Economics- Money and Inflation

7/28/2019 Economics- Money and Inflation

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Presented by

Dr. M. Anwar Ullah, FCMA (F- 629)

The Institute of Cost and Management Accountants of Bangladesh

ICMA Bhaban, Nilkhet, Dhaka 1205

Email: [email protected]

[email protected]

Business Economics and International Business
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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Meaning of Money

Functions of Money

Forms of Money Measuring Money

Quantity Theory of Money

Supply and Demand for Money

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Business Economics: Money and Functions of Money, inflation etc.


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What is Money?

Money is anything that is generally acceptable to sellers inexchange for goods and services.

A liquid asset is an asset that can easily (i.e., quickly,

cheaply, conveniently) be exchanged for goods andservices. Anything commonly excepted in exchange forgoods/services

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Example: many objects throughout history

livestock metals

cigarettes

grain


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money, income, & wealth

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money

what is accepted as payment

income

earnings during time period (year)

wealth

accumulated assets at pt. in time

money, wealth are STOCKS

amount at a point in time

income is a FLOW

amount during a time period


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I own $2 million in diamonds. period.I am wealthyI have no money

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Examples

money, income, & wealth

I win $25 million in lotteryI put it under my bedI quit my job

I am weathlyI have a lot of money

my income is zero

software engineerearnings $100,000/yrblows it all, every paycheck

high income

no wealth


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1) Medium of exchange

2) Unit of account

3) Store of value

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money is a means of payments (medium of exchange)-- accepted as payment for goods and services

Functions of Money

barter for stuff

-- need double coincidence of wants

Features of Money: to act as money, must bemeasurabledivisiblewidely accepteddurable


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money is a unit of account-- money is used to measure value

if something costs $5,

not that valuable if something costs $500,

thats valuable

money is a store of value

-- use money to save, accumulate wealth,

buy stuff later

-- money is liquid asset

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Business Economics: Money and Functions of Money, inflation etc.Functions of Money

money is NOT always a good store of value

-- political instability, -- poor economy, -- high inflation


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Forms of Money

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commodity money

has its own value as a good

-- gold & silver coins

fiat money

-- no value other than

fact that its accepted

in exchange for

goods and services

U.S. money is fiat money!

fiat money is more efficientcommodity money has opportunity cost: you could use it for something else

Debit or Credit cards?

NOT money payment mechanisms that access money


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Empirical Measures:

At present, the principal medium of exchange is

- currency ( paper notes and coins)

- checkable deposits at banks and other financialinstitutions

Centrals banks publish statistics on measures ofmoney supply, M1 which reflects the medium ofexchange concept of money.

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Measures of Money

Components of M1:

- currency

- sight deposits

- other checkable deposits- travellers checks

NOTE: M1 does not include credit card transactions. A credit

card purhase is not a transfer of medium of exchange, ratherit is a prenegotiated right to borrow from and repay the creditcard company. Credit card arrangements reduce the quantityof medium of exchange.

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What is Money?M1

M1 is the narrowest and most liquid measure of the money supply.

It includes financial assets that are immediately available for spending ongoods and services.

M1 includes:

Currency

Travelers Checks

Demand Deposits

Other Deposits (interest-bearing)

Money Market:A segment of the financial market in which financial instruments with highliquidity and very short maturities are traded. The money market is used by participants as ameans for borrowing and lending in the short term, from several days to just under a year.

Negotiable certificates of deposit, bankers acceptances, Treasury bonds, commercial paper, Margin Account: A brokerage account in which the broker lends the customer cash to

purchase securities. The loan in the account is collateralized by the securities and cash. Ifthe value of the stock drops sufficiently, the account holder will be required to deposit morecash or sell a portion of the stock.

Sweep Account:A bank account that automatically transfers amounts that exceed (or fallshort of) a certain level into a higher interest earning investment option at the close of each

business day. Commonly, the excess cash is swept into money market funds.

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Business Economics: Money and Functions of Money, inflation etc.What is Money?M1

Demand Deposits: An account from which deposited funds can be withdrawn atany time without any notice to the depository institution i. e accessible by theaccount holder at any time.

