Money and Monetary Policy

Money and Its Uses

Money is a fundamental concept in macroeconomics, serving as the backbone of modern economies. It is defined as anything that is generally accepted as a means of payment. Money fulfills three principal functions:

• Medium of Exchange: Money is used to purchase goods and services, facilitating transactions.

• Unit of Account: Money provides a common measure for valuing goods and services, allowing price comparisons.

• Store of Value: Money can be held and saved, retaining value over time for future use.

Modern money, such as currency and bank deposits, is called fiat money—objects that are money because the law declares them as such.

Measures of Money: M1 and M2

Money supply is measured using two main aggregates:

• M1: Includes currency in circulation, demand deposits (checkable deposits), and traveler’s checks. These are highly liquid and can be used instantly for payments.

• M2: Includes all of M1 plus savings deposits, small time deposits, money market funds, and other near money (such as government T-Bills and bank CDs). M2 assets are less liquid and may involve inconvenience or loss of interest when used for payments.

Example: A savings account is part of M2 but not M1, as it is not instantly usable for payments.

Money Demand and Supply

Money Demand

The demand for money refers to the relationship between the nominal interest rate (i) and the quantity of money demanded (MD) by individuals. Households and firms choose how much money to hold based on their need to make payments and the opportunity cost of holding money (interest forgone on alternative assets).

• Pros: Enables payments and transactions.

• Cons: Opportunity cost—foregone interest from holding money instead of other assets.

The general form of the money demand function is:

where Y is income (or real GDP) and i is the nominal interest rate.

Key Relationship: The higher the interest rate, the lower the money demand, due to increased opportunity cost.

Money Supply

Money supply is regulated by the central bank through monetary policy. The central bank uses several tools:

• Required Reserve Ratio: Determines banks’ loan capacity and affects money supply.

• Open Market Operations: Buying or selling government bonds to change the monetary base.

• Exchange Rate Policy: Buying or selling foreign currencies to influence the monetary base.

• Capital Recycling: Short-term loans to commercial banks to adjust bank reserves.

Bank Deposits and Reserves

• Bank Deposits: Money deposited by customers at commercial banks.

• Bank Reserves: Cash and similar assets held by banks to meet withdrawals and payments.

• Required Reserves: Minimum reserves mandated by the central bank.

• Excess Reserves: Reserves above the required minimum.

Formula for total bank reserves:

Reserve ratio:

Monetary Base and Money Supply

• Monetary Base: The amount of cash in circulation plus bank reserves.

• Money Supply: Includes monetary base and non-cash assets such as bank deposits.

Formulas:

where m is the money multiplier:

Additional info: The money multiplier reflects how much money the banking system can create from each unit of monetary base.

Monetary Policies

Required Reserve Ratio (RRR)

The RRR is the share of a bank’s total deposits that must be held in reserve, as regulated by the central bank. Changing the RRR affects the money multiplier and thus the money supply.

• Expansionary Policy: Lower RRR increases money supply.

• Contractionary Policy: Raise RRR decreases money supply.

Open Market Operations

The central bank buys or sells financial instruments (bonds, bills) in the open market to change the monetary base.

• Expansionary Policy: Open-market purchase increases monetary base and money supply.

• Contractionary Policy: Open-market sale decreases monetary base and money supply.

Exchange Rate Policy

The central bank buys or sells foreign currencies to meet targeted exchange rates, affecting the monetary base.

• Expansionary Policy: Buy foreign currencies increases monetary base and money supply.

• Contractionary Policy: Sell foreign currencies decreases monetary base and money supply.

Capital Recycling

The central bank makes short-term loans to commercial banks to change bank reserves.

• Expansionary Policy: Raise capital recycling increases money supply.

• Contractionary Policy: Lower capital recycling decreases money supply.

Money Market

Money Demand Curve

The money demand curve shows the relationship between the aggregate quantity of money demanded and the nominal interest rate. It slopes downward because a lower nominal interest rate reduces the opportunity cost of holding money.

• Factors that shift the money demand curve:

  • Real GDP: Higher GDP increases money demand (shifts curve right).

  • Price Levels: Higher prices increase money demand.

  • Financial Technology: Improved technology can reduce the need to hold cash, decreasing money demand.

Money Supply Curve

The money supply curve is vertical, fixed at a targeted level by the central bank. It shifts with changes in monetary policy.

• Expansionary Policy: Shifts money supply curve right.

• Contractionary Policy: Shifts money supply curve left.

Equilibrium in the Money Market

Equilibrium occurs where the money demand curve intersects the money supply curve, i.e., where the quantity of money demanded equals the quantity supplied.

Example: If the nominal interest rate is below equilibrium, the quantity demanded of money exceeds the quantity supplied, causing asset prices to fall and interest rates to rise until equilibrium is restored.

Applications and Examples

Functions of Money

• Medium of exchange: Used to purchase goods and services.

• Unit of account: Used to compare prices across websites.

• Store of value: Saving money for future use.

Money Supply Changes

• Transferring funds between accounts can affect M1 and M2 differently.

• Depositing currency into a checking account increases bank reserves, allowing more lending and increasing money supply.

• Withdrawing currency from a checking account decreases bank reserves and reduces banks’ lending capacity.

Money Multiplier Calculation

Example: If currency in circulation is $0 and bank reserves are $1000 with a reserve ratio of 0.25, then:

Monetary Policy Effects

• Open market purchase increases monetary base and money supply.

• Open market sale decreases monetary base and money supply.

• Buying foreign currency increases money supply and exchange rate.

• Short-term loans to banks (capital recycling) increase money supply and may lower nominal interest rates.

Money Market Equilibrium

• If nominal interest rate is below equilibrium, money demand exceeds supply, asset prices fall, and interest rates rise.

• If money supply exceeds money demand, people buy other assets, asset prices rise, and interest rates fall until equilibrium is reached.

Summary Table: Monetary Policy Tools and Effects

Additional info: These tools are used by central banks to manage economic activity, control inflation, and stabilize the financial system.