INTRODUCTION OF MONETARY ECONOMICS

MONEY Definition: An item that is widely acceptable as a medium of exchange (in order to get something you must give something as a return)

Barter System

CHARACTERISTICS OF MONEY Recognizable must be acknowledged by everyone in the economic system. Scarcity limited in supply but not too scarce. If it is too easy to obtain money, it will not be acceptable to be exchanged with goods and services. If it is too hard to find it will limited the economic activities. Durable last long and does not easily deteriorate

CHARACTERISTICS OF MONEY, cont.. Stable in value it will be difficult for people to use money as a mean of payment if its value changes or fluctuates frequently; too much supply of money will reduce its value Portable easy to carry Divisible and standardized money must be able to be divided into smaller units to the extend of countable and standardized

FUNCTIONS OF MONEY medium of exchange demanded for transaction purposes. store of value money does not suffer from any physical deterioration; it can be stored and can be turned into other forms of wealth quickly.

FUNCTIONS OF MONEY, cont.. a unit of account the value of goods and services are expressed in terms of a common measurement; which is money a standard for deferred payment money can be used as a payment at later date and not necessarily when the goods and services are purchased.

TYPES OF MONEY Coins

1. Coins,cont.. also known as token money; the face value is GREATER than the metallic content of the coins fiat money Standardized in weight, and produced in large quantities to facilitate the trade.

Cont.. pieces of hard material used as a medium of exchange or limited legal tender. Legal tender; made legally by government which must be accepted as a medium of exchange and in settlements of debt. Limited legal tender; certain values of coins can only be used in a limited amount.

2. Notes Unlimited legal tender where it can be used without any limit. Face value is greater than their own values fiat money

3. Current Deposits also known as demand deposit, sight deposit, bank deposit or cheque deposit transferable from person to person through the use of cheques considered as money because it possesses the functions of medium of exchange and a store of value. not legal tender like coins and notes.

4. Near Money consists of saving deposits and fixed deposits at commercial banks, Bank Negara Malaysia and other financial institutions and other short-term bills. why near money? insufficiently liquid to be a medium of exchange but it serves the function of a store of value how to use it? convert it into cash (coins and notes) first.

SUPPLY OF MONEY Total supply of money refers to the total money in economic circulation; not the same as the amount of money that the gov print. How we measure total money supply in the economy? using a narrow or broad definition of money So, in measuring the total money supply, we classify them according to the definitions as given by Bank Negara Malaysia (BNM), namely M1, M2 and M3.

M1 Supply of Money Comprises of the most liquid assets only coins, notes and demand deposit/current deposit (current accounts) at commercial banks. The most liquid assets since they can be used as payments and settlements of debts directly, without having to convert.M1 = (coins + notes) + demand depositM1 = fiat money + demand deposit

M2 Supply of Money also called as narrow near money Includes some less liquid assets because they need to be turned into cash first before can be used as a medium of exchange Can be converted easily Comprises of M1 and savings and fixed accounts at commercial banks and Bank Negara Malaysia (BNM), negotiable bills and Bank Negara Malaysias certificates.

M2 Supply of Money, cont..M2 = M1 + (savings and fixed accounts with commercial banks and BNM) + negotiable bills + BNMs certificates)

M2 = M1 + narrow near money

M3 Supply of Demand Includes all the M2 money supply PLUS saving and fixed deposits at other financial institutions, merchant banks and discount houses. The savings and fixed deposits at other institutions are part of near money because they need to be converted into cash too before using it to make payments or settling the debts.

M3 Supply of Money M3 = M2 + (savings and fixed deposits with other financial institutions, merchant banks and discount houses)

Broad near money = M3 M1

M1, M2 and M3 Supply of Money Coins Notes Demand deposits at commercial banksSavings and fixed deposits at com. BanksNegotiable bills and BNMs certificatesSavings & fixed deposits with other fin. Institutions, merchant banks & discount house

Fiat MoneyM1Narrow near moneyM2Broad near moneyM3

Money Supply and Price Level (Fishers Equation) Irving Fisher (one of the classical economists) had developed a study on the relationship between money supply and the general price level Through Quantity Theory of Money, he produces a famous Fishers Equation.

Fishers Equation Any changes in the total money supply in economy will produce the same rate of changes in the general price level

Change in money supply and rate of inflation is positively related.

Assumptions of Fishers Equation Money is demanded for transaction purposes only The economy is always at the full employment level Since the economy is always at the full-employment level, the volume of goods and services produced/exchanged and the velocity of circulation of money are constant.

Fishers Equation, cont..Where, M = total money supply in the economy V = velocity of circulation of each money in the economy P = general price level (reflects rate of inflation in economy) T = volume of goods and services produced / exchanged / purchased @ GDP @ the number of transactions in the economyMV = PT

Fishers Equation, cont.. M = total money supply- Central Bank controls the money supply in the economy- So, Central Bank will determine the amount of money supply and whether they want to increase or reduce its amount.

