Chapter 5
Money is for Lunatics
Demanders and Suppliers of Money
LEARNING OBJECTIVES
Functions of money
Four forms of money
Money creation by the Bank of Canada and
chartered banks
Relate bond prices and interest rates and
explain how money and bond markets
determine the interest rate
Differentiate the “Yes” and “No” camps’
positions on the monetary transmission
mechanism
IS IT SMART TO NOT WANT MONEY?DEMAND FOR MONEY
People demand money for its liquidity as a medium of exchange, unit of account, store of value. People willingly
give up interest on bonds to hold wealth as money.
DEMAND FOR MONEY
Money
anything acceptable as means of payment;
money has three functions
a) medium of exchangeacceptability solves barter problem of double coincidence of wants
b) unit of accountstandard unit for measuring, comparing prices
c) store of valuetime machine for moving purchasing power from present to future; earn now, spend later
Bondfinancial asset where borrower promises to
repay
original value, and make fixed interest
payments
Why hold wealth as money which pays no
interest, rather than as bonds which pay
interest?
money provides liquidity —assets easily convert into medium of exchange
money is most liquid asset — acceptable by sellers as means of payment
money pays no interest, but has liquidity; bonds pay interest, but do not have liquidity
Why hold money as a store of value?
“Yes” camphold more wealth as interest-paying bonds, since savings safely invested in loanable funds (bonds)
“No” camphold more wealth as money because fundamental uncertainty about future makes bond investments risky
Interest rate
price of holding money;
what you give up by not holding bonds
determined by demand and supply in both money and bond markets
Law of demand for money
as the price of money — interest rate — rises,
quantity demanded of money decreases
Fig. 5.1 Macroeconomic Demand for Money
Price(interest rate)
Quantity Demanded
(billions of dollars)
2% 100
4% 90
6% 80
8% 70
10% 60
Changes in real GDP or average prices
cause
change in demand for money
increase in real GDP increases demand for money; decrease in real GDP decreases demand
increase in prices increases demand for money; decrease in prices decreases demand
Fig. 5.2: Macroeconomic Demand for Money Before and After Real GDP Increases
Price(interest
rate)
Quantity Demanded (QD)
billions of dollars)
QD after Real
GDP Increases (billions of
dollars)
2% 100 200
4% 90 180
6% 80 160
8% 70 140
10% 60 120
SUPPLY OF MONEY
Forms of money
a)commodity money — saleable product with alternative uses
b)convertible paper money — paper money converted into gold on demand
c)fiat money — currency (government-issued paper bills and coins) with no alternative uses, valuable simply by government decree
d)deposit money — demand deposits — balances in bank accounts depositors withdraw on demand using debit card or cheque
CURRENCY IN CIRCULATION
M2
OTHERDEPOSITS
DEMANDDEPOSITSM1
$465 b
BILLIONS OF $
$951 b
Supply of money is
currency and deposit
money
M1 = currency in circulation and demand deposits
M2 = M1 plus all other less liquid deposits
continued…
Fig. 5.3 The Money Supply
Bank of Canada is Canada’s central
bank — government institution responsible
for supervising chartered banks and
financial institutions and for regulating the
supply of money
Bank of Canada roles issuing currency
banker to chartered banks — chartered banks pay each other with deposits at Bank of Canada
lender of last resort — making loans to banks to preserve stability of financial system
banker to government — managing government accounts, foreign currency reserves, national debt
conducting monetary policy — changing money supply and interest rates
Chartered banks create money (demand deposits) because of fractional reserve banking — banks hold a fraction of deposits as reserves
Banks face a tradeoff between profits and prudence
– smaller fraction of reserves, more loans, and higher-risk loans may yield more profits
Supply of money determined by Bank of Canada and chartered banks
– quantity of money supplied is a fixed amount at a moment in time
– supply of money does not change when interest rate changes
continued…
$ billion (August 2009)
Percentage of deposits
Total Funds 1925.3 169.0
Sources
Deposits 1139.1 100.0
Borrowing and own capital 786.2 69.0
Uses
Reserves 6.2 0.5
Liquid assets 319.4 28.0
Securities and other assets 169.8 14.9
Loans 1429.9 125.5
Fig. 5.4 Chartered Banks: Sources and Uses of Funds
Fig. 5.5 Supply of Money
Price(interest rate)
Quantity Supplied
(billions of dollars)
2% 80
4% 80
6% 80
8% 80
10% 80
WHAT IS THE PRICE OF MONEY?INTEREST RATES, MONEY, AND BONDS
Bond prices and interest rates are inversely related and determined together in money and bond markets.
