Unit 3: The money market and monetary policy

INDEX
▪ The money throughout history.
▪ The money demand and money supply. ▪ Banks and money creation.
▪ The tools of monetary policy.
▪ The European Central Bank.
▪ The Public budget.
▪ The LM curve.
▪ Introduction to cryptocurrencies.

WHAT MONEY IS AND WHY IT’S IMPORTANT

- Without money, trade would require barter, the exchange of one good or service
for another.
- Every transaction would require a double coincidence of wants. The unlikely
occurrence that two people each have a good the other wants.
- Most people would have to spend time searching for others to trade with a huge
waste of resources.
- This searching is unnecessary with money, the set of assets that people regularly
use to buy g&s from other people

THE 3 FUNCTIONS OF MONEY

1. Medium of exchange: an item buyers give to sellers when they want to
purchase g&s
2. Unit of account: people use to post prices and record debts
3. Store of value: an item people can use to transfer purchasing power from the
present to the future

THE 2 KINDS OF MONEY

1. Commodity money: takes the form of a commodity with intrinsic value
Examples: gold coins, cigarettes in POW camps
2. Fiat money: money without intrinsic value, used as money because of govt
decree Example: the U.S. dollar or the EURO
THE MONEY SUPPLY
- The money supply (or money stock): the quantity of money available in the
economy
- What assets should be considered part of the money supply?
Two candidates:
▪ Currency: the paper bills and coins in the hands of the (non-bank) public
▪ Demand deposits: balances in bank accounts that depositors can access on
demand (by writing a check for example)

Measures of Money Supply

▪ M1: currency, demand deposits, traveler’s checks, and other checkable deposits.
▪ M2: everything in M1 plus savings deposits, small time deposits, money market
mutual funds, and a few minor categories.
The distinction between M1 and M2 will often matter when we talk about “the money
sopply”.

CENTRAL BANKS & MONETARY POLICY

▪ Central bank: an institution that oversees the banking system and regulates the
money supply
▪ Monetary policy: the setting of the money supply by policymakers in the central bank
▪ Federal Reserve (Fed): the central bank of the U.S.
▪ European Central Bank (ECB): the central bank of the UE
Central bank control tools
Money supply:
- National Mint and Stamp Factory
- Deposit control Banking financial intermediaries (Financial System):
▪ Cash ratio: % of the total volume of deposits that banks must keep on hand to
meet possible cash withdrawals by the public.
▪ Open market operations: purchase and sale of securities by the BC.
▪ Rediscount rate: price charged by the BC to commercial banks for lending
them money.
▪ Level of reserves: volume of reserves that commercial banks must keep on
account.
Commertial banks: functions
These are the financial intermediaries that channel savings from households and
companies, which are not going to make immediate use of their funds, to other
companies or the public sector that are going to use them in productive activities.

BANK RESERVES
- In a fractional reserve banking system, banks keep a fraction of deposits as
reserves and use the rest to make loans.

- The Fed/ECB establishes reserve requirements, regulations on the minimum

amount of reserves that banks must hold against deposits.

- Banks may hold more than this minimum amount if they choose.

- The reserve ratio, R

▪ Fraction of deposits that banks hold as reserves
▪ Total reserves as a percentage of total deposits

BANK T-ACCOUNT
▪ T-account: a simplified accounting statement that shows a bank’s assets & liabilities.
▪ Example:

▪ Banks’ liabilities include deposits, assets include

loans & reserves.
▪ In this example, notice that R = $10/$100 = 10%

BANKS AND THE MONEY SUPPLY: AN EXAMPLE

Suppose $100 of currency is in circulation. To determine banks’ impact on money
supply, we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system: banks hold 100% of deposits as reserves, make
no loans
3. Fractional reserve banking system

CASE 1:
- No banking system
- Public holds the $100 as currency
- Money supply = $100
CASE 2:
- 100% reserve banking system
- Public deposits the $100 at First National Bank (FNB).
- FNB holds 100% of deposit as
reserves:

Money supply = currency + deposits = $0 + $100 = $100

In a 100% reserve banking system, banks do not affect size of money supply.
CASE 3:
- Fractional reserve banking system
- Suppose R = 10%. FNB loans all but 10% of the
deposit:
- Depositors have $100 in deposits, borrowers
have $90 in currency.
Money supply = C + D = $90 + $100 = $190

Fractional reserve banking system  How did the money supply suddenly grow? When
banks make loans, they create money.
The borrower gets:
- $90 in currency—an asset counted in the money supply
- $90 in new debt—a liability that does not have an offsetting effect on the money
supply
A fractional reserve banking system creates money, but not wealth.
 - Fractional reserve banking system
- Borrower deposits the $90 at Second National Bank.
- Initially, SNB’s T-account looks like this:
- If R = 10% for SNB, it will loan all but 10%
of the deposit.

- Fractional reserve banking system

- SNB’s borrower deposits the $81 at Third National Bank.
- Initially, TNB’s T-account looks like this:
- If R = 10% for TNB, it will loan all but 10%
of the deposit.

- Fractional reserve banking system Fractional reserve banking system

The process continues, and money is created with each new loan.

Original deposit = $ 100.00

FNB lending = $ 90.00
SNB lending = $ 81.00
TNB lending = $ 72.90
____________________________
Total money supply = $1000.00

THE MONEY MULTIPLIER

- Money multiplier: the amount of money the banking system generates with
each dollar of reserves
- The money multiplier equals 1/R.
- In our example, R = 10% money multiplier = 1/R = 10 $100 of reserves creates
$1000 of money

Example:
Banks and the money supply
While cleaning your apartment, you look under the sofa cushion and find 50 € (and a
half-eaten pizza). You deposit it in your bank account.
The ECB’s reserve requirement is 20% of deposits.
a. What is the maximum amount that the money supply could increase?
b. What is the minimum amount that the money supply could increase
SUMMARY

• Money serves three functions: medium of exchange, unit of account, and store of
value.

