Introduction to

Monetary Economics

Lecturer
Prof. Sheriffdeen A. Tella
• Course outline
– Definitions , origin or evolution, types and functions
of money. Roles of money in capitalist and socialist
economies. Financial institutions: Banks, non-
banks. Functions of banks. Central bank. Credit
creation in banks, Insurance. Theories of demand
for money; supply of money. Theories of interest
rates. Recent development in monetary thought.
Monetary policy: objectives, formulation, lags,
expansionary and contractionary policies, monetary
feedbacks. Problems of monetary policy in LDCs.
Monetary transmission mechanism. Effectiveness of
monetary policy.
• Recommended Textbooks:
• Ajayi, Simeon I. and Oladeji O. Ojo (2006) Money and Banking: Analysis and
Policy in the Nigerian Context, Ibadan: Daily Graphics Nigeria Ltd. 2nd Edition.
• Baye Michael R. and Dennis W. Jansen (2006) Money, Banking and Financial
Markets: An Economics Approach, Delhi: AITBS Publishers, Indian Edition.
• Jhingan, M.L. (2004) Money, Banking and International Trade, 5th Edition;
Delhi:Vrinda Publications Limited. Reprint.
• Mishkin, Frederic S. (2010) The Economics of Money, Banking and Financial
Markets, Pearson, Global Edition.
• Nnanna, O.J., A. Englama and F.O. Odoko (2004) Financial Markets in Nigeria,
Abuja: Central Bank of Nigeria.
• Ojo, M.O. (2001) Monetary Management in Nigeria, Abuja: Central Bank of
Nigeria.
• Subrata Ghatak (1983) Monetary Economics in Developing Countries, London:
The Macmillan Press.
• Vaish, M.C. (2000) Monetary Theory, New Delhi: Vikas Publishing House Ltd.
15th Edition.
• What is money?
• A commodity generally accepted as medium of exchange
and for settlement of debt in a community or country.
• A medium in which prices and values are expressed.
• A major measure of wealth
• It is derived from the Latin word “moneta” meaning
“coin” and French word “monnaie”.
• Technical definitions: M1, M2, M3, Accounting & CBN
• Monetary economics is the branch of economics that
studies different competing theories of money and
provides framework for analysing money and its
functions.
• Types of money:
– Commercial money: debt created by banks such as credit
cards, money order, postal order. Also called money
substitutes.
– Fiduciary money: backed up by trust e.g. cheque
– Fiat money: inconvertible paper money-currency
– Commodity money: value comes from commodity
– Near monies: can be used to settle certain debts but can be
converted to money shortly e.g. treasury bills, govt. securities,
etc.
• Functions:
– Static: Medium of exchange; unit of account; store of value;
standard for deferred payment.
– Dynamic functions: include determining boom and depression,
production and consumption, inflation and deflation. Makes
division of labour and specialisation possible
• Characteristics of money: General acceptability,
homogeneity, relative scarcity, durability, portability
and divisibility.
• Value of money: value of money is what money can
buy. There is inverse relationship between value of
money and price of goods. That is, when prices are
high, the value of money is low, vice-versa.
• Roles money plays in economy: depends on school of
thought. Classical and Neo-classicals, money plays
neutral role in growth and development while the
Keynesians see money playing major roles. Keynesians
also see money as non-interest bearing financial asset.
• Moneyless Economy or Barter system:
– Direct exchange of goods for goods or services for
services.
– Also referred to as counter trade.
– To be qualified, exchange will have to be organized
without use of money; must be double coincidence of
want; direct or indirect exchange.
– Factors responsible for proliferation: extreme distrust
in monetary system; religious objection to use of
money; totalitarian regime; absence of system of
private property like in communist system; low stage
of development; inadequate sense of value; lack of
forex for international trade
• Limitations:
– Difficulty of double coincidence of want
– Issue of unit of exchange (amount0
– Quality of goods to exchange – freshness, size,
durability, etc.
– Restriction in the number of transactions per day
– Increasing size of communities and increasing
needs of many people
– Development of industrial economies and
required efficient resource allocation
The Financial System
• Financial System comprises: Institutions, Markets and
Instruments.
– Financial institutions:
• Banks and non-bank institutions:
– Deposit money banks – commercial, merchant,
development or specialized banks,
microfinance banks, community banks, etc.
– Non-bank institutions – finance houses,
insurance, pension fund, bureau-de-change,
etc.
– Financial markets: Money and Capital
markets:
• Money market is where financial
instruments with maturity of 0-2 years or
short-term instruments are traded.
• Capital market is where medium-term
and long-term financial instruments are
traded.
• Medium-term instruments maturity is 2-5
years and long-term instruments maturity
is 5+ years.
– Financial instruments:
• Short-term: money, bank draft, treasury
bills, treasury certificates, short-term
loans and credits, insurance premium.
• Medium-term: medium-term loans,
letters of credit, insurance premium for
merchandise.
• Long-term: development stocks, long-
term bonds, shares, debenture, pension
fund, insurance premium for businesses.
• Roles of the financial system:
– Mobilisation and pooling of funds as financial
intermediaries as banks and non-banking
institutions thereby promoting banking habits.
– Capital formation
– Allocation of financial resources
– Monitoring investments
– Facilitating trading, diversification and management
of risks including risk sharing
– Exerting corporate governance after providing
finance
– Providing information about investment
opportunities
• Theories of Banking:
– Credit creation theory: proposes that a bank
can create money. Banks do not lend out
deposits but create money from deposits as a
consequence of bank lending. Constraints are
deposits and reserve ratios.
– Fractional reserve theory: refers to the policy
that requires bank to keep a proportion of its
deposits in reserve rather than lend all.
– Debt intermediation theory: relates to the
banking function as provider of loans and
advances for customers.
• Financial Institutions
• The Banks: Deposit money banks
– Commercial banks: engage mainly in retail
banking and operate all kinds of deposits for all
types of customers from individuals to corporate
bodies.
• Functions
– Primary functions are to collect deposits and
make payments
– Act as agency in collecting cheques, bills,
drafts, receipts of interests and dividends on
behalf of customers.
–Provision of loans and advances to
customers
–Discounting of bills, cash credit, etc.
–Creation of money
–Undertaking safe custody of valuables
for customers
–Foreign exchange dealings
–Underwriting shares and debenture
–Promote saving and investment
habits.
• Types of Commercial Banks
– Unit banking
– Branch banking
– Correspondent banking.
• Deposit Money Banks:
– Merchant Banks are wholesale banks that deal
with customers requiring special needs like
international trade or international business and
setting up of or expanding businesses.
– Functions:
• Portfolio management- joint ventures, mergers &
acquisitions
• Raising funds for clients: debt financing
• Broker in stock exchange
• Equipment leasing
• Managing public issue of companies
• Money market operation -
• Services to public sector – Joint ventures, PPP
• What are the distinguishing features of
commercial and merchant banks.
• Specialised or Development Banks:
These institutions are features of developing
economies.
– Bank of Industry: For lending to manufacturers
of all types – SMEs & large firms.
– Bank of Agriculture and Cooperatives: for
agriculture and cooperative societies
– Federal Mortgage Bank: for residential and
commercial buildings and construction sub-
sector.
– Bank of Commerce and Industry: for
commercial businesses and industries.
• Theories:
– Catalyst thesis: Banks play creative roles in
industrialisation processes but not directly
involved.
