MONEY

Money is the medium of exchange used by the economy; it is something ordinary used in transaction that transfers ownership of goods and services from one person to another. (Principles of macroeconomics) (3rd edition) (Roy J. Ruffin, Paul R. Gregory) Money is anything that is generally and instantly accepted in payment for purchases and in setting debts. It is generally accepted because it is the legal tender (notes and coins) or a representative of notes and coins (demand deposits with financial institutions). Since money is accepted in exchange for all things, it measures the values of all things, by comparing their prices: values measure in terms of money are called price. (The monetary and financial systems) (3rd edition) (Bjulian Beecham) Money is anything that is generally accepted in exchange as payment for goods and services. The emphasis is on "any" because any item or asset can serve as money so long as it is generally accepted in payment throughout an economy. While the key function of money is to act as a medium of exchange, money also functions as a store of value, standard unit of account, and standard of deferred payment.

FORMS OF MONEY
Transaction money: (M1) M1 = CC +DD + ODSBP (Pakistan) Monetary Assets: (M2) M2 = M1 + T.D + FCD

1 MONEY & INTEREST RATE

Broad money: (M3) M3 = M2 + NDFCBC + NSSD + FBCD

TOOLS OF MONEY SUPPLY

Open-market operations: Discount rate: Reserve requirement: Role of Money: Money has a monopoly in term of exchange so people cant imagine what would happen in a world without money and it is the most sophisticated social measurement system used in all over the world. It has played a major role in the development of economy. Money facilitates trade and commerce in economics that are characterized by specialization and exchange. In such economics, money performs four functions. (1) Medium of Exchange. (2) Standard Unit of Account. (3) Store of Value. (4) Standard of Deferred Payment. The Time Value of Money There are two tools used to evaluate the consequences of interest. Future value Present value

Future value Future value provides a way to determine how much you will have in future. The basic principle for calculating the future value for an investment leads to the following general formula. If the interest rate is i and the present amount to be invested is PV, the future value FV of that amount in T years is 2 MONEY & INTEREST RATE

FV = PV * (1 + i) T Present value The present value (PV) of an amount received T years in future when the interest rate is i: PV = FV / (1 + i) T Interest When a bank or other financial institution lends money, it requires to repay the fund lent (principal) + an additional payment is called interest. Interest Rate: The interest rate on a loan is the ratio of the investments on the loan to the principal amount (the amount borrowed), in other words the cost of borrowing funds as the percentage of amount borrowed. (Money Banking & Financial Markets) (Michael R. Baye & Dennis W. Jansen) The percentage return, or a percentage yield, earned by the holder of the financial instrument is known as interest rate. (Money Banking & Financial Markets) (Roger LeRoy Miller & David D. Vanhoose) (Second Edition) Interest rate is the price paid to borrow debt capital or in other words it is the cost of Money. To understand it better we can also say that interest rates transform money-today into money-tomorrow; it is the rate at which it grows when invested. There are 4 main factors that affect interest rates.

3 MONEY & INTEREST RATE

A rate which is charged or paid for the use of money. An interest rate is often expressed as an annual percentage of the principal amount. Types of Interest Rate A key question for you to ask yourself is what type of interest rate is best for me? There are basically 5 types from which we can choose one for us.

Variable Rate - This is the standard interest rate of the lender. It is an interest rate that moves up and down based on the interest rate index or lenders lending rate. There can be quite a difference between the variable rates of the various lenders and index rate.

Discounted Rate - This is where the lender specifies a discount off the variable rate for a given period of time, i.e. lender fix the time period to borrower that if he pay back the money in agreed time then lender will give him benefit in shape of discount. When the discount period ends the rate payable usually reverts to the lenders variable rate.

Fixed Rate - Fixed rate have the interest rate on the loan fixed for a period of time. They guarantee that borrower is protected from any upward and downward swing in rates.

Capped Rate - This is where an interest rate is charged in line with current rates, but the borrower is given a guarantee that the rate will not exceed a certain amount. This gives advantage to borrower that rate can fall down but cannot exceed up to the certain limit.

Capped & Collared Rate - This is where the interest rate is will not exceed a maximum rate (cap) or fall below a minimum rate (collar) for a fixed period. This will give benefit to both lender and borrowers that rate do not fluctuate too much.