Money At Call: A short-term loan that does not have a set repayment schedule,but is payable immediately on demand. Money-at-call loans give banks a way toearn interest while retaining liquidity. Investors might use money at call to cover amargin account. The interest rate on such loans is called the call-loan rate.

Frozen Account: An account to which no withdrawals or purchases can becharged. This usually occurs when the account holder fails to pay promptly forpurchases charged to the account. For example, cash accounts are frozen for 90

days until the full purchase price of the intended order is paid in full.Definition of 'Account :

1. An arrangement by which an organization accepts a customer's financial assetsand holds them on behalf of the customer at his or her discretion.

2. A statement summarizing the record of transactions in the form of credits,debits, accruals and adjustments that have occurred and have an affect on an

asset, equity, liability or past, present or future revenue.


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Measures of Money

A larger measure of money M2includes;

- M1 plus

- savings account deposits

- small denomination time deposits

- money market mutual funds (MMMF)- overnight repurchase agreements

(REPO)

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What is Money?M2

M2 adds to M1 less liquid assets thatcan be converted to M1 assets

quickly and at low cost. Includes everything in M1

Adds:

Savings deposits Small denomination time deposits (CDs)

Retail money market mutual funds

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Measures of Money

Largest measure M3 includes;

- M2 plus

- larger denominatrion of timedeposits.

M3 is the least liquid measure of money.

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Measures of Money

Monetary Base: (High powered money)

This measure is less inclusive even compared to M1

but is important for analytical purposes.

Monetary Base includes;

- currency outside banks

- bank reserves (currency held by banks and

banks deposits with the central bank)

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00 0 1


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Measuring Money

Money aggregates

amount of cashBUT

other forms of money too

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M1

= currency in circulation

+ demand deposits+ checkable deposits

+ travelers checks

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M2

= M1

+ savings deposits+ small time deposits

+ retail money market deposits

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Comparing measures

get larger

M1 < M2

add less liquid assets to largermeasures

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Components of M1

1%

23%

28%

48%

currency

traveler's checksdemand deposits

other checkable

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Business Economics: Money and Functions of Money, inflation etc.Components of M1

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Components of M2M1

22%

small CDs

20%savings

39%

money

market

19%

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Business Economics: Money and Functions of Money, inflation etc.Components of M2

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Which measure is best?

move together in general

BUT behavior can vary in short-term

M2 most watched

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The Demand for Money

Where does money demand come from?

Understanding the demand for money willallow us to examine the links betweenmonetary policy, inflation, andunemployment.

The quantity of money circulating aroundthe economy and the interest rate at whichit circulates are determined by both moneysupply and money demand.


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Tools of Monetary Policy

Legal reserve ratio: ratio of cashreserves to deposits that banks are

required to maintain

By lowering the ratio, banks will have

more reserves to lend and invest,increasing the money supply


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Discount rate: rate of interest BBcharges on loans to banks

By lowering the rate, banksencourage borrowing from BB and

lending to the public, increasing themoney supply


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Open Market Operations: BBspurchases and sales of government

bonds

By purchasing bonds and paying the

sellers, the BB increases the moneysupply


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Expansionary Monetary Policy

Increase the money supply by anyone or combination of the above

tools Reduce the interest rate to

encourage investment

Increase investment expenditures,thus creating employment & income


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Expansionary Monetary Policy

Quantity of Money

Interest Rate (%)

(M/P)d

5

80

(M1/P)s (M2/P)

s

4

85

money demand (M/P) depends onincome

interest rates

So, M/P = f(i,Y)


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The Quantity Theory of Money

How much money would you need to purchase theeconomys annual output of goods and services?

Suppose GDP (P*Y) was Tk.14 billion. Would you need a money supply of Tk.14 billion to buy all this

output over the course of a year? No! Each Taka is used multiple times. You would need

considerably less M than P*Y.

Velocity is defined as the number of times a dollar bill changeshands over the course of a year in an economy. It tells us the turnover rate for money in the economy.