– Exigency thesis: playing effective roles in
mobilization of funds for businesses such as
assisting SMEs to obtain loans from international
financial institutions and guarantee such loans.
– Gap thesis: The banks serve to bridge funding
gap for businesses, particularly from domestic
sources.
• Functions of specialized banks:
– Mobilise medium to long term funds from third party
for onward lending to specific sector of an economy
– Engage in securities activities in businesses
– Serve as guarantor in fund raising, particularly from
external sources
– Monitor fund disbursements and project
implementation
– Sometimes participate temporarily as shareholder in
business being financed
– Provide financial advise for clients
– Can serve as Agent banks mobilizing funds from many
creditors for a client.
The Central Bank
• A central bank is a regulatory authority and
usually owned by the central government of a
country.
• It can also belong to a number of countries
under monetary union arrangement.
• It is usually a single bank with or without
branches.
• It bears different appellation in different
countries e.g. Central Bank of Nigeria, Bank of
England, Bank of Ghana, Federal Reserve Bank.
• Functions: (Primary & Secondary)
– Bank of issue and currency regulator
– Custodian of cash reserve for government and
other banks
– Custodian of international currencies or foreign
reserves.
– Lender of last resort to other banks
– Clearing house for transfers and settlements
among banks
– Management of external reserves
– Management of value of domestic currency vis-à-
vis foreign currencies.
• Functions: (Developmental)
• These are functions that are peculiar to central
banks in developing countries. They include:
– Financial intervention in development projects
through specialized or development banks
– Provision of domestic and international statistics for
use by policy makers and researchers
– Involved in the training manpower for the financial
system
– Involvement in the establishment of specialized
financial institutions and supply of initial manpower
needs to the institutions.
• Central Bank Policy Tools and Techniques
– Tools and techniques can be referred to as:
• Direct- these are monetary policy tools and techniques
that have elements of force in changing volume, price
and direction of money in an economy.
• Indirect – they are market based monetary instruments
or techniques that when applied can change the
volume, price and direction of money in an economy. It
has no element of force but market mechanism.
• Quantitative – monetary tools and techniques that are
used to control volume and price of money.
• Qualitative – also called selective tools which are
monetary tools and techniques that affect the direction
or allocation of money in an economy.
• Direct monetary tools & techniques:
– Selective credit control
– special deposit
– credit rationing
– administered interest rates, etc.
• Indirect tools and techniques:
– OMO
– Reserve ratios or reserve requirements,
– discount rate,
– interest rate (market interest rates),
– Repurchase rate (Repo),
– moral suasion, etc.
• Quantitative tools:
– Bank rate (MPR),
– Repo rate in India (for repurchasing securities),
– Legal reserve ratios (cash and liquidity reserve ratios),
– OMO,
– market interest rates,
– special deposits,
– liquidity adjustment facilities, etc.
• Qualitative tools:
– Credit rationing or selective credit control,
– moral suasion,
– consumer credit regulation, etc
• Other financial institutions:
• Microfinance Banks
• Banks established to:
– finance micro and small scale businesses
– Service unemployed, low income individuals or
group who are desirous of starting, re-starting
and/or expanding their small businesses in
manner consistent with ethical lending practices;
– Encourage financial inclusion by enabling socially
vulnerable people;
– Encourage saving habit
• Functions:
– Engage in primary functions of all banks viz
accepting deposits and making payment;
– Help low income households to stabilize income
flows;
– Encourage saving habits in communities thereby
promoting financial inclusion and income growth;
– They assist local businesses and Associations by
playing the roles of treasury;
– Act as pay points for businesses and Associations
by paying staff salaries and allowances.
• Advantages:
– They provide collateral-free loans
– Disburse loans quickly and without delay
– Help vulnerable people to meet immediate financial
needs
– They promote self sufficiency and entrepreneurship
– Provide extensive portfolio of loans for different needs.
– Promote consumption, saving and investment
– Provide both financial and non-financial products such
as loans, savings, insurance, pension, remittances,
procurement of items for business and consumption.
• Disadvantages:
– Harsh condition for loan repayment
– High interest rates
– Limited funding capability.
• Note: Apart from MFBs, other financial
institutions that offer microfinance services
are community banks, cooperative societies,
credit unions, etc.
 Non-Bank Financial Institutions
• Insurance: is a policy or contract in which an insurer
indemnifies another against losses from specific perils or
dangers or contingencies.
• It is a situation in which the insured pays some money
(premium) for annual coverage against physical risk or
financial loss
• There are two types viz: General insurance and life
insurance. So, insurance can be purchased for such risks
as auto, shipping or maritime, home or property, fire,
health, life, etc.
• Purpose: to reduce financial uncertainty and make
accidental losses manageable.
• Benefits:
– Coverage against uncertainty thus assist in reducing
cost of managing risk through cost sharing;
– Cash flow management
– Provides saving and investment opportunity
particularly for life assurance.
• Insurance and Assurance: most insurance
coverage are for activities that may occur and
are thus referred to as insurance while life is
referred to as assurance because the probability
of death is one i.e. we have life assurance.
• Motor insurance: Comprehensive vs Third
party insurance.
– It is compulsory for vehicles in Nigeria to have
either comprehensive or third party insurance.
– Comprehensive insurance for vehicle is when a
vehicle is insured to cover the vehicle and other(s)
in case of accident or when a vehicle is stolen or
against other risks. The premium is high and
coverage of the insurance is equally wide.
– Third party insurance is when the insurance
company takes care of the third party’s vehicle in
case of accident.
• Pension fund: Refers to fund from which
pensions are paid to employees after
retirement. The fund accumulates from
monthly contributions from employers,
employee or both.
• Typically managed by companies referred to
as Pension Fund Administrators (PFAs), private
companies organized by employers or
employees or agreed to by both.
• Main benefit is the assurance that fund is
available for employees on retirement.
• Main types of Pension Scheme:
– Contributory Pension Scheme.
– Voluntary Contribution Scheme,
– Micro Pension scheme (for self employed),
– Cross-Border Pension Scheme (for those
working outside the country),
– Retirement Plan (individual investment plan)
and
– Institutional Pension Fund Management
(corporate bodies and public sector insurance
but not for individuals).
• The Stock Exchange or Stock market or
Europe bourse is an organized market for sale
and purchase of shares, stocks or bonds
(securities).
• It is a meeting place for buyers and sellers in
the primary and secondary market.
• Primary market is where firms float new
stocks and bonds for general public purchase.
• Secondary market is where existing stocks are
traded.
• Types of stocks: Growth stocks; Income
stocks; Dividend stocks; New issues; Defensive
stocks; Strategy or Stock picking; Penny stock;
cyclical stocks; value stock.
• Offer for sale and offer for subscription
• Functions of the Stock Market:
– Provide avenue for sale and purchase of securities
or shares or stocks
• Security and Exchange Commission (SEC): The
regulatory authority for the capital or stock
market market.
• Functions
 Theories of Demand for Money

