Session 1-Introduction to

Money and Monetary

Economics
1. Fredrick Mishkin, Chapter 3,What Is Money?
2. Meenai and Ansari, Chapter 1

© 2005 Pearson Education Canada Inc.

 Learning Objectives
• Describe what money is.
• List and summarize the functions of money.
• Identify different types of payment systems.
• Monetary Aggregates: Compare and contrast the M1 and M2 money
supplies.
• Motives of Holding Money
• Definition of Money according to Transactionary and Liquidity
Approaches
• Identify the basic links among monetary policy, the business cycle, and
economic variables.
The Subject Matter of Monetary Economics
• For short-run analysis,
monetary economics
is a central part of
macroeconomics.
• The main paradigms
of macroeconomics
Monetary are the classical and
Microeconomics Keynesian ones.
• Macro • C paradigm studies
Components Components the competitive
economy at its full
• Micro employment
Components • A proper definition of equilibrium, while the
K paradigm focuses on
Monetary money and its D and S
• Money Demand function its deviations away
from this equilibrium
Economics • Money Supply function
• Market for loanable
funds and determination
of interest rate Macro
component
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• Monetary economics has both a microeconomics component and a
macroeconomics one.
• The fundamental questions of monetary microeconomics concern the
proper definition of money and its demand and supply, and those of
monetary macroeconomics concern the formulation of monetary
policy and its impact on the economy.
Monetary Economics
• Monetary economics is the economics of the money supply, prices and interest rates, and their
repercussions on the economy.
• It focuses on the monetary and other financial markets, the determination of the interest rate,
the extent to which these influence the behavior of the economic units and the implications of
that influence in the macroeconomic context.
• It also studies the formulation of monetary policy, usually by the central bank or “the monetary
authority,” with respect to the supply of money and manipulation of interest rates, in terms both
of what is actually done and what would be optimal.
• In a monetary economy, virtually all exchanges of commodities among distinct economic agents
are against money, rather than against labor, commodities or bonds, and virtually all loans are
made in money and not in commodities, so that almost all market transactions modern monetary
economy involve money.
• Therefore, few aspects of a monetary economy are totally divorced from the role of money and
the efficiency of its provision and usage, and the scope of monetary economics is a very wide one.
Why Study Money and Monetary Policy?
• Evidence suggests that money, defined as anything that
is generally accepted as payment for goods or services
or in the repayment of debts, plays an important role in
generating business cycles.
• Recessions (unemployment) and expansions affect all
of us.
• Monetary theory ties changes in the money supply to
changes in aggregate economic activity and the price
level.
Money, Business Cycles, and Inflation
• The aggregate price level is the average price of goods and services in
an economy
• A continual rise in the price level (inflation) affects all economic
players
• Data show a connection between the money supply and the price
level
Figure 3 Money Growth (M2 Annual Rate) and the Business Cycle
in the United States, 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL

Figure 4 Aggregate Price Level and the Money Supply in the
United States, 1960–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GDPDEF
Figure 5 Average Inflation Rate Versus Average Rate of Money Growth
for Selected Countries, 2006–2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/

Money and Interest Rates
• Interest rates are the price of money
• Prior to 1980, the rate of money growth and the interest rate on long-
term Treasury bonds were closely tied
• Since then, the relationship is less clear, but the rate of money growth
is still an important determinant of interest rates
Figure 6 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term
U.S. Treasury Bonds), 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/M2SL
Fiscal Policy and Monetary Policy
• Monetary policy is the management of the money supply and
interest rates
• Conducted in the United States by the Federal Reserve System (Fed)
• Fiscal policy deals with government spending
and taxation
• Budget deficit is the excess of expenditures over revenues for a particular
year
• Budget surplus is the excess of revenues over expenditures for a particular
year
• Any deficit must be financed by borrowing
Meaning and Function of Money
Economist’s Meaning of Money
1. Anything that is generally accepted in payment for goods and services
2. Not the same as wealth or income
Functions of Money
1. Medium of exchange
2. Unit of account
3. Store of value
Evolution of Payments System
1. Precious metals like gold and silver
2. Paper currency (fiat money)
3. Checks
4. Electronic means of payment
5. Electronic money: Debit cards, Stored-value cards, Smart cards, E-cash

