CHAPTER SIX

MONEY MARKET
 Money and its Evolution

• In the early period, society had been exchanging goods and services in kind.
• This system of exchange is known as barter system.
• It means direct swap of one item for another.

• E.g. they are exchanging

bread and shoe.
 Cont.
• As the economic activities of the world become larger and more complex, exchanges of
the growing size of goods and services also became complex and more difficult.
• Defects of barter system;
• Lack of common unit of measurement
• The need for double coincidence of wants
• Lack of divisibility
• The difficulty in storing wealth
• Difficulty of deferred payments
• However, by the invention of money as a common unit of exchange, things became
simpler.
 Evolution of money
• What is money?
• Money was not invented overnight. In the process of its evolution different
types of money have been developed.
• Primitive money: In the early phases of evolution of money, arrowheads,
hides, shells, bones etc. were used as Money.
• Commodity money: it’s a time when some commodity considered as medium
of exchange and at the same time can be purchased and sold themselves as
commodities. E.g. gold, silver and other precious metals.
• Commodity money has intrinsic value.
Cont.
• Fiat money or tender money: This refers to paper money or legal money.
• Has no intrinsic value or may have lower material value than its face
value.
• Credit money or bank money: This represents types of financial
documents such as cheques, draft that banks provide to people and used in
making transactions.
• This money also has no intrinsic value.
• Electronic money (E-Money): with this money transactions can be made
from anywhere around the world with the aid of electronic money through
computerized communication technology.
• E.g. credit cards, visa cards, mobile money and etc.
 Types of money
• We can also classify money as:
• Narrow money: This is part of money that consists of only the
currency and deposits in current account that earns low interest.
• Narrow money is also known as M1.
• Broad Money: Broad money includes the narrow money, M1, and
some more non-liquid assets such as time deposit, saving deposit etc.
 Value of Money
• The value of money derived in the same way as the value of any other
commodity is derived.

• The value of money measured in terms of what it can buy. Therefore, value
linked to the price levels.

• An increase in price means a decline in the value of money.

• If supply of money grows faster than the real output then price rises and
value of money goes down.
 Functions of money
• Money has the following basic functions;
• Money as a medium of exchange
• It is used to pay for goods and services.
• Money as unit of account
• Measure the values of goods and services in terms of money.
• Money as store of value
• Money use to store wealth for future use because it has purchasing
power over time.
 Money Supply

• Money supply is the amount of money in circulation in an economy.

• Any fluctuation in money supply brings changes in the macroeconomic
variables.
• Money supply is one of the major policy instruments in the hands of
governments. The policy packages prescribed related to money supply is
known as monetary policy and the variables changed in achieving the
objectives are known as monetary policy instruments.
 Components of money supply

• Some of the components/measurements of money supply popularly used in

many countries are given as follows;
• M1 = currency + demand deposit + checks for current conversion and use
• M2 = M1 + deposit in saving account + money market mutual funds
• M3 = M2 + time deposits + financial securities
• M4 = M3 + Total post office deposits
 Creation of Money and Banking System
• The process of money creation represents the process by which a given
amount of money increases itself through interaction between central
bank, commercial banks and households.
• The central bank or national bank of Ethiopia control the money supply
through the following basic monetary policy tools;
• Reserve requirement
• Open market operations and
• Discount rate
Cont.
• Reserve Requirement: the central bank requires commercial banks to
retain a certain percentage of their deposits as a reserve in central bank.
• Higher reserve requirement reduce money supply and vice versa.
• Open market operations: refer to the buying and selling of governments
and other securities by the central bank in the money and capital market.
• Open market purchase raises money supply and open market sale reduce
money supply.
• Discount Rate: is the rate that commercial banks pay when they borrow
funds from the central bank. It is the cost of borrowing from central bank.
• When the central bank reduce discount rate so that they can borrow it
increase money supply and vice versa.
Cont.
• However, the effectiveness of the three tools depends on several conditions like;
• Market operation (e.g. if it is smooth OMO is effective),
• Level of economy or monetization (e.g. if it is monetized RR is effective)
• Liquidity (under shortage of liquidity, discount rate is effective)
• Otherwise central bank will meet desired level of money supply by printing and
releasing currency.
 A simple Model of Money Supply
• There are three players which affects money supply in economy. They are
central bank, financial institutions and public.
• So, let us see how they affect the money supply through simple model of
money supply. The model involves three basic variables such as MB, reserve
and demand deposits.
• The monetary base is the currency in circulation (C) and total reserves (R).
• The monetary base (MB) can be expressed as:
• MB = C + R
• Reserve requirement: This is the proportion of deposits that commercial
banks keep with central bank. Reserve-deposit ratio (R/D) or (rr) is the ratio of
reserves to the deposit kept with banks.
Cont.
• Currency-deposit ratio (cr) or (C/D): represents the preference of the
public about how much money to hold in the form of currency (C) and
how much to hold in the form of demand deposits (D) which is deposited
in banks.
• The sum of the two represents the money supply in circulation either in
the form of currency or deposit in banks given by:
•M=C+D
Cont.
• Deriving simple model of Money supply • M = cr+1/cr+rr (MB)
• MB = R + C • M = m*MB (simple model)
• MB = (rr*D) + (cr*D) • Where, m = cr+1/cr+rr (money multiplier)