• The Classical or Quantity theory

• The Neoclassical theory or
Cambridge School
• The Keynesian theory
• The Monetary school
• Issues in demand for money
• Nigeria: The TATOO Debate
 The Classical Theory of DD for Money

• The authors: Gerald de Malves, Thomas

Mun, Robert Bruce Cotton, Henry
Robinson and later John Locke all in 16th
century,
• Dudley North, 1661; Issac Gevaise, 1720;
Richard Cantillon, 1730; Jacob
Venderlint, 1734 and David Hume
popularise it in 1752.
• David Hume popularise it in 1752 in his essay
“Of Money”:
• Based on Classical economics assumptions viz:
– Economy always in full employment and
equilibrium
– Prices move up and down inhibited but based on
market mechanism
– Money is neutral in effecting real sector of the
economy
– Money supply is exogenously determined by the
monetary authority.
• There exists positive relationship between money
and price of goods.
• There is strict proportionality in the relationship
between aggregate money suppy and prices of
goods
• This implies that when money is doubled, prices
will also double since output cannot be increased.
• However, there came a review of strict
proportionality due to factors that can change
velocity such as changing nature of monetary
institutions.
• Irivin Fisher (1917) modernise the theory as
Quantity Theory of Money or Equation of
Exchange:

– MV = PQ
– Or
– MV = PY
– Where
• M = money demanded
• V = Velocity of money
• P = Price of Goods
• Q =Output or Y = Income.
• The equations says that ‘movement of
money from one hand to another must
at the end of the day be equal to the
amount of goods exchanged’ i.e. total
quantity of money (MV) paid for goods
and services must equal their value (PQ).
• To the classical economists money is held
for transaction purposes, so people are
always in the habit of exchange of goods.
• The velocity (V) is assumed constant
because it is determined by institutional
factors like payment period in the society
just as quantity (Q) is also assumed to be
constants because the economy is at full
employment whereby output cannot be
increased.
• Thus, any change in money holding (M),
increase for instance will only lead to
increase in price (P).
• Criticism:
• Unrealistic assumptions particularly not
recognising money in the demand and supply
equation; and only long run consideration.
• Ignore the role of money as store of value
• Velocity is not constant because of change in
policies over time.
• Neglect real balance effect of money and
value of money
 The Cash Balances Approach OR The
Cambridge Equation
• Cambridge economists like Alfred Marshall,
A.C. Piguo, Denis Robertson and J.M. Keynes
formulated the equation as alternative to Irvin
Fisher’s.
• Regard money within the context of value
theory i.e. money has value like any other
commodity and thus, there is DD & SS for it
which depicts its value.
• The demand for money is to act as ‘store of
value’.
• How much people want to hold depend on
income.
• Income determines the quantity or volume of
purchases and sales which in itself is a fraction
or proportion of the total income
M = kPY where M is the supply of money; k is
the fraction of real money income (PY) which people
hold in cash and spend; P is price level and Y is the
aggregate income of the community.
• Price level
P = M/kY which is value of money

 Like other commodities, determinants

of money demand include price of
commodities, price of financial
instruments (interest rates), wealth,
national income, etc.:
 Md = f(P, Pc, rc, W, Y…)
 Criticism:
Neglect of Saving & Investment
Fails to explain dynamic
behaviour of prices
Ignore effect of interest rate on
money
Neglects real balance effects
 The Keynesian Theory
• Keynes was part of the Cambridge School
but further research lunched him into
new discoveries and assumptions which
culminated into 3 motives:
• Transactionary Motive
• Precautionary Motive
• Speculative Motive
• Keynes Assumptions:
– The economy can be in equilibrium
without full employment
– All factors of production are in perfectly
elastic supply so long as there is
unemployment
– All unemployed factors are homogeneous
and perfectly divisible and
interchangeable
– Prices are sticky downward
– Money is not neutral in the short run such
that effective demand and quantity of
money do change in the same proportion so
long as there are any unemployed resources
– Given homogenous resources, there will be
diminishing returns as employment
gradually increases.
– The remuneration of factors entering into
marginal cost will not change in the same
proportion.
• Transactionary Demand: Like the classical
economists, money is demanded for day-to-
day purchases. How much held by people
depend on their incomes.
– i.e. MT = f(Y)
• Precautionary Demand: Like Cambridge
school, money is also held for unforeseen
circumstances, aside from transactions.
This also depend on peoples’ incomes.
– MP = f(Y)
• Speculative Demand:
– Keynes major addition to the theory of
demand for money.
– Opined that people choose between
holding money which yields zero
income and investing in bond which
yields some income
– There is inverse relationship between
price of bond and interest rate
– People invest when interest rate is rising and sell
when interest rate is falling, such that they make
gains.
– So, demand for money is related to income bust
also interest related or interest elastic.
– MSP = f(Y, i)
– Overall:
• MD = L1(Y) + L2(Y) + L3 (Y, i) = f(Y, i)