Measurement of Interest Rate: There are 4 ways to measure the interest rate. Simple Interest 4 MONEY & INTEREST RATE

Simple interest is the most basic type of interest and the easiest to calculate and understand. In this interest is paid once on the principal amount. The formula for simple interest is I=p*r*t or Interest=Principal*Rate*Time Period. Fixed Interest Savings account interest is probably the most common type of interest that individuals earn. Most savings accounts calculate interest monthly, using a method called Annual Percentage Yield, or APY. APY is the amount of interest you earn over a year, but it's a little different than simple interest in that it takes compounding into account. Compound Interest Interest rate is said to be Compound if interest is paid not only on the initial investment, but also on any interest re-invested in the previous period. This compound interest formula is also used by creditors to determine how much interest you will pay on money that you owe to others. It is calculated by a Formula A = P (1 + r) n Amortized Interest Amortized interest is another type of interest that many people pay. In this case, the customer has to pay off defined interest with small amount of principal.

Basic Theory There are many theories regarding Interest rates but we are sharing the most common theories of interest rate.

5 MONEY & INTEREST RATE

Fisher Equation The Fisher Equation (presented by famous economist (Irving Fisher) in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation. The Fisher equation is primarily used to calculate nominal and real interest rate behavior. Real Interest Rate r is the interest rate after adjustment for inflation. It is the interest rate that lenders have to be willing to loan out their funds. The equation is: i=r+ According to this equation, if Rate of Inflation increases by 1 percent the Nominal Interest Rate increases by more than 1 percent. If Real Interest Rate and Rate of Inflation are known then Nominal Interest Rate can be determined. On the other hand, if Nominal Interest Rate and Rate of Inflation are known then Real Interest Rate can be determined and the relationship is: Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual) r=i- Real Interest Rate vs. Nominal Interest Rate Generally a real variable is one where the effects of inflation are removed to know the real cost of the funds to the borrower and real return to lender. A nominal variable is one where the effects of inflation are not removed or interest rate is not adjusted to remove the factor of inflation. Common Theories The interest rate is a key part of the government's monetary policy so some relevant theories about how interest rates affect the economy and individual consumers, are studied. The theories considered are:

6 MONEY & INTEREST RATE

T1 Interest rate variation - why do interest rates vary? T2 Monetary policy - how is the interest rate used? T3 Affecting demand - how does the interest rate affect demand? T4 Maintaining interest - why do interest rates stay where they're set?

Interest Rate Theories - Interest Rate Variation - Why do interest rates vary? There is wide variation in interest rates. The actual interest rate will depend on a number of factors. These include:

The length of time for which the money is borrowed (or saved) The security of the loan (or investment) The nature of the financial institution the money is borrowed from (or lent to) The amount of competition between financial institutions

If a bank considers a particular loan to be a risky one, and there is little or no security for the loan then it is likely to charge a high rate of interest to compensate it for the risk it is taking. However, where there is security for the loan (as in the case of house purchase) then the interest will be relatively lower to reflect the lower risk. The interest rate will be set by the equilibrium in the money market. As in other markets, this equilibrium depends on the levels of demand and supply. In the money market, the demand comes from people wanting to borrow and spend, while the supply of money depends on the government's monetary policy. We can see this in the diagram below:

7 MONEY & INTEREST RATE

The equilibrium interest rate is at R*. If the demand or supply of money changes, then this will tend to change the equilibrium interest rate in the markets, and the government may need to act to maintain the level of interest rates. Interest Rate Theories - Monetary Policy - How is the interest rate used? The only chance that the government has to alter the stance of its fiscal policy is once a year in the Budget. This can tend to make fiscal policy a fairly dull instrument of economic management. Monetary policy and the alteration of interest rates are therefore important weapons in the government's economic armory. Interest rates are set by the central bank of Pakistan Monetary Policy Committee. They will set the rate according to the current economic conditions and the inflation target they have been set. If they feel that there are significant inflationary pressures in the economy, then they will tend to increase the level of interest rates. This will tend to discourage borrowing and therefore reduce aggregate demand. The effect of this is shown in the diagram below as a shift from AD3 to AD2:

As a result of the level of borrowing and therefore aggregate demand falling the inflationary pressures in the economy have been reduced. These inflationary pressures may have come from excessive growth in wages, excessive growth in lending by financial institutions or perhaps over-optimistic expectations in the economy.