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Functions of Money
i. Medium of Exchange
ii. Unit of Account
iii. Store of Value
• For savings
• To make deferred payments

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Meaning of Money (cont’d)
• Money (a stock concept) is different from:
• Wealth: the total collection of pieces of property that serve to store
value
• Income: flow of earnings per unit of time
(a flow concept)

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Functions of Money
Medium of Exchange
• Eliminates the trouble of finding a double coincidence of
needs (reduces transaction costs)
• Promotes specialization
• A medium of exchange must:
• be easily standardized
• be widely accepted
• be divisible
• be easy to carry
• not deteriorate quickly

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Functions of Money
• Unit of Account:
• used to measure value in the economy
• reduces transaction costs
• Store of Value:
• used to save purchasing power over time.
• other assets also serve this function
• Money is the most liquid of all assets but loses value during inflation

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Evolution of the Payments System
• Barter System-trading post economies-problems
• Commodity Money: valuable, easily standardized and divisible commodities (e.g.
precious metals, cigarettes).
• Commodity Backed Paper Money (Convertible Paper Money)
• Commodity standard (gold standard)
• Inconvertible Paper Money or Fiat Money : paper money decreed by governments
as legal tender.
• Most modern paper currencies are fiat currencies; they have no intrinsic value and
are used solely as a means of payment. Historically, governments would mint coins
out of a physical commodity, such as gold or silver, or would print paper money that
could be redeemed for a set amount of physical commodity.

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Evolution of the Payments System (cont’d)
• Checks: an instruction to your bank to transfer money
from your account
• Electronic Payment (e.g. online bill pay).
• E-Money (electronic money):
• Debit card
• Stored-value card (smart card)
• E-cash

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Are We Headed for a Cashless Society?

• Predictions of a cashless society have been around for decades, but

they have not come to fruition
• Although e-money might be more convenient and efficient than a
payments system based on paper, several factors work against the
disappearance of the paper system

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Why Money has Value?
• depends upon the role the money plays in the economy

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Motives to hold money
• Money is defined on the basis of the ‘motive’ people keep or use
money.
• There are three main motives to hold money:
i. Transactionary motive
ii. Precautionary motive
iii. Speculative motive

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WHY IS IT IMPORTANT TO DEFINE MONEY
• Because changes in the total money amount and in its growth rate are directly or indirectly affect
important economic variables like GDP, price level and employment it is important to determine
the optimal level of money supply in the economy.
• To have a meaningful definition of money, monetary policy requires:
1) A close correspondence between the theoretical definition of money and the empirical or
the measurable definition of money
2) The central bank must be able to control the empirically defined quantity of money and to
meet the target it sets for the money growth
3) The empirically defined money must be closely and predictably related to ultimate
economic goals.
• For the implementation of successful monetary policy, the central bank should be able to
properly measure money and effectively control its growth rate.

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• Major macro economic variables:
• GDP
• Unemployment
• Inflation
• Interest rate
• Exchange rate
• BOP

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Approaches to Define Money
• There are two approaches to define and measure money
i. The transactions approach
ii. The liquidity approach

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The Transaction Approach
• Stresses money’s role as a medium of exchange
• People hold money primarily for transaction purposes, i.e. to buy goods
and services in near future.
• In this view money is to be distinguished from other assets primarily
because other assets cannot usually serve as medium of exchange.
• Measuring money should involve counting assets that serve this
purpose (currency and demand deposits).
• Proponents of the transactions approach assert that the central bank
an control the supply of money that people use to make transactions
• Money thus defined (accordingly) shows a reliable and predictable
relationship to national economic goals.
• Traditionally, monetary assets held in such form do not earn interest
and therefore increase an opportunity cost in the form of ‘interest’.