• GRAPH
• Liquidity trap region: When interest rate is so
low that people prefer to hold money
indefinitely.
• Superiority over Quantity Theory
– Discarded believe that relationship between quantity
of money and price is direct and proportional.
– Brought out the relationship between money, prices,
output and employment as against pure theory of
prices.
– Shows the importance of interest rate in theory of
output, through investment and to employment,
thus
– It brings together the monetary and real sector, as
well as role of quantity of money under
unemployment and full employment situations.
• Criticism
– Position than money affect the economy indirectly
through interest rate, bond prices, etc is not true.
Rather, money can affect the economy directly.
– Assumption that demand for money is unstable is
not true as empirically shown by Friedman.
– Money can be exchanged for many other
commodities beside bond.
– The conclusion of Keynes that money may not
affect national income at liquidity trap region is
not empirically supported in reality.
 The Monetarist school
• The Chicago School: Milton Friedman,
Henry Simons, Lloyd Mints, Frank Night
and Jacob Viner.
• Milton Friedman – Led the Monetarist
Revolution with article entitled:
– The Quantity Theory of Money: A Re-
statement (1956)
• Friedman opined that the Demand for money
is the first part of wealth holders needs and is
identical to a demand for consumption
service. This implies that money, like the
position of the classical economists, is meant
for transaction purpose.
• Regards amount of cash balances, (M/P), as a
commodity which is demanded because it
yield satisfaction or benefits to its holders
such that demand for money forms part of
wealth or capital theory. Thus, money
– Is part of total wealth that include current
and expected incomes, bond equities,
physical goods and human capital.
– With expected rate of return like other
commodities
– Forms part of non-human wealth
– Has utility attached to its services which
determine liquidity proper
Thus, demand for money by individual is:
M/P = f(y, w, Rm, Rb, Re, gp, u)
• Where:
– M = total money stock demanded; P = price level; y
= real income; w = non-human wealth; Rm =
expected rate of return on money; Rb = expected
rate of return on bond; Re = expected rate of return
on equity; gp = expected nominal rate of return on
physical assets, u = other variables beside income
that affect utility of money.
 Aggregate demand for money function is the
summation of individual demand function.
 A increase in expected yield for the different assets
reduces demand for money.
 The income to which cash balances (M/P) are
adjusted is the long term level of income rather than
current income.
 Empirically, the income elasticity of money demand is
greater than 1 implying income velocity falls over the
long run i.e. demand for money is stable in the long
run or that interest elasticity for long run money
demand is negligible.
 To Friedman, the supply of money is independent of
demand for it, such that if MS is unstable, it is due to
activities of monetary authorities.
 The dd for money is related in a fixed way to their
permanent income.
 If monetary authorities decide to
buy securities and thus increase MS
people who sell will find that their
money holding has increased relative
to their permanent income, vice
versa
 They are likely to spend the excess
on consumption of goods and
services, as well as on assets, vice
versa.
 A change in MS causes proportionate
change in prices or income or both.
 Thus, given the dd for money and
employment level, it is possible to
predict the effects of changes in MS on
total expenditure and income. In under
full employment, increase in MS will
increase output and raise employment
with rise in total expenditure in the
short run.
• Friedman’s theory can be explained in graph:
• Criticism
– Very broad definition of money including time
deposits;
– Money regarded as luxury good (like inclusion of fixed
deposit) without luxury good effects empirically;
– MS regarded as exogenously determined;
– Ignores effects of prices, output & interest rates on
money;
– Does not consider time factor;
– No positive correlation between MS & GNP as
Friedman postulated (Kaldor on Britain).
– Important for introducing capital theory & Income.
 Friedman vs Keynes: Issues in DD for Money

• Friedman used broad definition of money than

Keynes in dd for money function; money as an
asset or capital good
• Demand for money as function of many variables
in Friedman while Keynes sees its alternative as
bond.
• To Keynes, changes in money affect economic
activities indirectly through bond prices and
interest rate while in Friedman, monetary changes
directly affect prices and production of goods.
• Keynes divides money into “active”
(transactionary & precautionary) and “idle”
(speculative dd) while Friedman said money is
held for variety of purposes and never idle.
• Friedman introduced permanent and nominal
income to explain the demand for money
while Keynes made no such distinction.

• W.J. Baumol (Treat to explain Keynes)

• Assignment: The TATOO Debate
 Money Supply Theory
• What constitute Money Supply (MS) or Money
Stock?
• There are two schools of thought or groups viz:
Exogenous Group: the Central Bank (CB) is
assumed to have the wherewithal to determine MS
using the monetary tools and techniques within its
purview. The tools are both quantitative (OMO,
Reserve Requirements, Special deposits, interest
rates, etc.) & qualitative (credit rationing, moral
suasion, etc.)
 Endogenous Group: Repudiates supremacy of
the Central Bank to control or determine MS
which is believed to be determined by
economic activities of the banks and non-bank
public as well as the CB itself ( referred to as
Portfolio approach to MS determination).
Money creation by banks depends on demand
for credit by customers which in turn depends
on economic conditions of the country; the
desire to hold money by the public is
important just as the central bank’s monetary
policy decision.
• Generally determinants of MS are:
Reserve ratio – cash reserve
requirements
Level of bank excess reserves
Desire to hold money rather than
deposits by public i.e. currency with the
public.
 This together is referred to as High
Powered Money (HPM) or Monetary
Base (MB).
• Cash Reserve requirement is the ratio
of cash to current and time deposit
liabilities which is determined by law.
Currency or cash held by banks in their
till is not included in the minimum
required reserve ratio.
• Bank or excess reserves consist of
reserve on deposit with the central
bank and currency in their till or vaults.
• The HPM or H or MB is the base for expansion of
bank deposits and creation of MS. The supply of
money varies directly with changes in the
monetary base and inversely with the currency
and reserve ratios.
• Other factors determining MS are:
– Interest rates,
– Incomes
– Changes in business activities
– behaviour of banks, and
– Behaviour of the public
• Portfolio approach to MS determination:
– Relates to roles of banks and non-bank public in
portfolio shifts and central bank reactions to it that
determine money stock rather than money supply.
– That is, stock of money at any time depends on
portfolio decision of the three agents. The CB
decides the amount of HPM to supply to the mkt;
the banks decides on the composition of financial
assets to hold in loans and in excess cash reserves
while the non-bank public decides on how to
allocate holding of monetary wealth among
competing assets.
– The multiplier takes cognisance of the three actors.
Money Supply Multiplier