8 MONEY & INTEREST RATE

Interest Rate Theories - Affecting Demand - How does the interest rate affect demand? The key to using the interest rate to help economic management is the effect that interest rates have on demand. If the central bank feels that inflationary pressures are rising in the economy then they will increase the rate of interest to dampen down the growth of aggregate demand. Demand falls when interest rates are raised through their effect on the components of aggregate demand. Aggregate demand is made up of the following types of spending: Consumption + Investment + Government expenditure + (Exports - Imports) Of these, the first two in particular will be affected by interest rate changes. Consumption Consumption will fall when interest rates are raised. This happens for two reasons. The first is that it is now more expensive to borrow money. This will put people off borrowing, and lower borrowing means lower spending. However, it is not just new borrowing that is affected, but also people who are still paying off existing borrowing. For many people their main investment is their house. To buy this they are quite likely to have taken out a mortgage and higher interest rates means higher mortgage payments. This reduces their disposable income and so leaves them with less money each month to spend. The same will be true for people who have borrowed to buy other things as well. Investment To invest many firms will, like people, have to borrow. They will borrow if they think that the rate of return on their investment is greater than interest rates. If interest rates rise then fewer investment projects are likely to be feasible, because with the higher cost of borrowing they are now less profitable. The rise in interest rates will therefore reduce the level of investment.

9 MONEY & INTEREST RATE

Interest Rate Theories - Maintaining Interest! - Why do interest rates stay where they're set? As we have seen the level of interest rates is set by the Monetary Policy Committee of the central bank. It has to ensure that this level of interest rates is not undermined by changes in the demand for money or in the supply of money. In other words they have to interfere in the money markets to ensure that this new level of interest rates remains the equilibrium level. They do this through their dealings with banks and other financial institutions. The central Bank will usually try to ensure that the markets are kept a little short of liquidity. This will happen automatically if the amount of tax paid in a given day (taken out of bank accounts) is less than the banks receive that same day in government expenditure being paid into accounts held by them. Even if this is not the case, sales of government debt (Treasury Bills and gilt-edged securities) will leave the banks short of cash. This is because the people buying the debt will take the money out of their bank accounts to pay the government, leaving the banks with less money. The banks being a bit short will turn to the central Bank 'Lender of Last Resort'. The central Bank will provide the banks with the necessary liquidity (usually by re-purchasing securities from them) but at the interest rate they choose. This interest rate will be the interest rate they have set. In this way interest rates are maintained. Expectations Theory of Interest Rates A theory that explain the Sharpe of the yield curve, or the term structure of interest rates. The forces that determine the shape of the yield curve have been widely debated among academic economists for a number of years. The American economist Irving Fisher advanced the expectations theory of interest rates to explain the shape of the curve.

10 MONEY & INTEREST RATE

According to this theory, longer-term rates are determined by investor expectations of future short-term rates. In mathematical terms, the theory suggests that: (1 + R2)2 = (1 + R1) x (1 + E (R1)) Where R2 R1 = = the rate on two-year securities, the rate on one-year securities, the rate expected on one-year securities one year from now.

E (R1) =

The left side of this equation is the amount per dollar invested that the investor would have after two years if he invested in two-year securities. The right side shows the amount he can expect to have after two years if he invests in one-year obligations. Competition is assumed to make the left side equal to the right side. The theory always explains the existence of longer-term rates in terms of expected future shorter-term rates. The expectations theory of interest rates provides the theoretical basis for the use of the yield curve as an analytical tool by economic and financial analysts. For example, an upward-sloping yield curve is explained as an indication that the market expects rising short-term rates in the future. Since rising rates normally occur during economic expansions, an upward-sloping yield curve is a sign that the market expects continued expansion in the level of economic activity. Financial analysts sometimes use this equation to obtain a market-related forecast of future interest rates. It can be rewritten as follows: E (R1) = [(1 + R2)2 / (1 + R1)] - 1 The equation suggests that the short-term rate expected by the market next period can be obtained from knowledge of rates today.

11 MONEY & INTEREST RATE

Reasons for Interest Rate Change

Deferred Consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.

Inflationary Expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.

Alternative Investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.

Risks of Investment: There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.

Liquidity Preference People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.

