Monetary Theory All Merged 04072023-2

FINC 402: Monetary Theory
FINC 402: MONETARY

THEORY
Dr. Edward Asiedu
University of Ghana Business School, Department of Finance
Offi ce Hours: Thursdays 10:00am - 1:00 pm (UGBS Main

Campus, Second Floor, S13)
Email: [email protected]
Why should Accountants and Financial Analysts be
interested in Monetary Theory
• Majority of us are going to be working with financial

institutions (Financial intermediaries, banks, insurance
companies, pension funds, mutual funds etc.).
Financial intermediaries: institutions that borrow

funds from people and give loans to others.
Banks: institutions that accept deposits and make loans.
And therefore it is important to understand how financial

institutions work.
•Also, importantly, to understand the role of money in

the economy.
Money, also referred to as the money supply, is defined as

anything that is generally accepted in payment for goods or
services or in the repayment of debts.
Money plays a key role in generating Business

Cycles (recessions and booms).
• Business Cycles are upward and downward movement

of
aggregate output produced in the economy.
Business cycles affect all of us in immediate and important ways.
When output is rising, for example, it is easier to find a good job;
when output is falling, finding a good job might be difficult.
• Thus, recession (unemployment) and economic booms affect

all of us.
• Changes in the money supply impacts changes in aggregate
economic activity and inflation.
• If you follow the news, you would have observed

that the Central Bank raises or reduces the
monetary policy rate by some percentage point.
• What effect might this have on the interest rate of

a loan you take to finance your purchase of a new
sports car? (consider an increase in the policy rate)
•Does it mean that a house will be more or less affordable

in the future? (consider an increase in the policy rate)
•Will it make it easier or harder for you to get a job

next year? (consider an increase in the policy rate)
Aims of the course
The main aims of the course are:
• To enhance students understanding of the role and nature of

money.
• To enhance students understanding of the monetary
and financial system.
• To equip students with the knowledge to understand
the impact of monetary policy on an economy.
• Students should be able at the end to evaluate
alternative monetary policy rules.
Outline of the course
o Introduction:
• Definition and Nature, Functions and Value of Money
• Evolution of Payment Systems
• Introduction of Financial Institutions in Ghana
o Central Banking and the Conduct of Monetary
Policy
• Structure of Central Banks and the Reserve System
• Bank Reserves and the Money Supply
• Determinants of the Money Supply
• Tools of Monetary Policy
Outline of the course
o Demand for Money
• Keynesian Theories Precautionary, Transaction and
Speculative Demand
• Income Velocity and the Quantity Theory of Money
o Money Supply Process
• Monetary and Fiscal policy in the Macroeconomy
• Interest Rates
• Monetary and Targeting and Money Control
• Inflation and Money
o Aggregate Demand and Supply Analysis
o Financial Crisis and the role of the central bank
Background readings
•Frederic S. Mishkin, The Economics of Money, Banking, and
Financial Markets, 7th or 9th edition (Addison Wesley: New
York).
• Walsh, Carl E. Monetary theory and policy. MIT press, 2010

Role and Nature of
Money
What Is Money?
•Money has been different things at different times; however, it
has always been important to people and to the economy.
•To understand the effects of money on the economy, we must

understand exactly what money is.
•We will explore the functions of money, looking at why and

how it promotes economic efficiency.
Role and Nature of
Money
Meaning of Money?
• As the word money is used in everyday conversation, it

can mean many things, but to economists, it has a very
specific meaning.
• Economists define money (also referred to as the money

supply) as anything that is generally accepted in payment
for goods or services or in the repayment of debts.
Role and Nature of
Money
Meaning of Money?
• Currency, consisting of cedi bills, euro bills, dollar bills and
coins, clearly fits this definition and is one type of money.
When most people talk about money, they're talking
about currency (paper money and coins).
Role and Nature of
Money
Meaning of Money?
•To define money merely as currency is much too
narrow for economists.
•Because cheques are also accepted as payment for

purchases, checking/current account deposits are
considered money as well.
Role and Nature of
Money
Meaning of Money?
•An even broader definition of money is often needed,
because other items such as savings deposits can in
effect function as money if they can be quickly and
easily converted into currency or checking/current
account deposits.
Role and Nature of
Money
Meaning of Money?
•Thus while “currency” is too narrow a definition of money,

this other popular usage is much too broad.
Role and Nature of
Money
Meaning of Money?
•To complicate matters further, the word money
frequently used synonymously with is
wealth.
When people say, Mike is rich he has an awful lot of money,
they probably mean that Mike has not only a lot of currency
and a high balance in his checking account but has also
stocks, bonds, four cars, three houses, and a yacht.
Role and Nature of
Money
Meaning of Money?
• People also use the word money to describe what

economists call income, as in the sentence Akosua would
be a wonderful catch; she has a good job and earns a lot
of money.
• Income is a flow of earnings per unit of time. Money, by

contrast, is a stock: It is a certain amount at a given point
in time.
Role and Nature of
Money
Meaning of Money?
• If someone tells you that he has an income of GHS1,000, you
cannot tell whether he earned a lot or a little without knowing
whether it is earned per year, per month, or even per day. But
if someone tells you that she has GHS1,000 in her pocket, you
know exactly how much this is.
• Keep in mind that the money discussed here is distinct from

income and wealth.
Role and Nature of
Money
Functions of Money
•Whether money is kola or shells or rocks or gold or paper, it

has three primary functions in any economy:
• Medium of Exchange
• Unit of account
• Store of value
Functions of Money
Medium of Exchange
• Of the three functions, its function as a medium of
exchange is what distinguishes money from other assets
such as stocks, bonds, and houses.
• In almost all market transactions in our economy,

money in the form of currency or checks is a medium of
exchange; it is used to pay for goods and services.
Functions of Money
Medium of Exchange
• The use of money as a medium of exchange promotes
economic efficiency by minimizing the time spent in
exchanging goods and services.
HOW?? Let's take a case of an Economics Professor, who