• HPM = H = C + RR + ER (1)
–Where C = currency; RR = Required
Reserves; ER = Bank or Excess
reserve
MS or M consists of deposits (D) and
currency held by public (C) i.e.
M=D+C (2)
The relationship between M and H can be expressed
as the ratio of M to H such that:
M/H = D + C / C + RR + ER (3)
Divide each item on the right hand side by D (why)
M/H = D/D + C/D / C/D + RR/D + ER/D (4)
OR
M/H = 1 + C/D_ =m
C/D +RR/D + ER/D (4’)
By substituting Cr for C/D and Rr for RR/D, (4)
becomes
M/H = 1 + Cr / Cr + RRr + Err = m (5)
Thus high-powered money is:
H = Cr + RRr + ERr / 1 + Cr x M = mM (6)
And money supply:
M1 = 1 + Cr / Cr + RRr + ERr x H = mH (7)
Eq. 7 defines MS in terms of H and thus expresses
MS as determined by four variables viz H, Cr, RRr &
Err.
The higher the value of the H, the higher will be
the MS. The lower the reserve ratio (RRr), the
cash currency ratio (Cr) & the excess reserve ratio
(ERr), the higher the MS, vice versa.
As definition of money changes, the m also
changes. For example, with M2 definition we
have M1 + ………
So we have M2 = D + C + ….. (8)
Recall H =RR + Er + C
Therefore, the ratio of M2 to H is:
• M2/H = D + C + TD/RR + ER + C = m (9)
– Using (5)
• M2/H = 1 + Cr + Td/Rr + Er + Cr = (*) (10)
• M2 = (*) x H = mH (11)
• Money creation by Banks:
– When deposits are collected by banks, they do not
keep the money in their vaults waiting for the
depositors to come and collect it in future. Rather,
they do business with a proportion of the money
based on the regulations of the central bank.
– The central bank normally impose legal reserve
requirements (cash and liquidity reserve ratios,
always a prescribed small percentage) on banks.
– The cash ratio dictates how much from every
deposit the bank is supposed to keep as reserve
and cannot lend out to customers. So, banks
create money from the remaining amount.
 – How much is created is found by the formular:
• Deposit (D) x 1/reserve requirement
• Suppose there is a new deposit of N1000 in a
bank and the cash reserve prescribed by the
Central Bank is 10%, how much would the
bank create from this?
• Applying the formular above:
Change in Deposit or amount = deposit x cash
reserve
i.e. N1000 x 10% or N1000 x 1/10 = N10,000.00
• Process of credit creation:
 Monetary Transmission Mechanism
• MTM refers to channels through which
monetary impulses are communicated to the
real sector of the economy.
• There exist many subsidiary channels but the
main channels have been identified as:
– Commodity Channel
– Portfolio channel
– Credit channel
– Expectation channel
• Commodity channel: Money can be divided into
two namely inside and outside money (Gurley &
Shaw).
– Inside money is money that has corresponding
claim on the society, e.g. bank draft, treasury
bill, etc. Has no effect on aggregate demand.
– Outside money is money that has no
corresponding claim on the society, e.g. coins
and currency. This affects aggregate demand.
∆MS Com. Mkt ∆Agg DD
• Portfolio channel: this has to do
financial investments. Change in
money supply goes into financial
market and people use the money to
adjust their financial assets with a view
to maximize returns. The purchase of
financial assets provides funds for
borrowers or investors.
∆MS Fin.Mkt ∆Agg DD
• Credit channel: Increase in money
supply is expected to lead to fall in
interest rates in order to encourage
borrowers. So credits become available
for borrowers at cheaper rate than
hitherto. Borrowed funds are invested
leading to increase in aggregate
demand.
∆MS Crd.Mkt ∆Agg DD
• Price expectation: Expectation of price
changes when a change in money supply
occurs can drive up purchases or change in
aggregate demand. Anticipated increase in
money supply can be expected to drive up
prices of commodities which would result in
purchases to beat the expected price
increased. The action is also likely to drive up
prices.
• ∆MS Expectation ∆Agg DD
• SUMMARY OF MONETARY CHANNELS:
–Commodity prices thro’ outside
money
–Financial market thro’ portfolio
investments
–Exchange rate market thro’ forex
inflows
–Credit markets thro’ interest rates
movements.
 The Theories of Interest Rates
• Classical Theory of Interest Rates
• Neo-Classical Theory of Interest Rate
or Loanable Fund Theory
• The Keynesian Theory of Interest
Rate
• The Hicksian Theory or General
Equilibrium Theory of Interest Rate
• The Classical Theory:
• (Popularised by A. Marshall & A.C. Piguo)
– Assumptions
• Economy is at full employment and
equilibrium
• Money supply exogenously determined
• Prices are flexible, so interest rates can
move upward or down ward
• Level of income is constant over time
•All money saved go to investments such that S =
l
Interest rate is the equilibrating factor between
saving (s) and investment (I).
S = f(r)
I = g(r)
In equilibrium S = I
Whenever S > I, interest rate falls to attract
investors; and
When S ˂ I, interest rates rises to attract savers;
THUS
• Investment is a decreasing function of
interest rate.
• Saving in an increasing function of interest
rate.
• Saving, which depends on real income, is
motivated somehow by thriftiness of the
society and productivity of capital.
• Thriftiness is hinged on the preference to
postpone today’s consumption to future.
• So, the rate of interest serves as the reward
for the abstinence. Higher reward leads to
higher Saving.
• The demand side is the investment demand
schedule while the supply side is the saving
schedule.
• The equilibrium rate of interest is
determined at the intersection of saving
and investment.
• Either of the two curves can shift. Why?
 r
S