Taxes Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

Negative Interest Rates Interest rates are usually positive, but not always. Given the alternative of holding cash (thus earning 0%) rather than lending it out, profit-seeking lenders will not lend below 0%, 12 MONEY & INTEREST RATE

as they will guarantee a loss, and a bank offering a negative deposit rate will find few takers, as savers will instead hold cash. However, central bank rates can be negative; in July 2009 Sweden's Riksbank was the first central bank to use negative interest rates, lowering its deposit rate to 0.25%, a policy advocated by assistant governor Lars E. O. Svensson. central bank they do not have the option of holding cash. Negative interest rates have been proposed in the past, particularly in the late 19th century by Silvio Gesell. A negative interest rate can be described (as by Gesell) as a "tax on holding money"; he proposed it as the Freigeld (free money) component of his Freiwirtschaft (free economy) system. To prevent people from holding cash (and thus earning 0%), Gesell suggested issuing money for a limited duration, after which it must be exchanged for new bills attempts to hold money thus result in it expiring and becoming worthless. Effect of interest rate on economy 1. The economy can be influenced easily by interest rates. When interest rates goes up, people do not take big loans for investment purpose or any other purpose like purchase of houses or cars because it becomes difficult to pay the loans back, so the number of purchases of cars and homes goes down along with investments. However, high interest rates are beneficial for banks or lenders. 2. The effects of lower interest rates on the economy are very beneficial for the consumers. When interest rate goes down, people start taking big loans for investment and in order to pay for things like houses and cars. This time is utilized very well by investors, who perceive less risk in taking out a loan and investing it in something because they would have to pay less back to the bank. 3. When people do not have to spend as much money on bank payments, they have more liquid income to put toward things they want to purchase or consumable things. At that time people utilize their money instead of saving it in banks. These This negative interest rate is possible because Swedish banks, as regulated companies, must hold these reserves with the

13 MONEY & INTEREST RATE

effects although certainly not direct but indirectly affects the market when interest rates are low. 4. Low interest rates are not beneficial for lenders, because it gives less return on their loan than in times when interest rates are high. This means that banks may think to reduce their interest rate of the money deposited in the bank in order to maintain a steady profit through spread. 5. When interest rates increase, foreign investment can increase because people outside of the country want a larger return for their investment, so they invest their money in the state of high interest rates. This causes more demand for the international currency like dollar. This is one of the reasons of increasing value of dollar in international market. How Interest Rates are Determined Interest rates are affected by a number of factors. The Federal Reserve, which is charged with maintaining the stability of the nation's financial system, raises or lowers short-term interest rates in an effort to maintain that stability. The Fed regularly takes these actions in response to economic ups and downs that the country goes through on a fairly routine basis. Regular Interest Rate Adjustments When the economy is growing companies are profitable, unemployment is low, and consumers are spending money short-term rates are raised to keep the economy from building too fast and risking inflation. Inflation is when too much money chases too few goods and services, driving prices upward. Raising interest rates slows the economy. Higher interest rates mean higher borrowing costs for individuals and businesses; and that usually means there's less money to spend elsewhere. The Fed will lower short-term rates when the economy is contracting or slowing. Lowering rates makes it less expensive to borrow money. Consumers and businesses can afford to buy more products and services. That speeds up the economy, keeps people employed, and keeps the economy from sinking into a recession. A recession occurs when consumers get 14 MONEY & INTEREST RATE

tight-fisted with their money and don't buy the products and services that keep companies afloat and workers employed. When the Fed cuts short-term rates it is cutting the rate that banks charge each other to borrow money. Those cuts are eventually passed on to businesses and consumers. The same thing happens in reverse when the Fed raises short-term rates. Other factors and their impacts other factors affect interest rates, too, but on a more irregular basis. A crisis involving the foreign oil-producing nations, for example, could have a major economic impact that could affect interest rates. Long-term interest rates aren't affected as quickly by economic conditions as are short-term rates, but there is a trickle-down factor and they reflect the impact eventually. What works for you as a saver works against you as a borrower. When rates are high, you're earning a hefty amount of interest for your deposits, but you're going to pay a high interest rate if you need to borrow. When rates fall, you don't get much interest on your savings, but it's a lot cheaper to borrow money. Money & Interest Rate Money Market Equilibrium Stories Any equilibrium in economics has an associated behavioral story to explain the forces that will move the endogenous variable to the equilibrium value. In the money market model the endogenous variable is the interest rate. This is the variable that will change to achieve the equilibrium. Variables that do not change in the adjustment to the equilibrium are the exogenous variables. In this model, the exogenous variables are P, Y, and MS. Changes in the exogenous variables are necessary to cause an adjustment to a new equilibrium. However, in telling an equilibrium story it is typical to simply assume that the interest rate is not at the equilibrium (for some unstated reason), and then to explain how and why the variable will adjust to the equilibrium value. 15 MONEY & INTEREST RATE