can do just one thing well: give brilliant economics lectures.
Functions of Money
Medium of Exchange
•In a barter economy, if the Professor wants to eat, she must
find a farmer who not only produces the food she likes but
also wants to learn economics. As you might expect, this
search will be difficult and time-consuming, and she might
spend more time looking for such an economics-hungry
farmer than she will be teaching.
•It is even possible that she will have to quit lecturing and
go into farming herself. Even so, she may still starve to death.
Functions of Money
Medium of Exchange
• The time spent trying to exchange goods or services is called a
transaction cost.
• In a barter economy, transaction costs are high because people
have to satisfy a “double coincidence of wants” -- they have
to find someone who has a good or service they want and who
also wants the good or service they have to offer.
• “The use of money as a medium of exchange therefore promotes
economic efficiency by minimizing the time spent in exchanging
goods and services and by allowing people to specialize in what
they do best”.
Functions of Money
Medium of Exchange
For a commodity to function effectively as money, it has to
meet several criteria:
• It must be easily standardized, making it simple to ascertain its
value;
• It must be widely accepted; It must be
• It must be divisible, so that it is easy to make change ;
easy to carry; and
• It must not deteriorate quickly.
• Examples of money that have satisfied these criteria (in
history): Tobacco, whiskey, cigarettes used in prisoner-of-
war camps, beads etc.
Functions of Money
Unit of Account
•The second role of money is to provide a unit of account;
that is, it is used to measure value in the economy. We
measure the value of goods and services in terms of money.
•Just as we measure weight in terms of kilograms or
distance in terms of kilometers.
•To see why this function is important, let's look again at a
barter economy where money does not perform this
function.
Functions of Money
Unit of Account
• If the economy has only three goods --say, Plantain, economics
lectures, and movies-- then we need to know only three prices to
tell us how to exchange one good for another: In other words, how
many kilos of plantain do you have to pay for an economics lecture
or movies, and so on .
• This will indeed become more complicated with more than three
goods. If there were ten goods, we would need to know 45 prices in
order to exchange one good for another. Imagine having to
exchange 1000 goods in a supermarket!
• The solution to the problem is to introduce money into the
economy and have all prices quoted in terms of units of that
money.
Functions of Money
Unit of Account
•We can see that using money as a unit of account
reduces transaction cost.
•The benefits of this function of money grow as the economy
becomes more complex.
Functions of Money
Store of Value
•Money also functions as a store of value; it is a repository of
purchasing power over time.
•A store of value is used to save purchasing power from the
time income is received until the time it is spent.
•This function of money is useful, because most of us do
not want to spend our income immediately upon receiving it,
but rather prefer to wait until we have the time or the desire
to shop.
Functions of Money
Store of Value
•Money is not unique as a store of value; any asset whether
money, stocks, bonds, land, houses, art, or jewelry can be used
to store wealth.
•Many such assets have advantages over money as a store of
value: They often pay the owner a higher interest rate than
money, experience price appreciation, and deliver services such as
providing a roof over one's head.
Question: If these assets are a more desirable store of value than
money, why do people hold money at all?
Functions of Money
Store of Value
•The answer to this question relates to the important economic
concept of liquidity, the relative ease and speed with which an
asset can be converted into a medium of exchange.
•Liquidity is highly desirable. Money is the most liquid asset of all
because it is the medium of exchange; it does not have to be
converted into anything else in order to make purchases.
•Other assets involve transaction costs when they are converted
into money.
• Examples?
Functions of Money
Store of Value
• Because money is the most liquid asset, people are
willing to hold it even if it is not the most attractive
store of value.
• How good a store of value money depends on the price

level, because its value is fixed in terms of the price level.
• A doubling of all prices, for example, means that the

value of money has dropped by half; conversely, a halving
of all prices means that the value of money has
doubled.
Functions of Money
Store of Value
• Question: inflation, what do you think
During happens?
• Money loses value rapidly, and people will be more

reluctant to hold their wealth in this form. This is
especially true during periods of extreme inflation.
Evolution of the Payments System
•We can obtain a good picture of the functions of money and
the forms it has taken over time by looking at the evolution
of the payments system, the method of conducting
transactions in the economy.
•Where the payments system is heading hasan
importan bearing on how money will be defined in
t future. the
• Commodity Money
• An object that clearly has value to everyone is a likely
candidate to serve as money, and a natural choice is a precious
metal such as gold or silver. Money made up of precious metals
or another valuable commodity is called commodity money.
• Fiat Money
• The next development in the payments system was paper
currency (pieces of paper that function as a medium of exchange).
• Fiat money: paper money decreed by governments as legal tender
(meaning that legally it must be accepted as payment for debts) but
not convertible into coins or precious metal.
• Major drawbacks of paper currency and coins are that they are
easily stolen and can be expensive to transport in large amounts
because of their bulk.
• To combat this problem, another step in the evolution of the
payments system occurred with the development of modern banking:
the invention of cheques.
• Cheques
• an instruction from you to your bank to transfer money from
your account to someone else's account when she deposits it.
• Cheques allow transactions to take place without the need to
carry around large amounts of currency. The introduction of
cheques was a major innovation that improved the efficiency of
the payments system.
• There are, however, two problems with a payments system
based on cheques. First, it takes time to get cheques from one
place to another, a particularly serious problem if you are paying
someone in a different location who needs to be paid quickly.
• Cheques
•In addition, if you have a current account, it usually
takes several business days before a bank will allow you
to make use of the funds from a cheque you have
deposited.
• Electronic Payment
• e.g. online bill pay
• Made convenient by the development of inexpensive
computers and the spread of the Internet.
• E-Money (electronic money):
• Electronic payments technology can not only substitute
for cheques, but can substitute for cash, as well, in the
form of electronic money (or e-money).
• Electronic money (or e-money), is money that exists only
in electronic form. The first form of e-money was the
debit card or bank card as usually called in Ghana.
• E-Money (electronic money):
• Debit cards or bank cards enable consumers to purchase
goods and services by electronically transferring funds
directly from their bank accounts to a merchant's
account.
• At most supermarkets, for example, you can swipe your
debit card through the card reader at the checkout
station, press a button, and the amount of your purchases
is deducted from your bank account.
E-Money (electronic money):
•Debit or bank card: your ATM card typically can function as
a debit card.
• Stored-value card (smart card)
• E-cash
Are We Headed for a Cashless
Economy?
•Predictions of a cashless society have been around for
decades, but they have not come to fruition.
•Although e-money might be more convenient and efficient
than a payments system based on paper, several factors work
against the disappearance of the paper system.
•Still, the use of e-money will likely still increase in the
future.
Measuring
Money
•How do we measure money? Which particular assets can
be called “money” ?
•Central banking authority responsible for monetary policy
has conducted many studies on how to measure money.
•The problem of measuring money has recently become
especially crucial because extensive financial innovation has
produced new types of assets that might properly belong in a
measure of money.
Measuring
• Central
Money
banks in many countries have modified
measures of their
money several times and have settled on the
following measures of the money supply, which are also
referred to as monetary aggregates.
•Construct monetary aggregates using the concept of
liquidity:.
•M1 or Narrow money (most liquid assets) = currency +
traveler's checks + demand deposits + other checkable
deposits.
Measuring
Money
•M2 or broad money (adds to M1 other assets that are not
so liquid) = M1 + small denomination time deposits + savings
deposits and money market deposit accounts + money
market mutual fund shares.
•In Ghana there is also M2+ which is M2 plus foreign
currency deposits
Measuring
Money
• Table 1 Measures of the Monetary Aggregates.
Measuring
• M1 vs M2
Money
• Does it matter which measure of money is considered?
•M1 and M2 can move in different directions in the short
run (see figure 1).
•Conclusion: the choice of monetary aggregate is important
for policymakers.
Measuring
Money
• Figure 1 Growth Rates of the M1 and M2
Aggregates, 1960 - 2011.
Measuring
Money
• Figure 2: Broad Money for Ghana, 2005 - 2016.
Measuring Money
• Q1: There are three goods produced in an economy by
three individuals:
• If the orchard owner likes only bananas, the banana grower likes
only chocolate, and the chocolatier likes only apples, will any
trade between these three persons take place in the barter
economy? How will the introduction of money into the economy
benefit these three producers?
The Bond Market and Interest Rates
•A security (financial instrument) is a claim on the issuer's
future income or assets.
•A bond is a debt security that promises to