re

I
0 I = S S, I
Interest rate determination under classical theory
• Criticisms: Keynes posits that:
– income can vary not static or constant. Variation in
S and I caused by varying income.
– The two variables, S and I, are not independent of
each other as proposed. If invention, for instance,
make investment curve shifts, income will rise and
cause saving to rise.
– Neglect effects of investment on income but put
everything on interest rate. Lower investment
results in fall in output and employment, affecting
saving.
– Indeterminate theory because, according to
Keynes, it is not possible to know the level of
interest unless the level of income is
predetermined.
– Ignores other sources of saving or fund such as
bank credit
– Ignores monetary factors in the short run but
based everything on time factor and productivity
of capital.
– Economy is not always at full employment
– Interest rates is not reward for thriftiness or not
hoarding but reward for parting with liquidity.
The Loanable Fund Theory
• The neo-classical theory, proposed by
Knut Wicksell, and based largely on the
assumptions of the classical economists.
• Refined by Gunner Myrdal, Bertil Ohlin,
Bent Hansen, Eric Lindahl and L.
Robinson.
• Introduced money created by banks or
credit into funds available for borrowers.
• In original form, Wicksell contended that the total
supply of loanable fund consists of saving
determined by thrift of the society and amount of
bank credit created depends on liquidity rather
than interest rate.
• Investment is linked with productivity of capital
i.e. MEC concept. The MEC is expected to slope
downward and to the right because of the
diminishing marginal product of capital as
production process becomes more capital
intensive. Thus, investment slopes downward.
• r = f(I, S, M)………………….. See graph.
• Interest rate is the price of credit, determined by
DD and DD of loanable fund.
• Lerner explained “it is the price which equates the
supply of ‘credit’ or saving plus the net increase in
the amount of money in a period to the demand
for ‘credit’ or investment plus net ‘hoarding’ in
the period”
• Loanable fund: saving plus money created by
banks or financial system and dishoarding. Main
sources are corporate and private saving.
– Private saving depends on level of income which the
theory assumes as given but interest elastic.
 – Corporate saving are undistributed profits
and somewhat interest elastic.
– Dishoarding is represented by purchase of
financial assets or securities our of cash
balances or ‘excess of disposable income’.
• It is demanded by governments, business
unit and non-bank public for different or
similar purposes. It is largely interest elastic
and the curve is downward sloping.
• GRAPH & explanation
r
M S M+S

rn

rm

M I
DD & SS for LF
 r
h M S BC

S + M + BC
rn

rm

I + DH
h I

0 S,M,I,DH

Loanable Fund Theory of Interest Rate -Refinement

• I = Investment
• S = Saving
• H = hoarding
• DH = Dishoarding
• M = Money supply
• BC = Bank created money
• r = real rate of interest
• rm = market rate of interest
• rn = natural rate of interest
• Natural rate of interest refers to the
interest rate that equate natural Saving
(supply of fund) and Investment
(demand for fund) in the context of the
classical economics
• Market rate of interest is the rate that
equates Supply of loanable fund to
demand for fund for investment and is
usually below the natural rate, Why?
More loanable funds available.
• The demand for loanable fund is primarily
from government (public sector) for public
works, businesses (private sector) for
purchase of capital goods and consumers
(households) for purchase of durable goods.
• The level of supply of loanable fund is
determined by the actions of the banks
(money creation activities), the non-bank
public (income) and the monetary authorities
(monetary policy).
r = f(I, S, M, h)
• Superiority over Classical:
–Recognises role of monetary influences on
interest rate.
–Recognises role of banks and non-bank
public in saving and loanable fund equation.
–Classicals did not recognise role of hoarding
and regards money as an active factor rather
than a ‘veil’. i.e. money is no longer neutral.
–Hence identify natural rate of interest and
market rate of interest
• Criticisms:
–Based on full employment situation and thus
ignores unemployment and output variations
–Ignores income variations, incomes on new
savings and activated saving with new
incomes, it becomes and indeterminate
theory (A.H. Hansen)
–Ignores issues of liquidity and interaction
between monetary and real sectors.
–Does not regard saving as fully interest elastic.
Keynes’s Liquidity Theory of Interest Rates
• In Keynes analysis, saving (S) and investment
(I) perform different functions.
• Equality of S & I determine level of aggregate
output and may influence its composition.
• Under equilibrium, changes in S & I only
change output composition.
• So long as unemployment exists, manipulation
of monetary variables can change natural rate
of interest.
• Determinant of saving is level of real
income, though interest rate may also
influence it. Note this from his theory of
consumption.
• Interest rate determines level of
investment but within the context of
MEI.
• So, what determines the rate of interest
a lá Keynes?
• In the “General Theory ……..” interest rate is
determined in the monetary sector thro
interaction between demand for money and
supply of money. That is interest rate is purely
monetary phenomenon.
• Thus, “Liquidity Theory of Interest Rate”.
• The Assumptions of the theory:
– Equilibrium without full employment
– Money is active not neutral
– But money supply exogenously determined and fixed
in the short run
– Prices not flexible downward
• MS schedule is vertical i.e. interest inelastic.
• Demand for money consists of three parts viz:
– Transactionary
– Precautionary
– Speculative

