Lecture 8 Money and Financial Market

Lecture 8
Money and Financial Markets
Derese G. (Assistant Professor) 1

Definition
• As Hicks (1967) pointed out define ‘money’ from the
viewpoint of its function.
– Usually, the economists define ‘money’ as the ‘generally
accepted means of payments or medium of exchange.
• As a result it is said that ‘money’ must have the following

three functions.
– Means of payments (or means of exchange)
– Measure of value (or unit of calculation)
– Means of store of value
Types of Money
a) Primitive money: early phases of evolution of money, arrowheads, hides, shells,
bones etc were used as Money.
b) Commodity money: those items which are considered as medium of exchange or as
money and at the same time can be purchased and sold themselves as commodities.
e.g. molded salt, gold, silver and other precious metals.
c). Fiat money or tender money: refers to paper money or legal money. In the later
stage of evolution of money.
The material from which such type of money is made may have lower material value
than its face value.
d) Credit money or bank money: represents types of financial documents such as credit
cards that banks provide to people and used in making transactions.
This money also has no intrinsic value.

Cont’d…
e. Electronic money (E-Money): refers to
electronic money exchange through
computerized communication technology.

Attributes/characteristics of money
divisibility
Homogeneity
Durability
Acceptability
portability

Cont’d…
Though commodity moneys may satisfy most of

these attributes of ideal money, in modern
society money is not commodity money but
paper money and/or credit money.
This is because commodity many has one serious
limitation: divisibility!

Value of Money
The value of money is derived in the same way as the value
of any other commodity is derived. The value of Birr is
measured in terms of what it can buy. Therefore value is
linked to the price levels.
An increase in price means, a decline in the value of birr.
If supply of money grows faster than the real output then

price rises and value of money goes down.

Functions of money
Transaction function (means of exchange);
Measure of value/unit of Account (measuring
outputs in terms of money); and
Money as store of value (converting other
assets into money and keep for future.

Money supply
Money supply simply means the amount of money in circulation in an economy.
Any fluctuation in money supply brings changes in the aggregate macroeconomic
variables.
For instance, a larger amount of money supply may lead to both negative and positive
impacts in other macroeconomic variables.
As MS increases : -employment increasing
- investment increases Positive impact
-cost of borrowing decreasing
As MS increases : inflation increasing Negative impact
 This makes money supply one of the major policy instruments in the hands of governments.

Major components of money supply
a) M1 (Narrow money): includes
1. Currency with public: coins and notes in circulations

2.Demand deposit: non-interest bearing checks at the banks
3.Traveler’s checks: checks for current conversion or use
4.Other checkable deposit: low interest earning checking accounts
the deposit holder keeps assets in saving accounts and the
bank transfer them automatically to the checking account when
payment has to be made
These are very liquid and they don’t pay interest
M1= [1+2+3+4]
Cont’d…
b) Intermediate" money (M2): includes M1 and
5.Deposit in saving account
6.Money market mutual funds
7. Overnight repurchase agreement : transaction in which a bank borrows from

a non bank customers by selling a security and promising to buy in back at
fixed price tomorrow
e.g. Treasury bills – for short periods
M2= M1+[5+6+7]
 Now a days the difference between saving and checking accounts are diminishing
because modern banks are paying interest for checking account.
 The distinction of M1 and M2 depends on the degree of liquidity.
 The more liquid the elements, the more to be a component of M1, and vice versa
Cont’d…
C. M3: includes M2 and
8.Large denomination time deposits ( longer time

deposit)
9.Term repurchase agreements: financial securities

e. g Treasury bills, sold by the bank for longer
than overnight.