make payments periodically for a specified period of time.
•An interest rate is the cost of borrowing or the price paid

for the rental of funds.
The Stock Market
•A common stock (typically just called a stock) represents a
share of ownership in a corporation.
•It is a security that is a claim on the residual earnings and
assets of the corporation.
Money, Business Cycles and Inflation
•The aggregate price level is the average price of
goods and services in an economy.
•A continual rise in the price level (inflation) affects
all economic players.
•Data shows a connection between the money supply and
the price level.
Figure 3 Average Inflation Rate Versus Average Rate
of Money Growth for Selected Countries, 2000-
2010
Money and Interest Rates
• Interest rates are the price of money
•Prior to 1980, the rate of money growth and the interest

rate on long-term Treasury bonds were closely tied
•Since then, the relationship is less clear but the rate of

money growth is still an important determinant of interest
rates
The Foreign Exchange Market
•The foreign exchange market is where funds
are converted from one currency into another.
•The foreign exchange rate is the price of one currency in

terms of another currency.
•The foreign exchange market determines the
foreign exchange rate.
Fiscal Policy and Monetary
Policy
• Money appears to be a major influence on inflation,
business cycles, and interest rates. Because these economic
variables are so important to the health of the economy, we
need to understand how monetary policy is and should
be
conducted.
• We also need to study government fiscal policy because it
can be an influential factor in the conduct of monetary
policy.
Fiscal Policy and Monetary
Policy
• Monetary policy is the management of the
money supply and interest rates
• Conducted by the Central Bank(Bank of Ghana)
• Fiscal policy deals with government spending

and taxation
• Budget deficit is the excess of expenditures over revenues for
a particular year
• Budget surplus is the excess of revenues over expenditures for

a particular year
• Any deficit must be financed by borrowing
Function of Financial Markets
•Perform the essential function of channeling funds from economic
players that have saved surplus funds to those that have a
shortage of funds because they wish to spend more than their
income..
•The principal lender-savers are households, but business
enterprises and the government (particularly state and local
government), as well as foreigners and their governments,
sometimes also find themselves with excess funds and so lend
them out (see figure 4).
•The most important borrower-spenders are businesses and the
government, but households and foreigners also borrow to finance
their purchases of cars, furniture, houses, etc.
Figure 4 Flows of Funds Through the
Financial System
Function of Financial Markets (cont'd)
•Direct finance: borrowers borrow funds directly from lenders in

financial markets by selling them securities. Securities are assets for
the person who buys them but liabilities (debts) for the individual
or rm that sells (issues) them.
•Financial markets are also essential to promoting economic

efficiency by producing an efficient allocation of capital, which
increases production.
Function of Financial Markets (cont'd)
•They also directly improve the well-being of consumers

by allowing them to time their purchases better.
•In essence, financial markets that are operating

efficiently improve the economic welfare of everyone in the
society.
Structure of Financial Markets
• Debt and Equity Markets
Debt instruments (maturity)
Equities (dividends)
• Primary and Secondary
Markets
 In primary markets, new issues of a security are sold to initial
buyers by the corporation or government agency borrowing the
funds. Investment Banks underwrite securities in primary
markets.
 In a secondary market, securities that have been previously
issued (and are thus secondhand) can be resold. Brokers and
dealers work in secondary markets.
Structure of Financial Markets
Secondary markets can be organized in two ways.
• Exchanges and Over-the-Counter (OTC) Markets
Exchanges: NYSE, Chicago Board of Trade
OTC Markets: Foreign exchange, Federal funds
• Money and Capital Markets
Money markets deal in short-term debt instruments.
Capital markets deal in longer-term debt and
instruments.
equity
Money market securities are usually more widely traded than
longer-term securities and so tend to be more liquid.
Table 1 Principal Money Market Instruments
Table 2 Principal Capital Market Instruments
Internationalization of Financial Markets
•Foreign Bonds: sold in a foreign country and denominated

in that country's currency.
•Eurobond: bond denominated in a currency other
than that of the country in which it is sold.
• Eurocurrencies: foreign currencies deposited in
banksthe home country.
outside
• Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign
branches of U.S. banks
• World Stock Markets
Also help finance the federal government.
Function of Financial Intermediaries:
Indirect Finance
•Lower transaction costs (time and money spent in carrying

out financial transactions)
• Economies of scale
• Liquidity services
• Reduce the exposure of investors to risk
• Risk Sharing (Asset Transformation)
• Diversification
Function of Financial Intermediaries:
Indirect Finance
• Deal with asymmetric information problems
(before the transaction) AdverseSelection: try to avoid
selecting the risky borrower
• Gather information about potential borrower.

(after the transaction) Moral Hazard: ensure borrower will not
engage in activities that will prevent him/her from repaying the
loan.
Sign a contract with restrictive covenants

Function of Financial Intermediaries: Indirect
Finance
Conclusion:
Financial intermediaries allow small savers and borrowers to
benefit from the existence of financial markets.
Regulation of the Financial
System
• To increase the information available to investors:

Reduce adverse selection and moral hazard problems
Reduce insider trading (SEC).
Regulation of the Financial
System
• To ensure the soundness of financial intermediaries:
Restrictions on entry (chartering process)

Disclosure of information.
Restrictions on Assets and Activities (control
holding of risky assets).
Deposit Insurance (avoid bank runs).
Limits on Competition (mostly in the past)
Branching
Restrictions on Interest Rates
Origins of the Central Bank( Bank of
Ghana)
•The principal objects of the new central bank, as enshrined
in the 1957 Ordinance,
•Were "to issue and redeem bank notes and coins: to keep
and use reserves and to influence the credit situation with a
view to maintaining monetary stability in Ghana and the
external value of the Ghana pound; and to act as banker and
financial adviser to the Government.
Functions of the Central Bank of Ghana
• Formulate and implement monetary policy aimed at

achieving the objectives of the Bank;
• Promote by monetary measure the stabilization of the
value of the currency within and outside Ghana;
• Institute measures which are likely to have a favorable
effect on the balance of payments, the state of public
finances and the general development of the national
economy;
• Regulate, supervise and direct the banking and credit
system and ensure the smooth operation of the financial
sector;
Functions of the Central Bank of Ghana
•License, regulate, promote and supervise non-banking
financial institutions;
•Act as banker and financial adviser to the Government;
Promote and maintain relations with international banking
and
•Financial institutions and subject to the Constitution or any
other relevant enactment, implement international
monetary agreements to which Ghana is party; and
•Do all other things that are incidental or conducive to the
efficient performance of its functions under this Act and
any other enactment
Money
Supply
•The supply of money in an economy is determined by
the banking system
Directly controlled by the central bank through monetary policy
Indirectly influenced by commercial banks (and the public)
through the deposit creation process
•The Central Bank controls the supply of