Md = Mt + Mp + Msp (1)
The Mt and Mp are functions of income and can be
presented together as MT :
MT = L1 (Y) (2)
 The speculative demand is mainly a function of
interest rate but still affected by income:
Msp = L2 (I, Y)(3)
The demand for money equation can therefore be
expressed:
Md = Mt + Mp + Msp = MT + Msp = L1 + L2 = h(Y,i) (4)
• The speculative demand for money (regarded as an
investment function) can be said to influence total
demand schedule such that the MD is inversely related to
interest rate. That is, the higher the interest rate the less
the money people want to hold.
Graphs
• Money supply (Ms) on the other hand is
assumed to be exogenously determined by
the monetary authority and interest inelastic.
i
MS
• Equilibrium interest rate is determined at the
point of intersection between the Ms and Md
i
Ms

ie

Md

Ms , M d
• Rate of interest can change due to
change in either money supply or money
demand
• Keynes opines that continuous increase
in money supply could drive interest rate
to liquidity trap region where interest
rate would not affect either investment
or income i.e. monetary policy becomes
useless.
• Criticisms:
– Monetarists argue that demand for money is
interest inelastic therefore interest rate cannot be
determined in the monetary sector.
– There are other financial assets that people can
invest in beside bond and they have different
maturity period, so one interest rate cannot fit all.
– Liquidity trap region can hardly be reached before
monetary authority intervene or market forces
reacts.
The General Equilibrium Theory of Interest Rate

• Hicksian or IS-LM Analysis

• J.R. Hicks (1937) argued that there should be
an interest rate that equates the real sector
and the monetary sector of an economy.
• It should be analysed within the context of a
General Equilibrium such that
• Determination of interest rate can be found to
include saving, investment demand, liquidity
preference and quantity of money.
• Using Classical school of thought, interest rate
can be determined in the real sector by
demand for and supply of loanable fund
• Demand side is given by request for fund for
investment purpose
• Supply side is given mainly by saving and dis-
hoarding
• Need to look at the basic relationship between
rate of interest and income via changes in
saving and demand for money; thus
• If income (Y) rises, saving (s) will rise.
• To attract investors or borrowers, interest
rate would have to fall:

S = s(Y, r) (1)
I = I(r) (2)
In equilibrium:
S = I (3)
This is the classical position
• Given a series of level of changes in incomes, there
will be corresponding level of saving resulting in
shifts in the income-saving schedule:
• [Plot Graph]
r Y oSo
a Y1S1
b Y2S2

• c
• I
y
• When income increases from Yo to Y1,
saving also increases from So to S1, such
that there is a shift. Further increase in
income would lead to increase in saving
and another shift. Joining the points of
each new equilibrium together with a
line would produce an IS curve which
shows the inverse relationship between
income and interest rate.
• The IS curve:
r

IS
y
• IS curve is defined as “the locus of various
combinations of real income and interest rates that are
required to keep the economy in equilibrium in good
market (real sector) with saving equals investment.
• Using Keynes’ liquidity preference theory, Hicks
informed that if income increases, the demand for
money will increase and its curve will shift upward,
with the vertical money supply curve remaining
constant.
• Further increase in income will make demand for
money to shift further with the money supply curve
still remaining interest elastic.
• The LM Curve formation:
I MS

f
e
d Y2Md2
Y1Md1
Y0Md0
MS,Md
• The LM curve
r
LM

f
e
d

0 y
• The LM curve is defined as “the locus of
various combinations of real interest rates and
real income that are required to keep the
economy in equilibrium in the money market,
prices remaining constant”.
• The LM curve represents the monetary sector
or monetary policy sector of the economy just
as the IS curve represents the real sector or
the fiscal policy sector.
• The General Equilibrium Interest Rate:
r
LM

re

IS
ye y
re = equilibrium int. rate; ye = equilibrium income
• Criticism
– Mainly by Monetarists. For example, Karl Bruner called
it “Ruling Paradigm” explaining that the spectrum of
assets and liabilities connecting production of new and
old assets result in substitution and wealth adjustment
that cannot be captured with slopes of two curves.
– That is, it is too simplistic for the growing complex
world with varying transmission of monetary impulses.
Whatever the shortcomings, they theory provides the
bedrock for later empirical analysis on interest rates and
the economy.
Graphical demonstration of IS-LM curves
• Fiscal-Monetary Policy relationships:
r IS LM1
LM2
LM1
LM2
LM1 LM2

0 y0 y 1 y0 y1 y
• Relationships between slopes of IS & LM
determine the efficacy of monetary and fiscal
policy.
• When IS slope is vertical, monetary policy or
increase in MS will not lead to increase in
income or output i.e. not effective.
• When IS slope is gentler, increase in MS will
generate some level of output or monetary
policy will be effective.
• When IS slope is horizontal, increase in MS will
lead to large output or income.
• Assuming a closed economy, a change in
autonomous spending by government and/or a
change in money supply by the monetary authority
or demand for money are the only possible causes of
change in output.
• An increase in MS will shift LM curve (monetary
policy) to the right and results in liquidity effect
(bringing down interest rate) and an output effect
(increase in output).
• The magnitude effects of both depends on the slopes
of the IS and LM curves or the sensitivity of
investments and money demand to interest rates.
• An increase in government spending (fiscal
policy) will result in shift of the IS curve to the
right, normally leads to increase in output and
rate of interest. The output effect of such action
depends on how sensitive is investment spending
and demand for money. When investment
spending is highly sensitive to interest rate, the
increase in government spending crowds out
borrowing and results in small change in output.
The output effect is also small if the demand for
money is not interest sensitive.
Mathematical Analysis
• In a two sector model, suppose the Md is
given as L = 0.20Y; MS is N200m; C = N100m +
0.80Yd; I = N140 – 5i. i)Derive the IS and LM
equation. ii) Plot the IS and LM; iii. Determine
the interest rate, income, consumption and
investment.
• What effect does an increase in MS have on
output?
• The LM equation is:
L=M
0.2Y = N200m
Y = N1000m
The IS equation is:
Y=C+I
Y = N100m + 0.80Y + N140m – 5i
Y = N1200 – 25i
(note that LM is vertical so that change in output is by ∆M(1/k).
Simultaneous equilibrium gives:
LM = IS
N1000 = N1200 -25i
25i = N200
I = 8%
Y = N1000m
C = N800m
I = N100m
• Monetary Policy:
– Definition and Objectives of monetary
goals
– Targets of monetary policy
– Monetary Transmission Channels
– Indicators of monetary policy
– Lags in monetary policy: Types and
nature
– Outcomes of monetary policy: Positive,
negative & neutral.
Introduction to Monetary Policy

