CHAPTER FOUR:THE MONEY MARKET

Money: is the stock of assets that can be readily used to make transactions.

4.1: Money and its Evolution

 In the early period, society had been exchanging goods and services in kind.

 This system of exchange is known as barter system.

 As production, consumption & other economic activities of world become

larger & complex, barter system was not capable of satisfying this
complicated demand for exchange.

 Money as a common medium of exchange was developed as response to

these difficulties.
 With the evolution of money, the exchange system was developed over some

stage like:
1. The stage of barter system: Initial phase of exchange of goods & services.

 Any commodity could be used for exchange for another as long as other
party making the exchange is willing to take the commodity.

2. The stage of commodity money: This was the stage of exchange system
where some commodities were used as the common medium of exchange.
 E.g. In Ethiopia molded salt (amole chew) had been used as exchange
purpose before several years ago.
 Similarly, ornaments and metals like gold and silver had been used for
exchange activities around the world.
3) The stage of legal/tender money: As commodity moneys were inefficient
in making exchanges of complex world economic activities, development
of legal/tender money were required.

 This is a form of easily manageable instruments which legally declared

to use as medium of exchange.
 4.2: Classification or Types of Money
a) Primitive money: In the early phases of evolution of money, hides, shells,
bones, etc were used as Money.

b) Commodity money: are considered as medium of exchange & at the same

time it can be purchased & sold themselves as commodities. E.g. gold, silver
and other precious metals.

c) Fiat money or tender money: In the later stage of evolution of money,

paper currencies or legal money were developed.

 It is a medium of exchange whose value derives from its official status as

a means of payment.
d) Credit money or bank money: This represents types of financial
documents such as credit cards that banks provide to people & use in
making transactions.

e) Electronic money (E-Money):- Recently, the medium of exchange has

been developed to the extent that by sitting at home transactions can be
made with aid of technology.

 E.g. Ethiopia telecommunication prepayment card.

 Typing the number on your cell-phone automatically confirms your

payment of the amount on the card.
 4.3: Money Supply
 Money supply means amount of money in circulation of a economy.

 Fluctuation of money supply brings changes in macroeconomic variables.

E.g. Increasing amount of money supply lead both negative & positive
impacts on macroeconomic variables.

 Some of such impacts are larger inflation rate, lower interest rate &
lower saving and better investment.

 The policy packages prescribed related to money supply is known as

monetary policy & the variables changed in achieving the objectives are
known as monetary policy instruments.
 Monetary policy mainly deals with the control of money supply & costs of
borrowing of money.

 Reduced money supply:- reduces the inflation rate, where as increased

money supply:- improves employment by increasing aggregate demand &
encourage investment through lower interest rate.
 4.3.1:The Major Components of Money Supply

 In a modern banking system, there are many assets, which can be termed as
money & they have defined as components of money supply.

 The degrees of liquidity of these components of money supply are different.

 For instance, birr notes are more liquid than some financial documents such
as cheques since birr can easily be exchanged for other goods than cheque

 Some of the components of money supply popularly used in many countries

are given as:

 M1 = currency (coin & notes) with public + demand deposit (funds people
hold in their checking accounts).
 M2 = M1 + deposit in saving account (Deposits at banks that are not
transferable by check)

 M3= M2+ Time deposits with the banking system (Interest bearing deposits
with a specific maturity date)+ financial securities like bonds.

 M4 = M3 + post office deposits

 The component M1 is sometimes defined as ‘narrow money’ whereas the

other components of money (M2, M3 and M4) are defined as ‘broad money’
 4.3.2: Creation of Money and Banking System
 Money creation is the process by which a given amount of money increases
itself through interaction b/n central bank & commercial bank & households

 The size of a given amount of money supply increases it self over time.

 This is b/c money can be lent by a market interest rate to borrowers &
they pay back to the bank by larger amount than amount the borrowed
including the interest payment.

 The central bank also generates some amount of money from deposits with
commercial banks.

 This part of money supply is known as reserve requirement.

 Central bank has three major monetary policy tools through which it
controls the money supply.