money through the conduct of monetary policy
Money
•
Supply
Central banks are responsible for the conduct of monetary policy
•In some countries, the central bank is independent of the central
government to conduct monetary policy (discuss for Ghana)
•Recall that monetary policy refers to changes in a country's stock of
money supply that seeks to stabilize the level of economic activity and
price level
• In most advanced countries, stable prices means inflation rate
very
close to 2%
• And output as close as possible to the full employment level
of
output
Supply of
•
Money
We will take the supply of money as a policy variable
•That is, the supply of money is the level determined
by central bank
Tools of Monetary Policy
•Central banks usually have an array of instruments for
conducting monetary policy
• The main ones are:

Open market operations (OMO)
Reserve requirement policy
Discount rate policy
Open Market Operations
•Open market operations (OMO) refer to the purchase or
sale of government securities in the open market
•The open market here refers to dealers in government

bonds and individuals government securities are government
bonds/treasury bills
•Open market purchases (sales) are meant to increase
(reduce) the money supply
•To see how OMO affects the money supply, consider
open market purchase of government securities worth GHC
100m
•The central banks issues the initial a check worth GHC 100m
which can be drawn as cash or deposited into an account
with a commercial bank
•Note that either of these actions will increase the money
supply If the check is deposited in an account, the commercial
bank can create additional loans out of it, increasing the
money supply further
•An open market sale will have the opposite effect on the
money supply
•In Ghana the Bank of Ghana's Monetary Policy Committee
announces the direction of monetary policy after its monthly
meeting
•In general the policy is announced as a target policy
interest rate
•In Ghana, the interbank rate in the US, the federal funds rate
•Open market activities are then carried out to meet the
target policy rate
Advantages of Open Market Operations
•The Central Bank(Bank of Ghana) has complete

control over the volume
• Flexible and precise
• Easily reversed
• Quickly implemented
Discount Rate
•Commercials banks can borrow from central banks when
they are short of reserves
•The interest rate charged on commercial banks borrowing
from the central bank is the discount rate (id )
•Central banks raise (lower) the discount rate to signal
tightening (loosening) of monetary policy
Reserve
Requirements
•For the purposes of prudence commercial banks keep a
small fraction of their deposits as cash or its close equivalent
to pay depositors who desire to withdraw
•Part of these reserves are required by regulators (central
banks)
•The required reserve ratio is the fraction of deposits
required by banks to keep as reserves
•Banks may in addition to the required reserves, keep
additional excess reserves
•An increase in the required reserve ratio signals a
tightening of monetary policy
Disadvantages of Reserve
Requirements
• No longer binding for most banks
• Can cause liquidity problems
• Increases uncertainty for banks
The Market for Reserves
•To derive the demand curve for reserves, we need to ask
what happens to the quantity of reserves demanded, holding
every thing else constant, as the Interbank rate changes.
• The amount of reserves can be split up into two
components: (1)required reserves, which equal the required reserve ratio
times the amount of deposits on which reserves are required, and
• (2) excess reserves, the additional reserves banks choose to hold.
• Therefore, the quantity ofreserves demanded
required reserves plus equals quantity of excess
reserves
the demanded.
The Market for Reserves and Discount
Rate
• Demand and Supply in the Market for Reserves
•What happens to the quantity of reserves demanded by
banks, holding everything else constant, as the federal funds
rate (interbank rate) changes?
• Excess reserves are insurance against deposit out outflows
•The cost of holding these is the interest rate that could have
been earned minus the interest rate that is paid on these
reserves, (ier )
Equilibrium in the Market for Reserves
Demand in the Market for
Reserves
•When the interbank rate is above the rate paid on excess
reserves,(ier) as the interbank rate decreases, the
opportunity cost of holding excess reserves falls and the
quantity of reserves demanded rises.
•Downward sloping demand that be comes at
curve (infinitely elastic) at ier
Supply in the Market for
Reserves
•Commercials banks can borrow from central banks when
they are short of reserves
(1)the amount of reserves that are supplied by the Central
Bank's open market operations, called non-borrowed
reserves(Rn) and
(2)the amount of reserves borrowed from the Central Bank,
called discount loans (DL).
Supply in the Market for
Reserves
•Cost of borrowing from the Central Bank is the
discount rate
•Borrowing from the Central Bank is a substitute
for borrowing from other banks (Rn) and
•If iff < id then banks will not borrow from the Fed
and borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id banks will borrow more and more at
id
and relend at iff
• The supply curve is horizontal (perfectly elastic) at id
Response to an Open Market Operation
How Changes in the Tools of Monetary Policy
Affects the Interbank Rate
•Effects of an open market operation depends on whether
the supply curve initially intersects the demand curve in its
downward sloped section versus its flat section.
•An open market purchase causes the interbank rate to fall
whereas an open market sale causes the interbank to rise
(when intersection occurs at the downward sloped section).
•Open market operations have no effect on the interbank rate
when intersection occurs at the flat section of the demand
curve.
Responds to a change in the Discount
Rate
How Changes in the Tools of Monetary
Policy Affects the Interbank Rate
•If the intersection of supply and demand occurs on the
vertical section of the supply curve, a change in the discount
rate will have no effect on the interbank rate.
•If the intersection of supply and demand occurs on the
horizontal section of the supply curve, a change in the
discount rate shifts that portion of the supply curve and the
interbank rate may either rise or fall depending on the
change in the discount rate
Responds to a change in the Required
Reserves
How Changes in the Tools of Monetary
Policy Affects the Interbank Rate
• When the Central Bank raises reserve requirement, the
interbank rate rises and when the Central Bank decreases
reserve requirement, the interbank rate falls.
Demand for Money
•Recall the demand for money is made of transactions
demand and asset demand
•The major determinants of demand for money are real
interest rate, level of income and expected inflation rate
•The quantity of money demanded falls when the interest
rate rises
•When interest rate rises, there is a higher incentive to
allocate more wealth to other interest-bearing assets and
reduce the holding of money balances
Velocity of Money and the Equation of
Exchange
• M = the money supply
• P = Price
• Y = Aggregate output (income)
• P * Y = Aggregate nominal income (nominal GDP)
•V = Velocity of money (average number of times per
year that a cedi is spent)
• V = P∗Y
• M
• Equation of exchange
• M*V= P*Y
Exchange
• Velocity fairly constant in short run
• Aggregate output at full-employment level
• Changes in money supply affect only the price level
•Movement in the price level results solely from changes in
the quantity of money
Exchange
•Demand for money: To interpret Fisher's quantity theory
in terms of the demand for money. . .
• Divide both sides by V
• When the money market is in the equilibrium