• Definition: A measure or combination of

measures designed to regulate and
control the volume, price and direction
of money in order to achieve
macroeconomic goals of full employment
of resources, economic growth, stable
price, income redistribution, balance of
payment equilibrium and sustainable
development.
• Objectives of monetary policy
– Economic growth: After the first World
War
– Full employment: In the course of 1929
economic depression
– Price stability: After the 2nd W.W. Post
war inflation in the 1950s.
– Balance of payment equilibrium:
1960s/70s stagflation
• Targets of Monetary Policy
– Choice of target for monetary policy depends on
the Monetary Transmission Mechanism (MTM)
through which money effects growth,
employment and prices. Monetary policy tools
cannot work directly on the policy variables, so
intermediate target are used to get to the ultimate
target. Three target variables of monetary policy
are:
– Money supply
– Credit availability, and
– interest rates
 Monetary Transmission Mechanism
• MTM refers to channels through which
monetary impulses are communicated to the
real sector of the economy.
• There exist many subsidiary channels but the
main channels have been identified as:
– Commodity Channel
– Portfolio channel
– Credit channel
– Expectation channel
• Commodity channel: Money can be divided into
two namely inside and outside money (Gurley &
Shaw).
– Inside money is money that has corresponding
claim on the society, e.g. bank draft, treasury
bill, etc. Has no effect on aggregate demand.
– Outside money is money that has no
corresponding claim on the society, e.g. coins
and currency. This affects aggregate demand.
∆MS Com. Mkt ∆Agg DD
• Portfolio channel: this has to do
financial investments. Change in
money supply goes into financial
market and people use the money to
adjust their financial assets with a view
to maximize returns. The purchase of
financial assets provides funds for
borrowers or investors.
∆MS Fin.Mkt ∆Agg DD
• Credit channel: Increase in money
supply is expected to lead to fall in
interest rates in order to encourage
borrowers. So credits become available
for borrowers at cheaper rate than
hitherto. Borrowed funds are invested
leading to increase in aggregate
demand.
∆MS Crd.Mkt ∆Agg DD
• Price expectation: Expectation of price
changes when a change in money supply
occurs can drive up purchases or change in
aggregate demand. Anticipated increase in
money supply can be expected to drive up
prices of commodities which would result in
purchases to beat the expected price
increased. The action is also likely to drive up
prices.
• ∆MS Expectation ∆Agg DD
• SUMMARY OF MONETARY CHANNELS:
–Commodity prices thro’ outside
money
–Financial market thro’ portfolio
investments
–Exchange rate market thro’ forex
inflows
–Credit markets thro’ interest rates
movements.
• Indicators of Monetary Policy
– Money supply: if central bank is the sole supplier
of money, then, MS is a good indicator of
monetary policy, particularly using OMO and
reserve requirements. Change in MS will affect
aggregate demand through effects on variety of
assets (Monetarists). Keynesians limit it to bonds
which is narrow.
– Bank credit and interest rates: The monetarists
and Kayenesians downgrade interest rate as
indicator of monetary policy because it is not
under the firm control of monetary authority.
– However, later believe that when MS is
increased, interest rate falls and encourages
investment. So long as MS is increased,
interest rate stays down, making credit cheap.
– To monetarists, increase in MS through OMO
will bring down interest rate but increase
reserves of banks which expand their loans i.e.
liquidity effects. The low interest will increase
investments in capital formation, inventory and
construction, etc. These lead to increase in
demand for financial and real assets which
increases their own prices.
• Eventually interest rate will rise (output effect).
These cycle in interest rate movement made
Friedman to insist that monetary authority should
concentrate on MS rather than manipulating
interest rates.
• To select appropriate indicator of monetary policy,
it is important to determine the definition of money
in question i.e. M1 or M2. Which one affect
economic activities and to what extent does MS
respond in predictable manner.
• Also which economic activities the monetary
authority is trying to influence?
Impact of Monetary Policy
• Impacts of monetary policy
depends on a number of factors
such as lags in effect, use of rules
or discretion, the nature of the
development of the financial
system, and, level of development
of the economy concerned.
• Lags in Monetary Policy
– Inside lags: consists of Recognition lag
and Action (Administration or Decision)
lag;
– Outside lags: consists of Credit or
Operation lag and Output lag:
• Recognition lag: when the need for change
in monetary policy is due or required
(sometime referred to as data lag) and
recognised by the monetary authority for
necessary action;
• Action lag: period between when the need is
recognised and when action is taken i.e. when
the policy change is effected after series of
meetings (Legislation).
• Operation lag: period when monetary action
is approved and effected and when the
financial stakeholders start implementing the
policy. Also called Transmission lag;
• Output lag: when the effects of the policy
start appearing on the final target e.g. when
aggregate demand or output start
responding.
• Rules vs Discretion in Monetary Policy
– Rules in monetary policy is when the monetary
authority, for example, decide to grow money supply
at a specified rate or percentage over a period of
time. This is a position cherished my monetarists as
it allows for planning by the private sector.
– Discretion in monetary policy is when the monetary
authority react to happenings in the economy i.e.
effect monetary policy to counter or propel the
condition shown as a result of economic activities
and indices. In most cases the monetary policy is
counter-cyclical:
• Contractionary monetary policy (or tight money
policy) is effected if the monetary authority find
that there is inflationary pressure or when there is
economic boom to prevent inflationary pressure.
For example, money supply is reduced through the
use of open market operation or by increasing
required reserves or use of other market and non-
market instruments;
• Expansionary monetary policy (easy money policy)
is promoted to engineer economic growth through
credit expansion such as reducing bank rate,
required reserves, purchase of securities, and use of
other market and non-market financial instruments.
• Monetary Policy Feedbacks:
– Positive monetary feedback: occurs when
monetary policy outcome is in tandem with
the expectation. If policy is effected to bring
down inflation and this actually occurs.
– Negative monetary feedback: results when
condition that warranted the monetary
policy action actually worsen. For instance,
if reflating the economy through
expansionary monetary policy further
deepens economic recession.
• Neutral monetary feedback: is when the
condition that warranted the monetary
policy remains unchanged and thus
requires new or additional measures.

THE END