 These monetary policy instruments are :

I. Reserve requirements

II. Open market operation and

III. Discount rate.

 1:Reserve Requirements
 Households & owners of financial resources save their money with
commercial banks.

 The central bank requires commercial banks to retain a certain percentage of

their deposits as a reserve in central bank.

 Suppose the total deposit made in Ethiopian commercial bank is 100 birr.

 If reserve requirement of central bank is 5%, then commercial bank has to

deposit 5 birr in central bank & use 95 birr for giving loans to their
customers.

 If central bank wants to expand money supply, it reduce reserve requirement

 E.g., if the reserve requirement is reduced to 1% then commercial bank
should deposit only 1 birr with the central bank as reserve.

 As a result, the commercial bank can use 99 birr for giving loan.

 The previous money supply was only 95 birr, however, as a result of

reduction in reserve requirement, money supply increased to 99 birr.

 Therefore, if the central bank wants to reduce money supply, it has to

increase the reserve requirement.

 E.g. : if it went to regulate inflation, central bank increase reserve

requirement to reduce money in circulation.
 Reserve requirement and money creation process
 If a central bank wants to expand money supply, it buys bonds & other
financial securities from the public and give money in return to them.

 If the central bank buys bonds that worth Birr 100,000, at this stage
money supply increases by Birr 100,000.

 Let the reserve requirement (rr) =10%.

 If seller of bonds deposit all Birr 100,000 in bank B, 10% of the total
amount (10,000) birr will be kept in central bank & the remain (90,000)
birr in circulation.

 If some other person borrow 90,000 & deposits in bank C, 10% (90.000) =
9000 will be kept again in central bank & 81,000 remain in circulation.
 If this process continues, the total money created is given as:

= 100,000 + 90,000 + 81,000 + ------

=100,000 + [100,000 – 0.1(100,000)] + {[100,000 (1- 0.1)] – 0.1[100,000 (1- 0.1)]}
+...

 The value 0.1 is (10% ) the deposit for reserve requirement (rr)

= 100,000 + 100,000(1-rr) +100,000 (1 – rr) [1 – rr] + ----

= 100,000 [1+ (1 – rr) + (1 – rr)2 + ………….] --------------------- (1).

 The series: [1+ (1 – rr) + (1 – rr)2 + … ] is a geometric series with common ratio (1–rr).

 Applying summation of geometric series the sum is given by:

= 1/[1 - (1 – rr)] = 1/rr -------------------------------------------- (2)

 So substituting the equation (2) in (1) we obtain the following.

= 100,000 [1/rr] = 100,000[1/0.1] = 1,000,000 Birr
 2: Open Market Operation

 Open market operation :is purchase & sale of government securities by

central bank to maintain the proper level of money supply in an economy.
 Suppose central bank want to increase money supply in the country.

 In order to increase money supply, central bank can buy government

bonds from the public.

 By doing so, it gives money to public & increase money supply

 Assume that the value of the bond is 1000 birr.

 Then, central bank can increases money supply in economy by 1000 birr
by purchasing bond from the pubic.
 On the other hand, by selling government securities to public central bank
can reduce supply of money in the economy.
 Addition to purchasing & selling government security by central bank , the
growth of money supply also depends on activities of individual who has
received the money.

 If the individual who sell the bond goes to the bank & deposit, again
bank takes it as deposit & keeps it's part as reserve requirement and gives
the rest amount to loan.

 This results multiplier effect and ultimately supply of money increases.

 This process of increase money supply resulting from open market operation
can be explained by different stages as follows:
 Stage-I: The central bank buys bonds that worth of 1000 birr.
 At this stage Money supply increases by 1000 birr.

 Let us assume reserve requirement is =10% & the seller of bonds

deposit all 1000 birr in commercial bank.
 Stage-II: The bank will keep 10% of 1000 = 100 birr as reserve requirement
with the central bank & the rest 900 birr will be used for loan and go back to
circulation in the economy.
 Stage–III: Assume another person takes the loan & deposits in another bank

 Then the bank will also follow the same procedure & keep 10% of the
amount deposited as reserve requirement & use the rest for giving loans.