• M = Md
• Let Md = k * PY
• Because k is constant, the level of transactions generated by a
fixed level of PY determines the quantity of M d .
• The demand for money is not affected by interest rates.
Exchange
•From the equation of exchange to the quantity theory
of money
•Fisher's view that velocity is fairly constant in the short
run, so that , transforms the equation of exchange into the
quantity theory of money, which states that nominal income
(spending) is determined solely by movements in the
quantity of money M.
• P * Y = M * V¯
Exchange
•Because the classical economists (including Fisher)
thought that wages and prices were completely flexible,
they believed that the level of aggregate output Y
produced in the economy during normal times would
remain at the full-employment level
.
•Dividing both sides by Y¯ , we can then write the price
level as follows:
Exchange
• Velocity fairly constant in short run
• Aggregate output at full-employment level
• Changes in money supply affect only the price level
•Movement in the price level results solely from change in
the quantity of money
Exchange
•Percentage Change in (x # y) = (Percentage Change in x)
+ (Percentage change in y)
•Using this mathematical fact, we can rewrite the equation of
exchange as follows:
• %ΔM + %ΔV = %ΔP + %ΔY
• Subtracting from both sides of the preceding equation,
recognizing
and that the inflation rate, isthe growth rate of the
price level,
• π= %ΔP = %ΔM + %ΔV - %ΔY
• Since we assume velocity is constant, its growth rate is zero,
the quantity theory of money is also a theory of inflation:
• so π= %ΔM - %ΔY
Relationship Between Inflation and
Money Growth
Budget Deficits and Inflation
•There are two ways the government can pay for spending:
raise revenue or borrow
•Raise revenue by levying taxes or go into debt by issuing
government bonds
•The government can also create money and use it to pay
for the goods and services it buys
Budget Deficits and Inflation
•The government budget constraint thus reveals two
important facts:
•If the government deficit is financed by an increase in bond
holdings by the public, there is no effect on the monetary
base and hence on the money supply.
•But, if the deficit is not financed by increased bond holdings
by the public, the monetary base and the money supply
increase.
Hyperinflation
•Hyperinflations are periods of extremely high inflation of
more than 50% per month.
•Many economies --both poor and developed– have
experienced hyperinflation over the last century, but the
United States has been spared such turmoil.
•One of the most extreme examples of hyperinflation
throughout world history occurred in Zimbabwe in the 2000s.
Keynesian Theories of Money
Demand
• Keynes's liquidity preference theory
• Why do individuals hold money? Three motives:
• Transactions motive
• Precautionary motive
• Speculative motive
•Distinguishes between real and nominal quantities
of money
Transaction Motive
•Keynes initially accepted the quantity theory view that
the transactions component is proportional to income.
•Later, he and other economists recognized that new
methods for payment, referred to as payment technology,
could also affect the demand for money
Precautionary Motive
•Keynes also recognized that people hold money as
a cushion against unexpected wants.
•Keynes argued that the precautionary money
balances people want to hold would also be proportional to
income.
Speculative Motive
• Keynes also believed people choose to hold money
as a store of wealth, which he called the speculative
motive
Putting the Three Motives Together
• = f(i,Y) where the demand for real money balances
is
• negatively related to the interest rate i,
• and positively related to real income
• Rewritting
•
• Multiply both sides by Y and replacing M d with M
Putting the Three Motives Together
• Velocity is not constant:
•The procyclical movement of rates
interest induce procyclical movements in should
•velocity.
Velocity will change as expectations about future
normal levels of interest rates change
Portfolio Theories of Money Demand
•Theory of portfolio choice and Keynesian liquidity
preference
•The theory of portfolio choice can justify the conclusion
from the Keynesian liquidity preference function that the
demand for real money balances is positively related to
income and negatively related to the nominal interest rate.
• Other factors that affect the demand for money:
• Wealth
• Risk
• Liquidity of other assets
Factors that Determine the Demand for
Money
Empirical Evidence on the Demand for
Money
•James Tobin conducted one of the earliest studies on the link
between interest rates and money demand and concluded
that the demand for money is sensitive to interest rates.
• Precautionary demand:
• Similar to transactions demand
•As interest rates rise, the opportunity cost of holding
precautionary balances rises
•The precautionary demand for money is thus
negatively related to interest rates
Interest Rate and Money Demand
•We have established that if interest rates do not affect the
demand for money, velocity is more likely to be constant or
at least predictable so that the quantity theory view that
aggregate spending is determined by the quantity of money
is more likely to be true.
•However, the more sensitive the demand for money is to
interest rates, the more unpredictable velocity will be, and
the less clear the link between the money supply and
aggregate spending will be.
Stability of Money
•If
Demand
the money demand function is unstable and
undergoes substantial, unpredictable shifts as Keynes
believed, then velocity is unpredictable, and the quantity of
money may not be tightly linked to aggregate spending, as
it is in the quantity theory.
•The stability of the money demand function is also crucial to
whether the Bank of Ghana (BOG) should target interest rates
or the money supply.
Stability of Money
Demand
•If the money demand function is unstable and so the
money supply is not closely linked to aggregate spending,
then the level of interest rates the BOG sets will provide
more information about the stance of monetary policy than
will the money supply.
FINC 402: Monetary Theory
FINC 402: MONETARY
THEORY
• Dr. Edward Asiedu
• University of Ghana Business School, Department of

Finance
• Office Hours: Thursdays 10:00am - 1:00 pm

(UGBS Main Campus, Second Floor, S13)
• Email: [email protected]
Outline
1. Introduction: The Money Supply Process

• Money Supply Process
2. The Risk and Term Structure of Interest Rate

• The Risk Structure of Interest Rate
• The Term Structure of Interest Rate
Supply of Money
4
The Money Supply Process
• The Central bank: Bank of Ghana
• Banks: depository institutions; Financial intermediaries
• Depositors: individuals and institutions
• Borrowers from banks

The BoG's Balance Sheet
• Bank of Ghana
System
Assets Liabilities
Securities Currency in Circulation
Loans to Reserves
Financial
Institutions
• Liabilities
• Currency in circulation: amount of currency in the hands of the

public
• Reserves: bank deposits at the BOG and vault cash (currency that
is
physically held by banks)
The Bank Of Ghana’s Balance Sheet
• Assets
•Government securities: holdings by the BOG that affect money supply
and earn interest
• Discount loans: provide reserves to the banking system by

making
discount loans to banks at an interest rate called the discount rate.
The Bank Of Ghana’s Balance Sheet
High-powered money (Monetary Base)
MB = C + R
• C = Currency in Circulation
• R = total reserves in the banking system.
The primary way in which the Central Bank causes changes

in the monetary base is through its open market operations
Open Market Purchase from Banks
• Banking System
Assets Liabilities
Securities -Ghc 100m
Reserves +Ghc 100m
• Bank of Ghana System
Assets Liabilities
Securities +Ghc 100m Reserve
Open Market Purchase from Banks
• Net result is that reserves have increased by Ghc100, the amount of

the open market purchase.
• No change of currency in circulation.
• Monetary base has increased by Ghc100.