Cont’d…
d. M4 : includes M3 and
10. Saving bonds
11. Banker’s acceptances: obligations of banks to pay specific amount at specific time
 arises largely in international trade
12. Commercial paper: Short term liabilities of corporation
13. Post office deposit
M4=M3+[ 10+11+12+13]
Notes: M1-Narrow money
M2,M3 and M4 –Broad money
Depending on the level of development of financial market, the component of money
supply differ from one country to another.
• M1, M2, M3 are all measures of money supply, that is the amount of money in
circulation at a given time.
A model of the money supply
– Hitherto, we have intrinsically and explicitly assumed
that the money supply is exogenous.
– But money supply is not completely exogenous
– There are three agents which play a role in MS:
• Private hhs: if M=C+deposit, it is the household who decides
how much money to hold as cash and how much to deposit
• Private banks: decides on how much deposits to lend to
investors and how much to hold as excess reserve (ER)
• Central bank: decides only on the minimum amount of money
(deposits) banks should hold
cont’d
To show that there are parties other than the central bank such as
households which affect money supply and how they affect money supply
we can use a simple money supply model.
This model involves three exogenous variables such as:
I. Monetary base,
II. Reserve requirement and
III. Demand deposits

Cont’d…
• The money supply equals currency plus demand (checking
account) deposits:
M = C + D
– Since the money supply includes demand deposits, the banking
system plays an important role.
Exogenous variables
• Monetary base, B = C + R
controlled by the central bank
- R is total that private banks puts with the NB
- R=RR (by law)+ER(reserves above RR)
- B is also called high powered money
• Reserve-deposit ratio, rr = R/D
depends on regulations & bank policies
• Currency-deposit ratio, cr = C/D
depends on households’ preferences
Solving for the money supply:
C D
M  C D  B  m B
B
where
C D
m 
B
C D  C D   D D   cr  1
 cr  rr
C R C D   R D 
cr  1
Thus, m 
cr  rr
m is called the money multiplier
Note: If rr < 1, then m > 1
The money multiplier
the money multiplier (m), is the increase in the
money supply resulting from a one-dollar increase
in the monetary base.
Note that M = m x B
– Thus, if monetary base changes by B,

then M = m  B

• Ms = mB
= f(rr, Cr). B
– But rr has two component
– Required reserve to deposit (k)
– Excess reserve to deposit(r)
• so,
Ms=f(r, k,cr)B

Hence, Ms is determined by the completely
different agents such as:
Behavior of NB …………. via cr and B
Behavior of private banks ……..via R (reserve)
Behavior of hhs ………………….via cr
So, the reason why the MA can’t precisely control
Ms is that
 Households can change cr, causing m and M to
change.
 Banks often hold excess reserves (reserves above the
reserve requirement). if banks change their excess
reserves, then rr, m, and M change.
Demand for money
The demand for money is how much money people
wish to hold as cash.
Money is money because it serves some functions which are
convenient for many purposes. So the demand for
money emanate from their function basically:
Money as a Medium of Exchange,
Money as a Unit of Account, and
Money as Store of Value

Theories of money
The major theories of money demand are:
a. Classical/ Transactions theory of money demand,
b. Keynesian theories of money demand, and
c. Portfolio theory of money demand

a. Transactions theories demand for money
people need or demand money solely for

transaction purpose called transaction motive
of money
• emphasize “medium of exchange” function
• also relevant for M1

b. Quantity Theory Of Money Demand
This is the classical quantity theory and first developed by the
American economist Irving Fisher
Fisher wanted to examine the link between the total quantity of

money (M) and the total amount of spending on final goods
and services produced in the economy (P×Y).
 He established this relationship as M=PY/V where P is the

price level and Y is aggregate output, V is he velocity of
money.
– The transaction velocity of money (V) is the average number of times that a
dollar is exchanged between
Derese G. a buyerProfessor)
(Assistant and a seller in one year. 24
Velocity
• This suggests the following definition:
T
V 
M
where
V = velocity
T = value of all transactions
M = money supply

Velocity
• Use nominal GDP as a proxy for total
transactions.
Then, P Y
V 
M
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P Y = value of output (nominal GDP)