 This process continues.

• The amount of money created by this simple operation is:

= 1000 + 900 + 810 +…= 1000/(1/0.1) = 1000(10) = 10,000 Birr

 3. Changes in Discount Rate
 A commercial bank that runs out of reserves for its operation such as making
loans can borrow from central bank.

 The cost of borrowing from central bank is known as discount rate.

 The willingness of borrowing of commercial banks depends on it.

 If discount rate is high, then cost of borrowing is high, so commercial

banks may not like to borrow.

 Thus, when central bank wants to increase money supply, it have to reduce
discount rate, so that commercial banks borrow from it.

 This borrowing takes idle money with central bank to circulation & thereby
increases money supply in circulation.
• If reducing money supply is required, for instance to control inflation,
central bank increases discount rate to discourage banks borrowing, thereby
money supply decrease the in circulation.
 4.3.3: Simple Model of Money Supply

 Addition to central bank, households affects money supply.

 Their effect on money supply expressed by simple money supply model.

 This model consist three exogenous variables: Monetary base, Reserve

requirements & Demand Deposits.

1. Monetary Base (B): This is total amount of money held by public as

currency (C) and the amount kept by banks as reserves (R).

 This relation is given by the following equation: B = C + R --------- (3).

2. Reserve Requirement (rr): This is proportion of deposits that

commercial banks keep with central bank.

 Reserve-deposit ratio (R/D), is ratio of reserves to deposit kept with banks.

3. Currency-Deposit ratio ,(C/D)=( cr) : The ratio of amount of currency
people hold (C) to the amount of demand deposits they hold at banks (D).

 The sum of the two represents the money supply in circulation and given by
the relation: M = C + D ----------------------------------------------------- (4)

 Taking the ratio of equation (4) to equation (3), we can obtain : .

 By dividing both numerators & denominators by ‘D’, we can obtain .

 Multiplying both sides by ‘B’ we obtain.

 Let ()=m, the simple money supply is given as follows:

M = mB = m(C + R) ------------------------------------------------------------ (5).

 Where, M = Money Supply and () called money multiplier which

indicate that each birr of monetary base produces ‘m’ birr of money.

 When B increases by a unit, money supply increases by ‘m’ factor.

 The lower reserve deposit ratio (rr), the more loans banks would make &
the more money they would create from every birr.

 This means, a decrease in (rr) leads to an increase in money supply.

• E.g. if currency deposit ratio=0.4 & reserve requirement = 10 % of

deposit then =2.8

• This simple money supply function is given by M = 2.8B.

 Components of money supply model (B, cr & rr) are affected by d/t actors.

 ‘B’ is affected by government action through R.

 The value of rr is also determined by the act of the government.

 ‘cr’ is determined by the households behaviors.

 This implies that money supply is not determined by government decision

alone but also by households’ decision.

 For instance, if households decide to deposit more money instead of

holding, money supply increases even if government takes no action.
 If we take open market operation, which is about purchases & sales of
government bonds by central bank:
a) Government purchase of bonds expands monetary base (B),
b) Government sales of bonds reduces monetary base & thereby reduces
money supply.
.
 The effect of open market operation is reflected in base money (B=C+R)
through the value of C.
 Government sales of bonds reduces B=C+RCMs.
 Government purchase of bonds increases B=C+RCMs.
 Income Velocity of Money and Quantity Theory
 People hold money to buy goods and services.

 The more money they need for such transactions, the more money they hold

 Therefore, the quantity of money in the economy is related to the amount

of exchanged in transactions.

 The link b/n transactions & money is expressed in the following equation,
called the quantity equation:

Money(M) × Velocity(V) = Price (P)× Transactions(T)

 T : Total number of transactions during some period of time, say, a year.

