liquidity preference curve is the horizontal summation of Tm, Pm and Sm at each
IR.
Liquidity Preference Theory
Shows that the demand for money is determined by Tm, Pm and Sm these added
together give a single demand curve called the liquidity preference curve. Tm and Pm
are not influenced by IR but Sm is hence the shape of the curve.
Keynes believes that there is an indirect relationship between changes in the money
market and the goods and services market. He noted that when Ms increases IR falls
causing investment to increase and AD to shift to the right (increase), real GDP
increases (real growth occurs as price is constant), unemployment will fall.
Curve
Some Keynesians believe that investment is not always responsive to IR as a result the
transmission mechanism would be short circuited/disrupted in those investment good
markets and the link between the money market and the good market will be broken.
They also argued that the demand curve for money could become horizontal at some low
IR resulting in a liquidity trap.
NB Keynesian transmission mechanism is indirect and interest insensitive investment
which leads to a liquidity trap. They believe that there isnt a direct relationship between
IR and investment (it does not mean investors will invest because of a fall in IR).
Liquidity Trap
The increase in money supply does not affect the IR and so does not affect investment
and AD.
Curve showing the Liquidity trap
prices increase which will lead to unemployment decreasing and vice versa. They believe
that the link between money and AD is very strong. They believe that if the economy is
near or at full employment an increase in AD will lead to inflation.
Curve
Supply of money
Supply of money refers to the quantity of money in circulation in an economy at a
particular time. The money supply includes M1 and M2
M1 (narrow money) this is money which is used as a medium of exchange and consists
of rates and coins in circulation and cash held in banks and in balances held by banks at
the central bank. It is sometimes referred to as the monetary base.
M2 (board money) this consists of the items above plus a range of items that relates to
moneys function as a store of value such as: savings deposits, foreign currency
transferable deposits, certificates of deposit and repurchase agreements, non-institutional
money market funds.
Monetary Policy
The government may choose a money supply of M0 but then the IR will be high Ro but if
they want IR of r1 MS will increase to M1.
Monetary policies may be expansionary or contractionary. The government may expand
the economy by increasing MS which cause IR to fall and investment to rise causing AD
to rise. To contract the economy MS will fall causing IR to rise and investment to fall
causing AD to fall as in the curve above.
The role of the central bank in creating high powered money (money base)
To control the money supply the monetary base must also be controlled which includes
highly liquid assets such as cash, demand deposits and chequing accounts. The
government could control the issuing of loans by reducing the amount of cash available
in the banking system via open market operations or increasing the legal reserve
requirement. This is more effective if the money multiplier is stable. The commercial
banks must not simply adjust their cash to reserve ratio in response to a cash squeeze the
money multiplier must be stable.
The central bank must relinquish its role as a lender of last resort, otherwise money
squeezed out of the system can re-enter through the discount market.
one commercial bank for simplicity). This second deposit is called derivative deposit
or secondary deposit. The central bank working on behalf of the government insists
that only a portion of the deposits can be lent out and the rest kept as cash called
reserves ration/liquidity ratio. Eg the government may request 20% cash ratio. If the
bank has $1000 and it lends $800 which will return to the bank then $640 will be lent
out etc. until there is no more to lend.
Depositor
Primary Deposit
Derivative deposits
Derivative deposits
Derivative deposits
Derivative deposits
Derivative deposits
Derivative deposits
Derivative deposits
Totals
1st
2nd
3rd
4th
5th
Deposits
Loans
Reserves
($)
1000
800
640
512
(80%)
800
640
512
410
(20%)
200
160
128
102
5000
4000
1000
Expansionary policies results in interest rate falling. If the price of bonds were to rise
causing them to be less attractive as returns fall investors will invest abroad in more
financially attractive assets. Therefore the capital section of the B.O.P will decline. There
will be an increase in demand for foreign currency causing the exchange rate to decline
and the local currency to lose value. Exports become cheaper and imports become
relatively more expensive causing the current account to improve.
Curve
Interest rate falls price of local bonds increases - demand for local bonds fall demand
for foreign currency increases local currency looses value exports become cheaper
imports more expensive. Therefore X>M resulting in a favourable BOP.
Contractionary Policy
Curve
Interest rate increased price of bonds falls greater demand for local bonds- demand for
local currency increases- local currency value increases imports are cheaper X<M.
BOP will be unfavourable.