Open Market Purchase: Summary
• The effect of an open market purchase on reserves depends on

whether the seller of the bonds keeps the proceeds from the sale in
currency or in deposits.
• The effect of an open market purchase on the monetary base always

increases the monetary base by the amount of the purchase.
• The impact of an open market purchase on reserves is much more

uncertain than its impact on the monetary base.
Open Market Sale
• The open market sales:
• Reduces the monetary base by the amount of the sale

• Reserves remain unchanged
• To conclude, the effect of open market operations on the monetary base is

much more certain than the effect on reserves.
Discount Loans
• The monetary base is also affected when the central bank

makes a discount loan to a bank.
• Reserves change by the amount of the discount loan and

the monetary base, too, changes by this amount.
• To conclude, the monetary base changes one-for-one

with the change in the borrowings from the Central
Bank.
Other Factors that Affect the Monetary Base
• Float
• Treasury deposits at the Bank of Ghana
• Interventions in the foreign exchange market

Overview of The BoG's Ability to Control the
Monetary Base
• The factor that most affects the monetary base is the
BoG’s holdings of securities, which are completely
controlled by them through its open market operations.
• Factors not controlled by the central bank (for example,

float and Treasury deposits) undergo substantial short-
run variations and can be important sources of
fluctuations in the monetary base over time periods as
short as a week.
• However, these fluctuations are usually quite predictable
and so can be offset through open market operations.
Overview of The BoG's Ability to Control the
Monetary Base
• Split the monetary base into two components:
• MBn = MB - BR
• The money supply is positively related to both the non-

borrowed monetary base MBn and to the level of
borrowed reserves, BR, from the BoG.
Multiple Deposit Creation: A Simple Model
• Deposit Creation: GHc100 Open market purchase with a Single

Bank (First National Bank)
Assets Liabilities
Securities -Ghc 100m
Reserves +Ghc 100m
• Let's say that the bank decides to make a loan equal in amount to
the GHc100 increase in excess reserves.
Assets Liabilities
Securities -Ghc 100m Checkable deposit +Ghc
100m
Reserves +Ghc 100m
Loans +Ghc 100m
• The borrower makes purchases by say, writing

cheques, they will be deposited at other banks, and
the $100 of reserves will leave the First National
Bank.
• First National Bank has this final T-account:

Assets Liabilities
Securities -GHc 100m
Loans +GHc 100m
• Excess reserves increase

• Bank loans out the excess reserves
• Creates a checking account, Borrower makes purchases
from other individuals and corporations.
• The Money supply has increased
Table 1 Creation of Deposits (assuming 10% reserve
requirement and a $100 increase in reserves)
Deriving The Formula for Multiple Deposit
Creation
• Assuming banks do not hold excess reserves
• Required Reserve (RR) = Total Reserve (R)
• RR = Required Reserve Ratio (r) times the
total amount of checkable deposit (D)
• Substituting
r*D=R
• Dividing both side by r
D = (1/r)* R
• Taking the change in both sides yields
D= (1/r)* R
Critique of the Simple Model
• Holding cash stops the process

– Currency has no multiple deposit expansion
• Banks may not use all of their excess reserves to buy

securities or make loans.
• Depositors' decisions (how much currency to hold) and

bank’s decisions (amount of excess reserves to hold) also
cause the money supply to change.
Factors that Determine the Money Supply
 Changes in the non-borrowed monetary base, MBn
• The money supply is positively related to the

non- borrowed monetary base MBn
 Changes in borrowed reserves from the central bank
• The money supply is positively related to the level

of
borrowed reserves, BR, from the central bank.
Factors that Determine the Money Supply
 Changes in the required reserves ratio

• The money supply is negatively related to the required reserve
ratio.
 Changes in currency holdings

• The money supply is negatively related to currency holdings.
 Changes in excess reserves

• The money supply is negatively related to the amount of
excess reserves.
Overview of the Money Supply Process
Deriving The Money Multiplier
• Define money as currency plus checkable deposits:
• M1 Link the money supply (M) to the monetary base (MB) and let m
be the money multiplier
• M = m * MB
• Assume that the desired holdings of currency C and excess reserves

ER grow proportionally with checkable deposits D.
• Then,
• c = {C/D} = currency ratio
• e = {ER/D} = excess reserves ratio
Deriving the Money Multiplier
• The total amount of reserves (R) equals the sum of the required
reserve (RR) and the excess reserve
• R = RR + ER
• The total amount of required reserves (RR) equals the required

reserve ratio (r) times the amount of checkable deposits
• RR = r * D
• Substituting for RR in the first equation

• R = (r * D) + ER
• The Fed sets r to less than 1

• The monetary base MB equals currency (C) plus reserves (R):
• MB = C + R = C + (r x D) + ER
• Equation reveals the amount of the monetary base needed to

support the existing amounts of checkable deposits, currency and
excess reserves.
• c = (C / D), therefore C = c * D and

• e = (ER / D), therefore ER = e * D
• Substituting the previous equation,
• MB = (r * D) + (e * D) + (c * D) = ( r + e + c) * D
• Dividing both sides by the term in paranthesis
1
• D= *MB
(𝑟+𝑒+𝑐)
• M = D + C and C = c * D
• M = D + (c * D) = (1 + c) *D
• Substituting again,
1+
M= 𝑐
(𝑟+𝑒+𝑐)
*MB
• The money multiplier is then

1+
m= 𝑐
(𝑟+𝑒+𝑐)
Intuition Behind the Money Multiplier
• M = money supply (M1) = C + D = Ghc1200B
• c = Ghc400B = 0.5
Ghc800B
•e = Ghc0.8B = 0.001
Ghc800B
m = 1+0.5 = 1.5 = 2.5
0.1+0.001+0.5 0.601
• This is less than the simple deposit multiplier. Although there is

multiple expansion of deposits, there is no such expansion for
currency
Reference Rate, The Risk and
Term Structure of Interest
Rate
The Ghana Reference Rate (1)
• New model for estimating interest rates in Ghana effective March 15,
2017.
• Published at first working day of the month using Rates recorded at

last working day of previous month.
• Banks add their Risk Premium to the GRR.
i
 T' 
GRR  MI i i
Bill 
1  CRR
W tbill

 1

W CIV
Ghana Reference Rate (2)
• GRR is the Ghana Reference Rate
• MI is Market Indicator (Policy Rate and Interbank Rate)