 P : Price of a typical transaction, the number of( dollar or birr) exchanged
 The product of price of transaction & number of transactions, equals
number of dollars exchanged in a year.
• M :is the quantity of money.
• V :is called transactions velocity of money & measures the rate at which
money circulates in economy.
• In other words, velocity tells us number of times a dollar/birr changes
hands in a given period of time.
• E.g. Suppose 60 loaves of bread are sold in a given year at $0.50 per loaf.

 Then T equals 60 loaves per year, and P equals $0.50 per loaf.

 Total number of dollars exchanged is P*T = $0.50/loaf × 60 loaves/year

= $30/year, which is the dollar value of all transactions.

• Suppose the quantity of money in the economy is $10.

• By rearranging the quantity equation, we can compute velocity as:

V = PT/M = ($30/year)/($10) = 3 times per year.

• That is, for $30 of transactions per year to take place with $10 of money,
each dollar must change hands 3 times per year.
 When we study role of money in economy, we can use d/t version of
quantity equation than the one just introduced.

 The problem with the first equation is that the number of transactions is
difficult to measure.

 To solve this problem, number of transactions (T) is replaced by total output

of economy (Y).

 Transactions & output are related, b/c the more the economy produces, the
more goods are bought and sold.

 The dollar value of transactions is proportional to the dollar value of output.

 If Y is amount of output & P is price of output, then dollar value of output is

P*Y (which is nominal GDP, that is product of real GDP & price of output)
 The quantity equation becomes: Money(M) × Velocity(V) = Price(P) × Output(Y).

 This equation indicate: money times velocity of money equal to nominal GDP

 The income velocity of money is average number of times each dollar

spent on final goods in a year.

 If MV = PQ then V= PY /M, It is ratio of nominal GDP to money stock

 Suppose the price level is 2 & real GDP is $500; nominal GDP, is $1,000.

 If the money supply is $200, then velocity is 5 ($1,000/$200).

 A velocity of 5 means, each dollar must be spent on final good by average 5

times during the year if $200 of money supply is going to support the
purchase of $1,000 worth of new goods.
 The above identity represents the classical quantity theory function.

 The theory states that if V &Y are fixed, then price level is proportional to
money stock and given as: P=VM/Y …………………. (8)

• This goes with the classical vertical supply function at full employment
level, where increase in money supply only increase price level (MsP)

• The classical aggregate supply curve is vertical, indicating that, the same
amount of goods will be supplied whatever the price level.

• It is based on the assumption that labor market is in equilibrium with full

employment of labor force & firms supply the full-employment level of
output at any level of prices.
• There are different macroeconomic variables.

• Some of these variables are measured by physical quantity, such as real

GDP & capital stock.

• All variables measured in physical units are called real variables.

• Nominal variables are variables expressed in terms of money, such as

price level, inflation rate, and wage of labor.

 Economists call this theoretical separation of real & nominal variables the
classical dichotomy.
 It is situation in an economic model where real variables are determined by
real factors & the money supply determines only the price level.
 In classical economic theory, changes in money supply don't influence real
variables (output).

 This irrelevance of money supply in determination of real variables is called

monetary neutrality.

 However, if supply curve is not vertical (the Keynesian case), an increase in

money supply increase nominal GDP, thus, price level is not proportional to
the quantity of money.

 In the long run monetary neutrality have acceptance and money supply &
price level have positive relation
 Money, Prices, and Inflation
• The quantity money theory explains what happens when the central bank
changes the supply of money.
• In a theory since velocity V is fixed & change in money supply (M ) lead
to proportional change in nominal output (PY).
• Output Y determined by factors of production (L,K), therefore the nominal
value of output (PY) can changed only if the price level P changed.
• Hence, the quantity theory implies that the price level is proportional to
the money supply.
• The percentage change in the price level is inflation rate, therefore theory
of the price level is also a theory of inflation rate.
• The quantity equation, written in percentage change form, as %ΔM*%ΔV=
%ΔP*%ΔY.

• Consider each of these four terms.

• First, percentage change in quantity of money, %ΔM, is under the control

of central bank.

• Second, percentage change in velocity, %ΔV, reflects shifts in money

demand; we have assumed that velocity is constant, so %ΔV is zero.