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The Liquidity Approach
• The liquidity approach to measuring money stresses that the essential distinguishing property
of money is that it is the most liquid of all assets.
• The liquidity attribute of an asset refers to the ease with which an individual can sell the asset
at an unknown future time at a nominal dollar price or at short notice and with minimum cost.
• All assets if ranked on a continuum serve the purpose of store of value but a different degree
of liquidity. (Money is the most liquid of all assets)
• Using a liquidity definition of money broadens the definition of money beyond transactions
approach.
• the liquidity approach in the measurement for money those assets that are highly liquid.
• Any asset for which no capital gain or loss is possible qualifies as a perfectly liquid asset and is
therefore money.
• The highly liquid assets for which only slight gains or losses are possible are classified as ‘near
monies’

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• Increasing asset liquidity is a means of reducing the cost of transaction.
• Advancement in technology has made the exchange mechanism more
efficient.
• Exchange instruments have increased but they do not all constitute
money (e.g:credit cards)
• Electronic transfers increase the speed of exchange (V) and also the
liquidity of the assets (more and more financial assets are assuming the
characteristics of near money)
• In a developed financial system the share of ‘near money’ assets in
total monetary transactions is significantly high.
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Measurement of Money
Transaction Approach
• According to transaction approach only those commodities will be included in money which
are just "Medium of Exchange". Thus all those goods which facilitate the sale or purchase of
goods, or which facilitate the transaction of goods and services can be given the name of
money. Hence, in the light of such approach to be money a commodity must have the quality
of medium of exchange. As a result, the coins and currency notes which are issued by central
bank and govt. and cheques of demand deposits which are issued by commercial banks will
be called money.

Liquidity Approach of Money:

• Money is not just a medium of exchange, it is also a store of value. As Prof. Gurly and Shaw
says: "Money as a store of value is an important property of money".
• Thus money should not include only currency and demand deposits, the assets should also
be added in money. Thus according to this definition, "Money is like an asset", or money is
like 'Reserve Purchasing Power' which people keep with them during the interim period of
earning and spending. Thus according to this definition of money: "All those goods which
have the quality of reserve purchasing power be also included in money".
• In the light of this theory we will add all those goods in money which are liquid. The liquidity
represents how soon an asset with low costs can be used to purchase goods and services. In
this way, not only currency but all other monetary and non-monetary assets like shares,
bonds, houses, vehicles and shops will also be included in money.
Measurement of Money Supply In Pakistan
Measurement of Money Supply In Pakistan( Example)
Item # Particular
1 Currency in Circulation 50,000
2 Cash in Tills 10,000
3 Other Deposits with SBP 5,000
4 Bank Deposits 391,760
Base money, seed money,high powered money, or
reserve money. (M0)
Sum of 1 +2+3+4 456,760
5 Schedule Banks Demand deposits 5,000
M1: Narrow Money Sum of Mo + 5 461,760
6 Time Deposits 1,000
7 Residents Foreign Curency Deposits 500
8 Coins In Circulation 400
M2: Broad Money Sum of M1 + 6+ 7 + 8 463,660
Deposits held with Non-Bank Financial Companies
9 (NBFCs) 100
10 National Saving Schemes - Outstanding Amount 50
11 Deposits held with Post Offices 10
sum of M2 + 9+ 10
M3: Broad Money +11 463,820
Measuring Money
• How do we measure money? Which particular assets can be called
“money”?
• SBP incorporates both transactions approach, as well as, liquidity
approach when it measures the quantity of money
• Monetary Aggregates are the numeric names given to different
measures of money (ranging from the narrowest measure to broadest
measure of money) by the monetary authority (Central Bank ) of an
economy.

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Measuring Money

• Monetary Base(M0):
• It is the narrowest measure of money
• It is also called the high powered money, base money, seed money or reserve money
• It is the quantity of government produced money.
• It equals to currency plus deposits of commercial banks with SBP
• Base money is created when SBP either buys domestic assets, mainly government securities, and
foreign exchange from the banking system or directly lends to the government or financial
institutions.
• For example, when SBP buys government securities through its open market operations from the
interbank market, it gives banks equivalent rupee liquidity in return; which banks use to create
more assets, such as loans to private and public sectors
• M1: is considered a narrow definition of money
• M2: A broad definition of money
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Growth Rates of the Bank’s
Monetary Aggregates

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