• There are two types of money: commodity money has intrinsic value; fiat money does
not.

• The U.S and EU. uses fiat money, which includes currency and various types of bank
deposits.

• In a fractional reserve banking system, banks create money when they make loans.
Bank reserves have a multiplier effect on the money supply.

• Because banks are highly leveraged, a small change in the value of a bank’s assets
causes a large change in bank capital. To protect depositors from bank insolvency,
regulators impose minimum capital requirements.

• The Federal Reserve is the central bank of the U.S as the Central European Bank for
UE, are responsible for regulating the monetary system.

• They control the money supply mainly through open-market operations. Purchasing
govt bonds increases the money supply, selling govt bonds decreases it.

DEMAND FOR MONEY

Example:
50,000 is saved, and you can only choose between cash and
bonds:
- Money: can be used for transactions, it does not yield
interest.
There are two types:
▪ Cash: coins and bills.
▪ Demand deposits: are bank deposits against which
checks or “Bizum” may be drawn.

- Bonds: they yield a positive interest rate, but do not can be used to perform
transactions.
The ideal is to have as much money as bonds. The question is, in what proportions. It
depends on two variables:
1. The level of transactions: to have enough cash on hand and not have to sell
bonds too often.
2. The interest rate of bonds: the reason for having wealth in bonds is that they
yield interest. The higher they are, the more willing we are to buy bonds.

▪ Let MD be the money demand of the economy as a whole, MD is the sum of the
individual money demands. It therefore depends on the level of all transactions in the
economy, but is probably more or less proportional to nominal income.
▪ If nominal income increases, for example, by 10%, it is reasonable to think that the
value of transactions in the economy will also increase by 10% or so.

Thus, the relationship between the demand for money, nominal income, and the rate of
interest is:

The demand for money (MD), is equal to nominal income (Y), multiplied by the interest
rate function (L(i)), where L is liquidity.
The negative sign indicates that the interest rate produces a negative effect on the
demand for money (a rise in the interest rate reduces the demand for money, as people
place more of their wealth in bonds).

Therefore:
- MD increases in proportion to nominal income. If Y doubles (2Y), then MD also
doubles (becoming 2YL(i)).
- MD depends negatively on the type of interest. A rise in the interest rate reduces
the demand for money.

The curve MD represents the relationship between the

demand for money and the interest rate corresponding to the
nominal income level (Y).
It has a negative slope, because when the lower the interest
rate, the more money individuals want
MONEY SUPPLY AND MONETARY EQUILIBRIUM
- The only variety of money that exists is cash, which is offered by the central
bank.
- The central bank offers an amount of money equal to M, so MO =M, where MO
is the money supply.
- For a market in equilibrium, (MO =MD), so if (MO =M) and (MD =YL(i)€),
then, (M=YL(i)), which means that the interest rate (i), must be such that
individuals, given their income Y€, are willing to have an amount of money
equal to the existing money supply M, where L is liquidity. This equilibrium
relation is called LM.

This figure represents the equilibrium condition:

▪ The demand for money MD , corresponds to a given
level of nominal income Y€. It has a negative slope,
because when the interest rate rises the demand for
money decreases.
▪ The money supply MO , is equal to M independent
of the interest rate
▪ The equilibrium is at A, and the equilibrium interest
rate is i.

Examples:
▪ How does an increase in the nominal income affect the interest
rate:
 - An increase in nominal income from Y'€ to Y'€
raises transactions, which increases the demand for
money whatever the interest rate.
- The demand curve for money shifts towards the right
of MD to MD’.
- The equilibrium is transferred from A to A'.
- The interest rate rises from i to i'.

“An increase in nominal income leads to an increase in

interest rate”

▪ How does an increase in the offer monetary at interest rate:

- An increase in the money supply MO = M to MO ‘
=M', causes a shift of the money supply curve to the
right from MO to MO ‘.
- The equilibrium moves from A to A' and the interest
rate falls from i to i'.
“An increase in the money supply by the banks. The central
bank's interest rate is lowered.”

INTRODUCCTION TO CRYPTOCURRENCIES

DEFI → Collaborative economy decentralised. Peer to peer (P2P) is an intrinsic part

of the block chain
Risks:
- High risk of volatility (speculation)
- Hacking
- Rug pull
- Inpermanent lost
- Everything is digital → block chain is the technology that supports
cryptocurrencies

Types of cryptocurrencies: BTC, STH, DODGE, WORLD COIN

How does the collaborative economy works?

 1. Someone request a transaccion
2. The requested transaction is broadcast to P2P network consisting of computers
known as nodes.
3. Validation  the network of nodes validates the transacction and the user’s
status using known algorithms.
4. A verified transaction can incolve criptocurrency, contracts records or other
information.
5. Once verified, the transaction is combined with other transactions to create a
new block of data for the ledger.
6. The new block is then added to the existing blockchain, in a way that is
permanent and unalterable.
7. The transaction is complete.

 Criptocurrency is a medium of exchange, created and stored electronically in

the blockchain, using encriptiontechniques to control the creation of monetary
units and to verify the transfer of funds. Bitcoin is ythe best known example.

Criptocurrency:
- Has no intrinsic value in that it is not redeemable fr another commodity such as
gold.
- Has no phisical form and exist only in the network
- Its supply is not determined by a central bank and the network is completely
decentralised.
LM CURVE