• Third, Percentage change in price level, %ΔP, is rate of inflation.

• Fourth, Percentage change in output, %ΔY, depends on growth in factors of

production, for our present purposes we are taking as given.

• This analysis tells us that the growth in money supply determines rate of

inflation.

• Thus, quantity theory of money states that central bank, which controls

money supply, has ultimate control over rate of inflation.

 If central bank keeps money supply stable, the price level will be stable

 If the central bank increases money supply, the price level will rise.
 Money supply, Near Money and Seigniorage
 Near-moneys are financial assets that can’t be directly used as a medium of
exchange but can be readily converted into cash or checkable bank deposits.

 The development of near money causes instability in money demand &

finally gives wrong signals about aggregate demand.

 One solution to such problem is use of a broad definition of money which

incorporates these near money as part of the money supply.

 Seigniorage

 Governments spend money on buying goods and services and on

providing transfer payments (for the poor and elderly).

 A government finance its spending through raise revenue from taxes,

selling government bonds to the public and by printing money.
 The revenue raised by printing of money is called seigniorage.

 When government prints money to finance its expenditure, it increases

money supply.

 Increasing money supply increase price & causes inflation.

 Printing money to raise revenue is like imposing an inflation tax.

 As prices rise, the real value of the money in hands of the public falls.

 Therefore, when the government prints new money for its use, it makes
the old money in the hands of the public less valuable.

 In essence, inflation is a tax on holding money.

 4.4:The Demand for Money

4.4.1:Major functions of money

 Money has three major functions: it is a store of value, a unit of account, and
a medium of exchange.

1.Money as a Medium of Exchange

 It is widely accepted in transactions for goods and services.

 Sellers willingly accept money as payment for products that they produce.
 E.g. When you walk into stores, you are confident that the shopkeepers
will accept your money in exchange for the items they are selling.
2. Money as a Unit of Account

• As a unit of account, money provides the terms in which people quote the
prices of goods and services.

• This common unit of measurement allows us to measure outputs & compare

relative values goods easily in terms of money.

 E.g. 1: GDP is money value of goods and services produced in a country

in a given year.

2. Microeconomics teaches that resources are allocated according to

relative prices, the prices of goods relative to other goods in order to
produce certain output.
3. Money as Store of Value

 The store of value is ability of money to hold value over time.

 You can keep your money for years and use it in the future.

 E.g. if you are paid today, it will have value next week or next month.
 Suppose you work today and earn $100, you can hold the money and
spend it tomorrow, next week, or next month.

 Values of goods produced can be changed to money & kept in form of

money

 This is b/c keeping products for future sale may not be possible or may be
wasteful.
 4.4.2:Theories of Demand for Money
• The uses of money are explained by various theories of money demand.

• Major categories of these theories are : Classical, Keynesian & Portfolio

theory of money demand.

I. Classical theory of money demand

• As this theory, people demand money only for transaction purpose.

II. Keynesian theories of Demand for Money

• According to the Keynesian, money is demanded for:

1. Medium of exchange,

2. Precaution and

3. Speculative purpose
I. Transaction demand

• Almost everyone needs to hold money to carry out ordinary day-to-day

transactions (selling and buying).

• According to this theory, money demanded for transaction (Mt) depends on

income (Y) and they are linearly related.

• In equation form, this can be written as: Mt=f(Y).

• we can say that transaction demand for money, is a constant proportion, k,

of the level of national income, Y i.e., Mt= k.Y , 0<k<1
II. Precautionary Demand for Money

 This motive refers to the desire of people to hold cash for unexpected
contingences such as sickness and accidents.

 The precautionary money demand is also function of income & can be

written as Mp=f(Y).

 As income increases, people keep more money for precautionary purpose.

 Since both transaction and precautionary demand for money are functions of
income and the money demanded is finally used for transaction purpose, we
can club together and write as Mt=f(Y).

 Where Mt includes both transaction and precautionary demand for money.

III. Speculative Demand for Money (Ms)

 The speculative demand for money is demand for money as an asset or as a

store of value.