Fishers Equation, cont.. V = velocity of circulation- The average number of times that every single money is being used to purchase goods and services in a year or the frequency that money is used in doing transactions.- If V = 5, it means that, in average every money is used for 5 times or 5 transactions during that year.

Fishers Equation, cont.. As Classical economists always believed that economy achieved full-employment level, the amount of labors being employed will remain constant thus, there would not be any changes in the total volume of GDP or the number of goods and services produced every year it makes T constant.

Fishers Equation, cont.. when the level of economic activities is constant, the average of using every money in doing transactions will also be constant. (

Fishers Equation, cont..The Fishers equation explains that when:MV = total money supply in economy X velocity of circulationThus, MV = total expenditure in economy

Whereas, PT = general price level X total volume of goods and services Thus, PT = total value of national output

Cont..Therefore, MV = PT means,Total expenditure in economy = total value of national outputSince V and T are constant, therefore,M = P.

It means that, change in money supply, M will lead to change in the general price level, P with the same rate. (CB increase money supply by 5%, the general price level will also increase by 5%, with assumption, V and T are constant.

ExampleSuppose:Money supply= $80 millionPrice level= $5.00Velocity of circulation = 4 timesa. Determine the quantity of output, Tb. If there is an increase in the money supply by 6%, determine the new amount of money supply.c. What happen to the price level? Determine the new price level (Assuming others remain unchanged)d. Determine the rate of changes in the price level above.

Demand for Money (Keynes Liquidity Preference Theory) According to Keynes,-money is not demanded for the purpose of purchasing output only. -money is also demanded for other reasons like saving and speculation Thus, Keynes developed a theory of demand for money liquidity preference theory

He incorporate the significance of interest rate in this theory. Keynes stated that people want to hold money for 3 purposes only 1)transactions, 2)Precautionary and 3)speculative Demand for Money (Keynes Liquidity Preference Theory)

1) Transaction Purpose, Lt people hold money to buy goods and services which depends on the level of income and has no relation to interest rate at all. the higher the income of individuals, the greater the amount of money that they want to hold to do transaction. positively related with income level

Transaction Purpose, cont..Income, YQuantity of LtLt

2) Precautionary Purpose, Lp Individuals demand money for the emergency or unexpected circumstances accidents, sickness, fire and others. total money demanded for precautionary is influenced by the level of income and not related to interest rate.

Precautionary Purpose, cont..Income, YQuantity of LpLp

3) Speculative Purpose, Ls Individuals hold money to speculate on securities (bonds and shares) The quantity of money depends on the rate of interest and not influenced by income level anymore. they hold money for the purpose of getting profit from the speculation activities. Speculators will buy more securities when the prices are low and sell the securities when the prices are expensive

Speculative Purpose, LsInterest rate, rQuantity of Lsr0r1r*Q1Q0LsBonds and shares prices are negatively related with rate of interest Low r (r0) and high Psec expect r to and Psec to sell Security now quantity of money balances (Q0)

Conclusion of Money DemandThe total demand for money is given as:

Mdd = Lt + Lp + Ls

Monetary Policy One of the major stabilization policies adopted by the government to overcome two major macroeconomic problems inflation and deflation. this policy is designed to influence the supply of money and/or interest rate through Central Bank. Tools (methods) of monetary policy are all related to the financial and banking system raise or reduce the amount of money supply in the economy

Contractionary Monetary Policy the government will restrict the credit and reduce the money supply in the economy. adopted by gov to control inflation. purpose: to reduce peoples spending by reducing the amount of money supply available Mss - adopt during inflation

Expansionary Monetary Policy Gov encourage the availability of credit and increase the money supply Adopted when the gov wants to deal with deflation problem where the level of economic activity is slow. It is expected to boost the spending activities in the economy as people hold more money.

Mss - adopt during deflation

Tools of Monetary Policy Open Market Operation- the activities of selling and buying of government securities by the Central Bank in the open marketTo Mss BNM buy securities banks reserves credit To Mss BNM sells securities banks reserves credit

Tools of Monetary Policy, cont.. Reserves Ratio- the proportion of commercial banks deposits that must be kept with Central Bank.- the ratio is set by CB.

To Mss ratio reserves ability to give credit To Mss ratio reserves ability to give credit

Cont.. Discount Policy (Bank rate)- the rate charged by the Central Bank on banks and discount houses loan.- any loan made by the banks from the CB will be discounted by certain rate called as bank rate which influence the interest rate charged by the banks on the loans made to the public.

To Mss: bank rate interest rate reserves creditTo Mss: bank rate interest rate reserves credit

Cont.. Selective Credit Control- the gov control ways of giving loans by the commercial banks and other financial institutions. - the gov (through CB) can either tighten or loosen the provisions of giving loan to the public.

To Mss: less strict provision creditTo Mss: stricter provision credit

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