• MB = (rr + cr)*D • E.g., if cr= 0.4 (currency = 40% of total

• D = 1/ rr+ cr (MB)……….(1) deposit) and rr = 10 % of deposit.
• Then, find money multiplier and derive
• M = C + D (Money supply)
money supply equation.
• M = (cr*D + D ) • m = cr+1/cr+rr
• M = (1 + cr) *D • m=0.4+1/0.4+0.1
• m=2.8
• D =M/1+cr………………..(2) • M = mMB
• Equating both equation 1 and 2. • M = 2.8MB
• M/1+c = 1/cr+rr (MB)
 Nominal Vs Real interest rate
• Nominal interest rate is the interest rate before taking the inflation into
account.
• The real interest rate equals the nominal rate minus the expected
inflation rate.
• i.e.
• Where is real interest rate, is nominal interest rate, is expected
inflation rate.
 The demand for money
• People demand money because it serves some functions which are convenient
for many purposes. Basically, there are three major functions of money. These
are;
• Money as a medium of exchange,
• Money as a unit of account, and
• Money as store of value
• But high inflation or hyperinflation generally affects the functions of money
as store of value and medium of exchange.
• Hyperinflation represents very high inflation. It is defined as the level of
inflation that exceeds 50% per month. This is a level of inflation which is
greater than 1% per day. The purchasing power of money will be falling
sharply since one need larger amount of money to purchase any small good or
service.
 Theories of Demand for Money
• A. Classical theory of money demand
• For classical economists, who represent the early stage of development of theories of money
demand, people need or demand money solely for transaction purpose called transaction
motive of money demand.
• B. Keynesian theories of Demand for Money
• Keynes postulated that there are three motives behind the demand for money;
• The transactions motive
• The precautionary motive
• The speculative motive
• The transactions motive: money is used as a medium of exchange.
• People keep money for purpose of making daily transaction i.e.
• To purchase different goods and services daily.
Cont.
• Precautionary Motive: people will keep money on hand just in case some
unforeseen emergency arises.
• e.g., an unexpected bill for car repair or Medical bills.
• Speculative Motive: Keynes took the view that money is a store of wealth. If the
future rate of interests is known with certainty, there would be no speculation.
However, in real world situation, people gain or loss due to the fluctuation of interest
rates.
• Since speculation depends on the interest rate (they are inversely related), we can
write the relation as Ms=f(r) ; where ‘r’ is the rate of interest.
• Generally, Keynesian money demand formula written as follows;
• Md = Mt + Ms or Mt = f(Y) and Ms = f(r)
• Md = L(Y, r)
Cont.
• C. 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.
• Thus, the demand for money depends on the risk and return offered by money
and by various other assets. e.g., if holding other assets becomes highly risky
then people would prefer to keep money.
• Real money demand;
• Md/P= f (rb, rs, ∏e, W)
• Where, rs = is expected return on stocks, rb = is expected return on bonds,
∏e = is expected inflation rate, and W = wealth
• 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 as:
• Md = Mt + Ms or
• Md = f (Y) + f(r)
• Graphically, we can represent the money market equilibrium as follows;
Cont.

Figure 1: Money Market Equilibrium