 The speculative demand for money arises from the desire to hold money in
order to gate advantage from fluctuation of interest rate in future.

 For instance, if people expect increase of interest rate in future, to take

advantage of that situation they hold money in liquid form.

 While holding money in liquid form, they don't get interest, but they assume
that, future interest rate can offset the present loss of holding money.

 According to Keynes, the higher rate of interest, the lower speculative

demand for money, and lower the rate of interest, the higher speculative
demand for money
 Thus there is an inverse r/ship b/n money held for speculative purpose & the
rate of interest.

 Algebraically, the speculative demand for money is: Ms=f(r); where ‘r’ is
the rate of interest.

 The transaction & precautionary demands for money depend on level of Y

 Moreover, this r/ship is given by the proportionality factor, k.

 We can now aggregate the demand for money, which is given by:

Md = k.(Y) + f(r), Md = f(Y, r). …………… (9)

 Money demand increases as income increases & decreases as interest rate

increases.
 Thus, money demand is positively related to income & negatively related to
interest rate.
 Interest rate (r)

Mt Ms

Md

0 Mt + Ms = Md (Total Money Demand)

Figure 4.1: Total Demand for money

 The reason why the declining line begins from the vertical broken line is
that the transaction and precautionary demand for money does not depend
on interest rate measured along the vertical axis.

 Speculative theory of money demand is more valid in countries with

developed money market.
 4.4.2.3:Portfolio Theory of Money Demand

 This theory emphasizes the role of money as store of value.

 People hold money as part of their portfolio of assets.

 The demand for money depends on the risk & return obtainable by money
and by various other assets.

 E.g., if holding other assets becomes highly risky then people would
prefer to keep money.

 For instance in a country in civil war producers usually prefer to keep

money than other assets.

 However, if inflation is expected to occur, people prefer to keep real assets

than money.
• The money demand would also depend on total wealth, b/c wealth measures
the size of the portfolio to be allocated among money & alternative assets.

•Thus, the demand for real money (Md/P) can be given by:

Where, rs = is expected return on assets, rb = is expected return on bonds,

∏e = is expected inflation rate, and W = is wealth.

• Since people hold money to avoid risk of losing money, money demand falls
as rs, rb, ∏e increases and wealth falls.

• As rs & rb increases, money demand falls, b/c people change their money to
bonds and stocks to receive higher interest rate.

• If the expected inflation rate (e) is high, then demand for money will be
• If wealth is increasing then money demand is also increasing as people
prefer to buy luxurious goods.

• This theory is similar to Keynesian theory as we can take interest rate (r) as
an average of rs, rb, and e and we can express the equation as: Md = L(r, y).

• Whether the portfolio theory of demand is realistic or not depends on the

type of money we use.
• If it is M1 which includes only currency and demand deposit then it is not
much applicable.
• However, if it is M2 which includes M1, time deposit & others, then it is
more useful because interest rate has a role to play.
• So Portfolio theory of money demand is more acceptable as theories of
money demand if we adopt a broad measure of money like M2, M3 etc.
 4.5 : Money Market Equilibrium

 Money market equilibrium is determined by interaction b/n the level of money

supply generally determined by central bank and money demand, which is
determined by different factors such as income, and interest rate.

 Total demand for money in real terms can be expressed above as:

Md = Mt + Ms or Md = f (Y) + f(r) (11)

 Graphically, we can represent the demand for money as shown in Figure above.

 Money supply (MS) is assumed to be given in this case as it depends on the

central bank and as it is independent of interest rate.

 That is why it is straight line shown by vertical broken line in Figure below

through re and e.
 Income (Y) MS = exogenous money supply

Interest rate (r)

Mt Ms
re e
Md

0
Mde Mt + Ms = Md

Figure 4.2: Money Market Equilibrium

 Equilibrium in money market obtained when money demand graph and
money supply curve intersect each other.
 In the case of Figure 4.2, the equilibrium rate of interest is r e whereas the
equilibrium demand for money is Mde determined at point ‘e’ where the two
functions intersect.