• W is the weight of Market Indicator “i”.
• T’Bill is the 91-day Treasury Bill rate
• is the weight of the 91 day Treasury bill rate.
• CRR and CIV are Cash Reserve Requirement and Cash-In- Vault
respectively.
• The weights assigned to the market indicators are 40%, 20%, 40%
for Policy Rate, Interbank Rate and the Treasury Bill Rate
Respectively.
• Calculate the GRR given the following:
– 91-Day Treasury Bill Rate: 14.17%
– Interbank Rate: 15.19%
– Monetary Policy Rate: 14.5%
– Cash Reserve Requirement (CRR) of 8% and industry agreed

Cash in Vault (CIV) limit of 2%.
Risk Structure of Interest Rates
• Bonds with the same maturity have different interest rates due to:
– Default risk
– Liquidity
– Tax considerations
• Default risk: probability that the issuer of the bond is unable or

unwilling to make interest payments or pay off the face value
• Government bonds are considered default free (government
can
raise taxes).
• Risk premium: the spread between the interest rates on bonds

with default risk and the interest rates on (same maturity)
Government bonds.
Figure 2 Response to an Increase in Default
Risk on Corporate Bonds
Table 1 Bond Ratings by Moody's, Standard
and Poor’s, and Fitch
Risk Structure of Interest Rates
• Liquidity: the relative ease with which an asset can be converted into
cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market
• Income tax considerations

– Interest payments on municipal bonds are exempt from federal
income taxes
Figure 3 Interest Rates on Municipal and
Treasury Bonds
Effects of the Obama Tax Increase on Bond Interest Rates
• In 2013, Congress legislation favored by the Obama

approved
administration to increase the income tax rate on high-income
taxpayers from 35% to 39%. Consistent with supply and demand
analysis, the increase in income tax rates for wealthy people helped to
lower the interest rates on municipal bonds relative to the interest rate
on Treasury bonds.
Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax characteristics may have
different interest rates because the time remaining to maturity is
different.
• The term structure of interest rates shows the relationship between

the term to maturity and the yield on the security.
• The plot of the term structure gives the yield curve.
• Yield curve: a plot of the yield on bonds with differing terms to

maturity but the same risk, liquidity and tax considerations
– Upward-sloping: long-term rates are above short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term rates
• The theory of the term structure of interest rates must explain the
following facts:
1. Interest rates on bonds of different maturities move together over

time.
2.When short-term interest rates are low, yield curves are more likely
to have an upward slope; when short-term rates are high, yield curves
are more likely to slope downward and be inverted.
3. Yield curves almost always slope upward.

Yield Curve
Yield
%
Time to
Maturity
An upward-sloping yield curve indicates that Treasury

Securities with longer maturities offer higher annual yields
Yield Curve Shapes
Normal Level or Flat Inverted

• Three theories to explain the three facts:
1. Expectations theory explains the first two facts but not the third.
2.Segmented markets theory explains the third fact but not the first
two.
3. Liquidity premium theory combines the two theories to explain all

three facts.
Expectations Theory
• The interest rate on a long-term bond will equal an average of the

short-term interest rates that people expect to occur over the life of
the long-term bond.
• Buyers of bonds do not prefer bonds of one maturity over another;

they will not hold any quantity of a bond if its expected return is less
than that of another bond with a different maturity.
• Bond holders consider bonds with different maturities to be perfect

substitutes
Expectations Theory
• An example:
• Let the current rate on one-year bond be 6%.
• You expect the interest rate on a one-year bond to be 8% next year.

• Then the expected return for buying two one-year bonds
• Averages (6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be 7% for you to be

willing to purchase it.
Expectations Theory
For an investment of $1
it = today's interest rate on a one-period bond
ite = interest rate on a one-period bond expected for next

1
period
i2t = today's interest rate on the two-period bond
Expectations Theory
Expected return over the two periods from investing $1 in the
two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t ) 1
 1 2i  (i )2 1
2t 2t
 2i2t  (i2t )2
Since (i2t )2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
Expectations Theory
If two one-period bonds are bought with the $1

investment (1 i )(1 ie ) 1
1 i  ie  i (ie ) 1
t t 1 t t 1
i  ie  i (ie )
t t 1 t t 1
it (ite ) is extremely
1 small
Simplifying we
get it  t
i1
e
Expectations Theory
Both bonds will be held only if the expected returns are

equal 2i  i  ie
i 
i2t  it e 2 t
1
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
i  i e  i e  ...  i e
t t 1 t 2 t
int  (n1)
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the
bond
Expectations Theory
• Example: The expected one-year interest rates

over the next six years are 12%, 13%, 14%, 15%,
16% and 17%. The interest rate on the two-year
security would be:
𝑒
𝑖𝑡 + 𝑖 𝑡+1
• 𝑖2 =
2
𝑡
• 𝑖2 = 12% + 13% = 12.5%

2
𝑡
Expectations Theory
• The interest rate on the six-year security would also

be:
• 𝑖6 = 12%+13%+14%+15%+16%+17% = 14.5%
6
𝑡
Expectations Theory
• Expectations theory explains:

– Why the term structure of interest rates changes at different
times.
– Why interest rates on bonds with different maturities move

together over time (fact 1).
– Why yield curves tend to slope up when short-term rates are low
and slope down when short-term rates are high (fact 2).
– Cannot explain why yield curves usually slope upward (fact 3)

Segmented Markets Theory
• Bonds of different maturities are not substitutes at all.
• The interest rate for each bond with a different

maturity is
determined by the demand for and supply of that bond.
• Investors have preferences for bonds of one maturity

over
another.
• If investors generally prefer bonds with shorter maturities that

have less interest-rate risk, then this explains why yield curves
usually slope upward (fact 3).
Liquidity Premium & Preferred Habitat
Theories
• The interest rate on a long-term bond will equal an average of short-

term interest rates expected to occur over the life of the long-term
bond plus a liquidity premium that responds to supply and demand
conditions for that bond.
• Bonds of different maturities are partial (not perfect) substitutes.
• We can adjust the pure expectations theory to reflect the inclusion of

the liquidity risk premium in the equation.
Liquidity Premium Theory
it  t1 ie  ...
in it2
e
ie n t( n1)

t
where lnt is the liquidity l
premium
Preferred Habitat Theory
• Investors have a preference for bonds of one maturity over another.
• They will be willing to buy bonds of different maturities only if they

earn a somewhat higher expected return.
• Investors are likely to prefer short-term bonds over longer-

term bonds.
Figure 5 The Relationship Between the Liquidity
Premium (Preferred Habitat) and Expectations
Theory
Interest Liquidity Premium (Preferred