The Quantity Equation
• The quantity equation

M V = P Y
follows from the preceding definition of
velocity.
–It is an identity:
it holds by definition of the variables.
c. Keynesian’s Liquidity Preference Theory of Demand
for Money
According to the Keynesian theory money, is
demanded not only because of medium of
exchange to facilitate transaction, but also
because people demand money for:
I. Transaction purpose
II. Speculative purpose
III. Precautionary demand
Cont’d…
I. Transaction demand
Almost everyone needs to hold some amount of money to carry
out ordinary day-to-day transactions (selling and buying).
The amount of money to be kept for transaction depends on the
timing of receipts and the timing of payments.
For example, if a person gets daily wage, the amount he wants
to keep with him for transaction is different from a person who
gets monthly salary.
In this case, on an average level a daily labour would keep
fewer amounts for transaction.
Cont’d…
Note that if people save their money to receive interest income until they consume or
use for transaction purpose, higher interest rate reduces money holding or demand.
Moreover, transaction demand (Mt) depends on the income (Y). In equation form, this
can be written as . The transaction theory of money demand in detailed explained
by Baumol-Tobin Model of cash Management.
Baumol-Tobin Model of cash Management
This theory is concerned with the calculation of the optimal number of time of cash
withdrawal from banks and optimal amount of cash to hold during any given period.
This depends on the benefit and cost of holding money.
Benefit of holding money: This is convenience of making transactions i.e. avoiding

making trips to banks every time they wish to buy something.
Cost of holding money: This is the foregone interest income that they would have
received had they left their money in the saving account.
Cont’d…
II. Precautionary Demand for Money
This demand for money arises due to uncertainty of future receipts and expenditures. For instance,
unexpected expenses include:
 family wants to spend its vacation aboard then they would keep more money than the required
amount
 purchases of something interesting you get on your way without your intention.
 missing bus and paying more money to travel by minibuses.
 getting car trouble unexpectedly and paying for mechanics for maintenance.
 losing your bag on your way and purchasing new materials for use on your journey.
 staying more days away from home unexpectedly and pay more for food and bed and
 getting trouble with your home phone or electricity system and paying for maintenance.
This demand for money can also be linked to income. As their income increases, people are expected
to keep more money than the lower income group for precautionary purpose.

Cont’d…
Thus one can say that precautionary money demand is also a function of income .
Mp  f (Y )
Since both transaction and precautionary demand for money are functions of income
and precautionary, money is finally used for transaction purpose, write as:
M t  f (Y )
where Mt includes both transaction and precautionary demand for money.

Cont’d…
III. Speculative Demand for Money (Ms)
• So far we have seen that money is demanded basically for transaction and
till now classical theory is true. However, Keynes introduced another motive
of holding money called speculative motive.
• The speculative demand for money is money that forms part of an individual’s
portfolio of assets.
 Keynes believed that interest rates have an important role to play in influencing
the decisions regarding how munch money to hold as a store of wealth.
• Speculative demand for money is negatively related to the level of interest

rates.
Note that: speculative theory of money demand is more valid in countries with
developed money market.
Cont’d…
Combining all the demands for money, we can write a general Keynesian formula
for demand for money as:
Md = Mt + Ms or
k(Y) + h(r), since Mt = f(Y) and Ms = f(r)
Md = L(Y, r).
This relation simply means that money demand is a function of income (Y) and
interest rate (r).
Money demand increases as income increases and decreases as interest rate

increases.
Thus, money demand is positively related to income and negatively related to

interest rate.

Cont’d…
Figure: Total Demand for money
Interest rate (r)
Mt Ms
Md
0 Mt + Ms = Md (Total Money Demand)

Cont’d…
d. 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.
emphasize “store of value” function
relevant for M2, M3
not relevant for M1. (As a store of value,
M1 is dominated by other assets.)
Thus, the demand for money depends on the risk and return offered by
money and by various other assets.
For example, 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.
Cont’d…
However, if inflation is expected to occur, people
prefer to keep real assets than money.
The money demand would also depend on total

wealth because wealth measures the size of the
portfolio to be allocated among money and
alternative assets.