Interest Rate too Low Suppose that for some reason the actual interest rate, i, lies below the equilibrium interest rate, i. At i', real money demand is given by the value A along the horizontal axis, while real money supply is given by the value B. Since A is to the right of B, real demand for money exceeds the real money supply. This means that people and businesses wish to be holding more assets in a liquid, spendable form rather than holding assets in a less liquid form, such as in a savings account. This excess demand for money will cause households and businesses to convert assets from less liquid accounts into checking accounts or cash in their pockets. A typical transaction would involve a person who withdraws money from a savings account to hold cash in his wallet. The savings account balance is not considered a part of the M1 money supply, however the currency the person puts into his wallet is a part of the money supply. Millions of conversions such as this will be the behavioral response to an interest rate that is below equilibrium. As a result, the financial sector will experience a decrease in time deposit balances, which in turn will reduce their capacity to make loans. In other words, withdrawals from savings and other type of non-money accounts will reduce the total pool of funds available to be loaned by the financial sector. With fewer funds to lend and the same demand for loans, banks will respond by raising interest rates. Higher interest rates will reduce the demand for loans helping to equalize supply and demand for loans. Finally, as interest rates rise, money demand falls until it equalizes with the actual money supply. Through this mechanism average interest rates will rise, whenever money demand exceeds money supply. Interest Rate Too High If the actual interest rate is higher than the equilibrium rate, for some unspecified reason, then the opposite adjustment will occur. In this case, real money supply will exceed real money demand meaning that the amount of assets or wealth people and businesses are holding in a liquid, spendable form is greater than the amount they would like to be holding. The behavioral response would be to convert assets from money into interest 16 MONEY & INTEREST RATE

bearing non-money deposits. A typical transaction would be if a person deposits some of the cash in their hand into their savings account. This transaction would reduce money holdings since currency in circulation is reduced, but will increase the amount of funds available to loan out by the banks. The increase in loan able funds, in the face of constant demand for loans, will inspire banks to lower interest rates to stimulate the demand for loans. However, as interest rates fall, the demand for money will rise until it equalizes again with money supply. Through this mechanism average interest rates will fall, whenever money supply exceeds money demand. Effects of Expansionary Monetary Policy on Interest Rates Expansionary monetary policy refers to any policy initiative by a country's central bank to raise, or expand, its money supply. This can be accomplished with open market purchases of government bonds, with a decrease in the reserve requirement or with an announced decrease in the discount rate. In most growing economies the money supply is expanded regularly context, to keep up with the policy than a the cannot project expansion of GDP. In this dynamic expansionary monetary can mean an increase in the rate of growth of the money supply, rather mere increase in money. However, money market model is a nondynamic (or static) model, so we easily incorporate money supply growth rates. Nonetheless, we can

the results from this static model to the dynamic world without much loss of relevance. (In contrast, any decrease in the money supply, or decrease in the growth rate of the money supply, is referred to as contractionary monetary policy.) Suppose the money market is originally in equilibrium in the adjoining diagram at point A with real money supply MS'/P$ and interest rate i$' when the money supply increases, ceteris paribus. The ceteris paribus assumption means that we assume all other exogenous 17 MONEY & INTEREST RATE

variables in the model remain fixed at their original levels. In this exercise it means that real GDP (Y$) and the price level (P$) remain fixed. An increase in the money supply (MS) causes an increase in the real money supply (MS/P$) since P$ remains constant. In the diagram this is shown as a rightward shift from MS'/P$ to MS"/P$ . At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. This means that money supply exceeds money demand and the actual interest rate is higher than the equilibrium rate. Adjustment to the lower interest rate will follow the "interest rate too high" equilibrium story. The final equilibrium will occur at point B on the diagram. The real money supply will have risen from level 1 to 2 while the equilibrium interest rate has fallen from i$' to i$". Thus, expansionary monetary policy (i.e., an increase in the money supply) will cause a decrease in average interest rates in an economy. In contrast, contractionary monetary policy (a decrease in the money supply) will cause an increase in average interest rates in an economy.

CONCLUSION
In summary, money is a regulator between what people want to do and what other people want to receive. Before money if based on gold was in an insufficient quantity or lead to inflation. Interest rate has brought price stability as money got value on itself. Before money has no value in itself so it was preferable to keep goods than money. But with interest rate, money creates money. So, it starts to be interesting to keep it. The fact that people are ready to keep money a long time as make possibly long time perspective investment and industrialization. Interest rate has made industrialization possible. And, the main reason of not success in industrialization itself is due to the absence of practice of interest rate.

18 MONEY & INTEREST RATE