Equation of Exchange: M*V P*Y The total money supply multiplied by the number of times this

money changes hands must be equal to nominal income (ornominal GDP)

Total expenditure (M*V) = Total production (P*Y) Everything produced is consumed


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Individuals hold money (Liquidity Preference) for three reasons:1. Transactions Motive people hold money to buy stuff

as income rises Money demand rises

2. Precautionary Motive You might need money on hand for anunexpected purchase

House breakdown Job loss Money demand rises

3. Speculative Motive You hold your wealth as money (asopposed to bonds) to store value

high interest rates bonds more attractive, hold less moneyMoney demand negatively related to interest rate


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Equation of Exchange:

MV = PYM = money supplyV = velocity : # times money used to purchase output

P = general price level

Y = output of goods & services

2 Assumptions: V is constant in short-run

depends on institutions, technology that change slowly

Y is at full employment level

also constant in short-run


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MV = PYif V, Y constant then A change in M must cause an equal % change in P

Quantity Theory of Money V is the velocity of money. It is supposed to measure how often

the money stock turns over in each period. Alternatively,we can write V = nominal GDP/nominal money supply, i.e., V =PY/M.

MV = PY should be treated as an identity, rather than an equation,because by the definition of V, it must always true. When there arechanges in M, P, or Y, then V may have to adjust.



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Income Velocity of Money

(M/P)d = kY where k is the percentage of moneybalances held for transactions

Equilibrium (M/P)s = (M/P)d

M/P = kY

M/k = PY

So, V = 1/k

If k = 0.10, then V = 10: a Tk.1 changes hands 10time a year

V= Velocity is defined as the number of times a Taka changes handsover the course of a year in an economy. It tells us the turnover ratefor money in the economy.


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Money

Supply

MoneyDemand

Price

Level

Inflation

Rate

Nominal

Interest

Rate

Linkage Among Money, Prices, and Interest Rates

Money demand is not directly affected by interest rates.


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The Transactions Motive for Holding Money

Suppose you earn Tk.3000 per month and consume Tk.100 per day. Well assume30 day months and a constant rate of consumption over this period.

Case 1: You hold the entire Tk.3000 in cash to carry out your transactions. You have Tk.3000 at the beginning of the month and Tk.0 at the end.

Your average cash balance is Tk.1500. Your annual income (P*Y) Tk.36,000 and your holdings of money (M) average

Tk.1500. V = PY/M = 36,000/1500 = 24

Case 2: You hold Tk.1500 in cash and buy Tk.1500 in bonds at the beginning ofeach month

After 15 days, you sell your bonds and use the principal (Tk.1500) to makeyour purchases, keeping any earned interest for yourself.

Your average cash balance is now Tk.750 (1500 at day 1, 0 at day 15, 1500 atday 16, 0 at day 30: (1500+0+1500+0)/4 = 750.

V = PY/M = 36,000/750 = 48 If i = 1% per month, you also earned (i/2)*1500 = .005*1500 = Tk.7.50

Motive for Holding Money

The Transactions Motive for Holding Money


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The Transactions Motive for Holding Money Case 3: Now suppose you hold Tk.500 in cash and buy Tk.2500

in bonds. Every 5 days (1/6th month) you run out of cash and have to sell

Tk.500 worth of bonds to make your purchases.

Your average cash holdings over the course of the month is M =Tk.250.

V = 36,000/250 = 144 At 1% monthly interest, you earn

(1/6*1%*Tk.2500)+(1/6*1%*Tk.2000)++(1/6*1%*500) = Tk.12.50

Finding from three cases: As your average cash balance shrinks, bothvelocity and the interest earned on bonds increases.

So why not hold the smallest amount of cash possible? Transactions costs of bonds!

Brokerage fees Time costs

As interest rates rise, people want to hold smaller average cashbalances, causing money demand to fall and velocity to rise.

As transactions costs of bonds rise, people want to hold more money atany given point, causing money demand to rise and velocity to fall.

Economics- Money and Inflation

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