Cont’d…
Thus, the demand for real money (Md/P) can be given by the following
function:
Md
 L (rs , rb ,  e ,W )
P
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 loosing money, money
demand falls as rs, rb, ∏e increases and wealth falls. As rs and /or rb
increases, money demand falls because people change their money
to bonds & stocks to receive higher interest rate.

Cont’d…
If the expected inflation rate e is high then demand
for money will be low as people change their money
to real assets. 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).

Money Market Equilibrium
Money market equilibrium is determined by interaction

between 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)

The money demand function
(M P )  L (i ,Y )
d
(M/P )d = real money demand, depends

negatively on i
i is the opp. cost of holding money
positively on Y
higher Y  more spending so, need more money
(L is used for the money demand function because
money is the most liquid asset.)

The money demand function
(M P )  L (i ,Y )
d
 L (r  , ) e Y
When people are deciding whether to hold

money or bonds, they don’t know what
inflation will turn out to be.
Hence, the nominal interest rate relevant for
money demand is r + e.

Equilibrium
M
 L (r   , Y )
e
The supply of
Real money
real money
demand
balances

Cont’d…
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 = M d

Cont’d…
Once we have a total demand for money and supply

of money then we can find the equilibrium in money
market by equating both demand and supply curve.
In the case of Figure 8.3, the equilibrium rate of

interest is re whereas the equilibrium demand for
money is Mde determined at point ‘e’ where the two
functions intersect.

How P responds to M
M
 L (r   , Y )
e
• For given values of r, Y, and e,

a change in M causes P to change by
the same percentage --- just like in
the Quantity Theory of Money.

How P responds to e
M
 L (r   , Y )
e
P
• For given values of r, Y, and M ,
  e   i (the Fisher effect)

  M P 
d
  P to make M P  fall
to re-establish eq'm

Cont’d…
What is liquidity trap?

Further Developments In The Keynesian Approach
The Baumol- Tobin Model
It is the Transactions theory of demand for Money
• William Baumol and James Tobin independently
developed similar demand for money models, which
demonstrated that even money balances held for
transactions purposes are sensitive to the level of
interest rates.
• In developing their models, they considered a
hypothetical individual who receives a payment once a
period and spends it over the course of this period.
Cont’d….
The conclusion of the Baumol-Tobin analysis is as follows:

• as interest rates increase, the amount of cash held for
transaction purposes will decline, which in turn means that
velocity will increase as interest rates.
• thus, the transactions component of the demand for money is

negatively related to the level of interest rates.

Cont’d…
Assumptions and notations:
 Household expenditure at time t is Y (=C.P)
 C is quantity of goods and services consumed and P is their price
 All purchases are evenly spread over the period

 All purchases are paid in cash
 Income is earned at the start of each period
 Deposits in saving account earns interest (Rt)
N = number of trips consumer makes to the bank
to withdraw money from savings account
 F= cost of a trip to the bank (F=P𝜹)
(e.g., if a trip takes 15 minutes and
consumer’s wage = $12/hour, then F = $3)
Cont’d…
Since expenditure is a constant flow, the number of

times you decide to go bank determines the amount
of money you hold in your pocket.

Money
holdings N=1
Y
Average
= Y/ 2
1 Time

Money
holdings N=2
Y Average = Y/ 4
Y/ 2
1/2 1 Time

Money
holdings N=3
Y
Average
Y/ 3 = Y/ 6
1/3 2/3 1 Time

In general, households’ average money holdings =
Y/2N
M= Y/ 2N
• Foregone interest = Rt (Y/2N )
• Cost of N trips to bank = FN

Thus, Y
Total Cost  Rt x  ( FxN )
2N
 Given Y, i, and F, consumer chooses N to minimize total
cost

• Finding the cost-minimizing N
Cost Foregone
interest =
iY/2N
Cost of trips
= FN
Total cost