MONEY AND BONDS
a) Interest rate is the price of money
– opportunity cost of holding money
– cost of borrowing money
b) Bonds promise to pay back original
value plus
fixed dollar amount of money
– bonds do not promise fixed interest percent
– when interest rates rise, market price of bond falls, vis-à-vis
– holding a bond until maturity, you receive fixed dollar payments plus original value
Fig. 5.6 Macroeconomic Demand and Supply for Money
Price(interest
rate)
Quantity of Money
Demanded(billions of
dollars)
Quantity of Money Supplied (billions of dollars)
2% 100 80
4% 90 80
6% 80 80
8% 70 80
10% 60 80
Interest rate determined by demand and
supply
in money and bond markets
at market-clearing interest rate, quantity of money demanded equals quantity of money supplied
when interest rate below market-clearing rate, excess demand for money; people sell bonds to get money; increased supply of bonds causes bond prices to fall, interest rate to rise
Many different interest rates on financial assets, but most interest rates rise and fall together
continued…
J.B. SAY AND J.M. KEYNES AS FACEBOOK FRIENDS?
MONEY, INTEREST RATES, INVESTMENT, & REAL GDP
“Yes” and “No” camps disagree about money’s effect on the frequency of business cycles and on how quickly markets adjust.
MONEY AND BUSINESS CYCLES
Does money affect key macroeconomic
outcomes of real GDP per person,
unemployment, inflation?
– money can affect inflation, according to quantity theory of money
– money does not directly increase aggregate supply or economic growth
continued…
Money indirectly affects real GDP and
unemployment through monetary transmission
mechanism —
how impact of money transmitted to real GDP
– demand & supply of money determine interest rate
– when interest rate falls, interest-sensitive purchases become cheaper so consumer spending (C) and business investment spending (I) increase
– increases in C and I increase aggregate demand
continued…
Fig. 5.7 Transmission Mechanism from Money Demand and Supply to Real GDP
lower interest rates are positive demand shock, increasing aggregate demand, increasing real GDP, decreasing unemployment, causing inflation
higher interest rates are negative demand shock, decreasing aggregate demand, decreasing real GDP, increasing unemployment, causing deflation
continued…
Economists disagree on the question “How
much does money change the economy
when economy is not in equilibrium?”
Say and “Yes, markets quickly self-
adjust” camp answer “not much.”
o money does not affect external supply shocks that are main source of business-cycles
o money allows savings to flow easily through loanable funds market for business borrowing, for investment spending
o money helps quick adjustments to equilibrium
continued…
Keynes and “No, markets fail to adjust”
camp answer “a lot”
o money gives people a way to save, creating possibility of financial crises and new internal demand shocks for business cycles
o money gives people a way not to spend, blocking transmission mechanism so loanable funds market does not match spending to savings
o money slows market adjustments to equilibrium
Fig. 5.8 How Much Does Money Matter for Business Cycles?
Camp
Compared to a barter economy, how does money
affect:
Yes — Left Alone, Markets Quickly Self-Adjust (Say)
No — Left Alone, Markets Fail to
Adjust (Keynes)
How Often Business Cycles
Happen
Money has no effect.
Money does not affect external supply shocks that are main source of business
cycles.
Money creates new shocks.
Money gives people a way not to spend, adding new internal
demand shocks.
How Quickly Markets Adjust
Money helps loanable funds market quickly
adjust to equilibrium.
Money blocks transmission mechanism,
slowing adjustment to equilibrium.