lecture 03. money market

8/3/2019 Lecture 03. Money Market

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A Closer Look At The Financial Markets


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An Overview of MoneyWhat is Money? Money is a means of payment what sellers / buyers accept

to pay for goods and services

Money is a store of value an asset that can be used totransport purchasing power from one time period to another

- it is convenient- it is portable- it is easily exchanged for goods

Money is a unit of account - a consistent way of quotingprices

liquid


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An Overview of Money

These three features are so important though we maytake them for granted that we are willing to incur acost to hold currency. The sacrifice in interest thatcould be earned by holding money rather than a

riskier, less liquid financial asset is calledopportunity cost of holding money


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An Overview of MoneyCommodity Money and Fiat Money

1. Commodity Money items designated as moneywith intrinsic value like gold and other preciousmetals

2. Fiat Money items designated as money with nointrinsic value other than what the Governmentdeclares it to have


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A Brief History of Money

Mr. GoldsmithMr. Richman

goldsafety


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Mr. GoldsmithMr. Richman

assurancesafety


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Mr. RichmanMr. Artist


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A Brief History of Moneyand

Banking

Mr. Goldsmith

interest


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The Creation of Money Like the goldsmith, banks today earn income by

lending money at a higher interest rate than what theypay their depositors for the use of their money

Banks and similar institutions who act as linksbetween those who have money to lend and those who

need money to borrow are called financialintermediaries


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The Creation of MoneyConsider Bank A

Bank A would have a value equal to:

Assets Liabilities = Net Worth

OR

Assets = Liabilities + Net Worth


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In Accounting terms, we could see Bank As value thru:

Assets Liabilities

Net Worth

The Creation of Money

Debit Credit


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We can define Bank As assets and liabilities thru:

Reserves 20 100 DepositsLoans 30

Investments 100

50 Net Worth

TOTAL 150 150 TOTAL


Assets Liabilities


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Reserves 20

Loans 30Investments 100

TOTAL 150


Assets

Reserves are cash on hand and depositsthat Bank A holds at the Central Bank

Loans and Investments are assets of Bank Athrough which they earn their income

The Central Bank requires a fixedpercentage of all Deposits as reserve


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100 Deposits

50 Net Worth

150 TOTAL


Liabilities

Deposits are debts /obligationsowed to depositors

The Central Bank requires a fixedpercentage of all Deposits as reserveThis percentage is called the

required reserve ratio


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So, how do banks create money?

Lets begin with Bank A and a deposit of $ 1,000


Bank A

Reserves 1,000 Deposit 1,000

Central Bank

Reserves 1,000 Deposit 1,000

BEGINNING MONEY POSITION


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Lets assume the Central Bank (CB) puts a 10 % reserverequirement rate. Then Bank A will be required toleave $ 100 with the CB, and will have $ 900 to loan out


Bank A

Reserves 100Loans 900

Deposit 1,000

Central Bank

Reserves 100(From Bank A)

Deposit 100

SECONDARY MONEY POSITION


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Assume Mr. M borrowed the $ 900, and deposited it toBank B, then Bank Bs account will be below, and theCB will be


Bank B

Reserve 90Loans 810

Deposit 900

THIRD MONEY POSITION

Central Bank


Deposit 100Deposit 90

(from Bank B)

Reserves 90(From Bank B)


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If we repeat this cycle with Mrs C who borrows Bank Bs$ 810 and deposits it to Bank C, then Bank C and theCB will be


Bank C

Reserve 81Loans 729

Deposit 810

FOURTH MONEY POSITION

Central Bank


Deposit 100Deposit 90

Deposit 81(from Bank B)Reserves 90

(From Bank B)

Reserves 81(From Bank C)


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The Creation of MoneyIf we tally the actual value of each Banks balance, we

will have:

Deposit Loans Reserves

Bank A 1,000 900 100

Bank B 900 810 90

Bank C 729 656.10 72.90

And so on and so forth

Total for all Banks 10,000 9,000 1,000


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The Creation of MoneyAs you can see, from an INITIAL deposit of S 1,000, the

new total deposit has ballooned to

Deposit Loans Reserves

Total for all Banks 10,000 9,000 1,000

The entire banking system can transform an initialincrease in the reserves into a multiplied anoubt ofnew deposits or bank money

The value of the new total of deposits is given as theproduct of 1/ reserve requirement rate and the initial

deposit


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The Creation of MoneyIn our example, given the initial deposit of $ 1,000 and

the reserve requirement rate of 0.10 ( 10%), then

1

The product of the money supply multiplier and theinitial deposit is the total new value of all deposit

10 x $ 1,000 = $ 10,000

0.10

= 10 10 is the money suppy multiplier

and


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The Demand for Money The demand for money is a demand for liquidity. The

quantity/amount of money we can hold is directlyproportional to our income (nominal).

The demand for money also depends on theopportunity cost of holding money. The relationship is

negative, so the higher the opportunity cost, the lesswe want to hold money


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The Demand for MoneyThese relationships are summarized in the function

below:

Md=f$Y(-i)

Where Md= demand for money

$ Y = nominal income , positive relation

- I = interest rate, negative relation


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The Demand for Money

i

In

terestrate

i

Money, M

M M

Md1Md2

At a constant Ian increasein nominal income shiftsthedemand for money curve tothe right

At a constant Mda decreasein the interest rate movesthe demand for money to the

right


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The Supply of MoneyHOW THE CENTRAL BANK AFFECTS THE MONEY SUPPLY

As seen in the previous section, the supply of money can be affected by

the level ofreserve requirement rate.

The money supply can also be influenced by the discount rate , theinterest rate banks pay the Central Bank to borrow from it

The money supply can also be influenced when the Central Bank decidesto engage in open market operations the buying and selling ofbonds


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The Supply of MoneyAs can be seen from the way the Central Bank can affect

the supply of money in the economy, interest plays akey role.

And yet, when we look at the interaction between theSupply and Demand for Money, we will treat the

Supply of Money as an exogenous variablefor now.


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The Supply of Money

In

terestrate

i

Money Supply, M

Ms

Assuming that the interest ratedoes not influence the money supply,

then the Money Supply Ms is avertical line

Ms


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Money Market Equilibrium Rate

In

terestrate

i

Money, M

M

Md Money Demand

Ms Money Supply

iA

Equilibrium A is where theDemand for Money equalsSupply for Money


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In

terestrate

i

Money, M

M

Md1

Ms Money Supply

i2

A

Equilibrium B is where theDemand for Money equalsSupply for Money, but withhigher interest rates

Md2i

B


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In

terestrate

i

Money, M

M

Md1

Ms1

i3

A

Equilibrium C is where theDemand for Money equalsSupply for Money, but withlower interest rates

i

Ms2

C


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Notes on Monetary PolicyWhen the Central Bank increases the Money Supply, it

engages in expansionary monetary policy

When the Central Bank decreases the Money Supply, itengages in contractionary monetary policy

Affecting the Money supply via open market operations

involve the Central Bank selling and buying ofgovernment securities, Treasury bills, and similarinstruments.


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Notes on Monetary PolicyThere is an inverse relationship betweenBond Prices and the Interest Rate

Bond Price Interest Rate

Bond Price Interest Rate


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SummaryEquilibrium interest rate is determined by the

equilibrium between the supply and demand formoney.

The Central Bank can affect the supply of Money by theRRR, discount rate, and the open monetary

operations.

lecture 03. money market

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