Y
Total Cost  Rt x  ( FxN )
2N
Take the derivative of total cost with respect to N, set it equal to zero:
Rt Y
 2
F 0
2N
Solve for the cost-minimizing N* Rt Y
N 
2F
 This is the cost minimizing value of N

To obtain the money demand function,
plug N* into the expression for average money
holdings:
YF
Average Money Holding 
2R
Money demand depends positively on Y and F, and

negatively on R.
• The Baumol-Tobin money demand function:
YF
M  d
 L( R, Y , F )
2R
How this money demand function differs from the others:
 B-T shows how F affects money demand.
 B-T implies:
 income elasticity of money demand = 0.5,
interest rate elasticity of money demand = 0.5

Then this function in such away that money demand
is positively related to Ct and negatively related to
Rt
Empirical results for developing countries:
although the sign of Rt is negative, it is not significant
because people is not sensitive interest rate.
Currency substitution (holding money in foreign currency)
is more significant
When people expect domestic currency to depreciate, they
prefer to hold their money in foreign currency
In subsistence economy, no money

Derese G. (Assistant Professor) left for saving 61
Cont’d…
Thus, the assumption that monetary authorities (MA)
have full control is not true.
The MA controls MS iff money is commodity money, not

fiat money, because in the latter case banks have no
ability to create.
 When the required reserve ratio is 100%, only then do the
MA has full control on fiat MS.

Cont’d…
But there are economists who argued that MS is not
defined (measured) accurately. This is because
over time money is continuously changing its form
So, we shall focus on two things:

What is the definition or measurement of MS?
How do monetary authorities try to control the MS

the tool to gauge (supply) the amount of money the economy
need
Money Control
What instruments do MA use to control
money?
There are three common instruments of
monetary policy
1. Open-market operations
2. Reserve requirements
3. The discount rate

• Open-market operations
– definition: The purchase or sale of government bonds by the NB or MA.
– how it works: If MA buys bonds from the public,

it pays with new dollars, increasing B and therefore M.
• Reserve requirements
– definition: MA regulations that require banks to hold a minimum reserve-deposit ratio.
– how it works: Reserve requirements affect rr and m:

If MA reduces reserve requirements, then banks can make more loans and “create” more
money from each deposit.
• The discount rate

– definition: The interest rate that the MA charges on loans it makes to banks.
– how it works: When banks borrow from the MA, their reserves increase, allowing them to make
more loans and “create” more money.
The MA can increase B by lowering the discount rate to induce banks to borrow more reserves
from the MA.

Which instrument is used most often?
Open-market operations:
• most frequently used.
Changes in reserve requirements:

• least frequently used.
Changes in the discount rate: largely symbolic.

• The MA is a “lender of last resort,” does not usually
make loans to banks on demand.

• Is MA often effective in attempting to control
the money supply?
• Lets see the effectiveness of MA that attempted

to control the money supply via different
targets.
– Money targeting
– Interest targeting

• Money targeting:
– MA can identify the monetary target Mt that the
economy need and supply that amount
– Recall that
Mt
 f (cr , kt , rt )
B
Mt
 f (cr , kt , rt )
B
 f (rt )
– kt and cr can be assumed exogenous to the MA
– Thus,

• Money demand on the other hand is
Mt
 L (Yt , Rt )
pt
Mt  Mt 
 L Yt , f ( )
pt  Bt 
M t*  e Mt 
e
 L Yt , f ( )
pt  Bt 
• In practice, however, the expected value may not be

the correct figure. So, there is always a problem in
using expected values.

• Hence, the MA has two problems:
– Their expectation of Md may not be exact
• Because it depends on Ye and Pe
– The targets can not be achieved even when the

government try to supply Mt*
• Because private banks and hhs may disturb the Ms (the real
money may be above or below Mt*)
– To avoid this, they set their target to a range of values,

not a specific value.
• How?
– They estimate (predict) the max and min of both Md and Ms
Cont’d…
This means, if MA set the maximum and
minimum of both Ms and Md, the probability of
making a wrong target is low.
In such cases, the actual Ms is likely to be

between Mt1 and Mt2

Interest Targeting:
This is fixing the interest rate and supplying the
amount of money that equates R* and M*

• Which targeting is superior?
– Which of the instrument is superior depends on the
nature of error made by MA
• Note that:
– The larger the range of Mmax and Mmin is, the larger the
error of MA
• To evaluate which one superior, lets consider two
cases:
– Case 1- Ma makes large error in predicting Ms
• i.e, the gap between max and min of MS is larger than the
gap between the max and min of Md
– Case 2- Ma makes large error in predicting Md
• i.e., variation in Ms is small and the variation in Md is large
Case-1: MA makes a larger mistake in predicting Ms than Md
Rt MSmax – If the MA use monetary targeting,

MS
the range by which the MA makes
MSmin
error is given by M1-M4
– If the MA use interest targeting,

Rt
the range by which the MA makes
error is given by M2-M3
MDmax
MD
– Hence in this case, interest rate
MDmin targeting is superior to the
money marketing!
M1 M2 M* M3 M4 Mt

Case 2-MA makes larger error in predicting Md than Ms
Rt MSmin – If the MA use monetary targeting,
MS the range within which Mt
MSmax achieved varies is given by M2-M3
Rt – If the MA use interest targeting,

the range within which MS
achieved varies is given by M1-M4
MDmax
MD • Hence in this case, money

MDmin
targeting is superior!
M1 M2 M* M3 M4 Mt

• Thus, it can be conclude that:
– If Md variation is greater than Ms variation, the MA
better use the interest rate targeting.
– If Ms variation is greater than Md variation, the MA

better use the monetary targeting.

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Lecture 8

Money and Financial Markets

Derese G. (Assistant Professor) 1

• As a result it is said that ‘money’ must have the following

Derese G. (Assistant Professor) 3

Derese G. (Assistant Professor) 4

Derese G. (Assistant Professor) 5

Though commodity moneys may satisfy most of

Derese G. (Assistant Professor) 6

An increase in price means, a decline in the value of birr.

If supply of money grows faster than the real output then

Derese G. (Assistant Professor) 7

Measure of value/unit of Account (measuring

outputs in terms of money); and

Money as store of value (converting other

assets into money and keep for future.

Derese G. (Assistant Professor) 8

As MS increases : inflation increasing Negative impact

Derese G. (Assistant Professor) 9

1. Currency with public: coins and notes in circulations

5.Deposit in saving account

6.Money market mutual funds

7. Overnight repurchase agreement : transaction in which a bank borrows from

e.g. Treasury bills – for short periods

C. M3: includes M2 and

8.Large denomination time deposits ( longer time

9.Term repurchase agreements: financial securities

Derese G. (Assistant Professor) 12

This model involves three exogenous variables such as:

II. Reserve requirement and

III. Demand deposits

Derese G. (Assistant Professor) 15

– Thus, if monetary base changes by B,

Derese G. (Assistant Professor) 18

Derese G. (Assistant Professor) 19

Derese G. (Assistant Professor) 21

a. Classical/ Transactions theory of money demand,

b. Keynesian theories of money demand, and

c. Portfolio theory of money demand

Derese G. (Assistant Professor) 22

people need or demand money solely for

• also relevant for M1

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Fisher wanted to examine the link between the total quantity of

 He established this relationship as M=PY/V where P is the

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• The quantity equation

Baumol-Tobin Model of cash Management

Benefit of holding money: This is convenience of making transactions i.e. avoiding

 missing bus and paying more money to travel by minibuses.

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• Speculative demand for money is negatively related to the level of interest

k(Y) + h(r), since Mt = f(Y) and Ms = f(r)

Money demand increases as income increases and decreases as interest rate

Thus, money demand is positively related to income and negatively related to

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Interest rate (r)