Rate, Habitat) Theory
int Yield Curve
Liquidity
Premium, lnt
Expectations Theory
Yield Curve
0 5 10 15 20 25 30
Years to Maturity, n
Liquidity Premium & Preferred Habitat
Theories
• Interest rates on different maturity bonds move together over
time; explained by the first term in the equation
• Yield curves tend to slope upward when short-term rates are

low and to be inverted when short-term rates are high;
explained by the liquidity premium term in the first case and
by a low expected average in the second case
• Yield curves typically slope upward; explained by a larger

liquidity premium as the term to maturity lengthens
Figure 6 Yield Curves and the Market's Expectations of Future Short-
Term Interest Rates According to the Liquidity Premium (Preferred
Habitat) Theory
Figure 7 Yield Curves for U.S. Government
Bonds
Using the Term Structure
• The term structure of interest rates is used to:
– Forecast interest rates
– Forecast recessions
– Make investment decisions
– Make financing decisions
6/13/2023 66
AGGREGATE DEMAND
AND AGGREGATE
SUPPLY
Outline
1. Aggregate Demand and Aggregate Supply

• Aggregate Demand
• Aggregate Supply
Aggregate Demand
Aggregate demand is made up of four component parts:
Consumption expenditure: the total demand for consumer

goods and services
Planned investment spending: the total planned spending by

business firms on new machines, factories, and other capital goods,
plus planned spending on new homes
Government purchases: spending by all levels of government

(federal, state, and local) on goods and services
Net exports: the net foreign spending on domestic goods and services
Aggregate Demand
Aggregate Demand
• The fact that the aggregate demand curve is downward

sloping can also be derived from the quantity theory
of money analysis
• If velocity stays constant, a constant money supply

implies constant nominal aggregate spending, and a
decrease in the price level is matched with an increase in
aggregate demand.
Figure 1. Aggregate Demand
Figure 2. Rightward Shift in the Aggregate
Demand Curve
Factors that Shift the Aggregate Demand
Curve
 An increase in the money supply shifts AD to the right:

• holding velocity constant, an increase in the money
supply increases the quantity of aggregate demand at
each price level.
• An increase in spending from any of the components C, I,

G, NX, will also shift AD to the right.
Figure 3. Summary: Factors That Shift the Aggregate Demand
Curve
AGGREGATE SUPPLY(AS)
Long-run aggregate supply curve:

• Determined by amount of capital and labor and the
available technology
• Vertical at the natural rate of output generated by the natural rate of
unemployment
Short-run aggregate supply curve:

• Wages and prices are sticky
•Generates an upward sloping SRAS as firms attempt to take
advantage of short-run profitability when price level rises
Figure 4. Long and Short Run Aggregate
Supply Curve
Shift in the Aggregate Supply Curve
Shifts in the long run aggregate supply curve
 The long-run aggregate supply curve shifts to the right

when there is:
• An increase in the total amount of capital in the economy
•An increase in the total amount of labor supplied in the economy
• An increase in the available technology, or
• A decline in the natural rate of unemployment
An opposite movement in these variables shifts the LRAS curve to the

left.
Figure 5. Shift in the Long Run Aggregate
Supply Curve
Factors that can Shift Aggregate Supply
 There are three factors that can shift the short-

run
aggregate supply curve:
• Expected inflation
• Price shocks
• A persistent output gap
Figure 6. Factors that Can Shift the Short-
Run Aggregate Supply Curve
Figure 6. Shift in the Short-Run Aggregate Supply Curve
from Changes in Expected Inflation and Price Shocks
Figure 7. Shift in the Short-Run Aggregate Supply Curve
from a Persistent Positive Output Gap
Equilibrium in Aggregate Demand and
Supply Analysis
We can now put the aggregate demand and supply curves

together to describe general equilibrium in the economy,
when all markets are simultaneously in equilibrium at the
point where the quantity of aggregate output demanded
equals the quantity of aggregate output supplied.
Short-Run Equillibrium
• Figure 7 illustrates a short-run equilibrium in which the

quantity of aggregate output demanded equals the
quantity of output supplied.
• In Figure 8, the short-run aggregate demand curve AD

and the short-run aggregate supply curve AS intersect at
point E with an equilibrium level of aggregate output at
Y* and an equilibrium inflation rate at ᴨ*
Figure 8. Short-Run Equilibrium
Figure 9. Adjustment to Long-Run Equilibrium in
Aggregate
Supply and Demand Analysis
Self-Correcting Mechanism
 Regardless of where output is initially, it returns eventually to the

natural rate.
 Slow:
• Wages are inflexible, particularly downward
• Need for active government policy
 Rapid:
• Wages and prices are flexible
• Less need for government intervention
Changes in Equilibrium: Aggregate Demand
Shocks
• With an understanding of the distinction between the

short-run and long-run equilibria, you are now ready to
analyze what happens when there are demand shocks,
shocks that cause the aggregate demand curve to shift.
Figure 10. Positive Demand Shock
Figure 11. The Volcker Disinflation
The Volcker Disinflation
Figure 12. Negative Demand Shocks, 2000-
2004
Negative Demand Shocks, 2000-2004
Changes in Equilibrium: Aggregate Supply
(Price) Shocks
• The aggregate supply curve can shift from temporary supply (price)
shocks in which the long-run aggregate supply curve does not shift,
or from permanen supply shocks in which the long-run aggregate
supply curve does shift.
Changes in Equilibrium: Aggregate Supply
(Price) Shocks
 Temporary Supply Shocks:
• When the temporary shock involves a restriction in supply,
we refer to this type of supply shock as a negative (or
unfavorable) supply shock, and it results in a rise in
commodity prices.
• A temporary positive supply shock shifts the short-run

aggregate supply curve downward and to the right, leading
initially to a fall in inflation and a rise in output. In the long
run, however, output and inflation will be unchanged
(holding the aggregate demand curve constant).
Figure 13. Temporary Negative Supply
Shock
Figure 14. Negative Supply Shocks, 1973-1975 and
1978-1980
Negative Supply Shocks, 1973 1975 and
1978-1980
Permanent Supply Shocks and Real
Business Cycle Theory
A permanent negative supply shock such as an increase in ill-advised

regulations that causes the economy to be less efficient, thereby reducing
supply would decrease potential output and shift the long-run aggregate
supply curve to the left.
 Because the permanent supply shock will result in higher prices, there
will be an immediate rise in inflation and so the short-run aggregate
supply curve will shift up and to the left.
Permanent Supply Shocks and Real
Business Cycle Theory
 One group of economists, led by Edward Prescott of Arizona State

University, believe that business cycle fluctuations result from
permanent supply shocks alone and their theory of aggregate
economic fluctuations is called real business cycle theory.
Figure 15. Permanent Negative Supply
Shock
Figure 16. Positive Supply Shocks, 1995-
1999
Positive Supply Shocks, 1995-1999
Conclusions
 Aggregate demand and supply analysis yields the following

conclusions:
• A shift in the aggregate demand curve affects output only in the

short run and has no effect in the long run.
• A temporary supply shock affects output and inflation only in the
short run and has no effect in the long run (holding the aggregate
demand curve constant).
• A permanent supply shock affects output and inflation both in the
short and the long run.
• The economy has a self-correcting mechanism that returns it to
potential output and the natural rate of unemployment over time.
The Phillips Curve and the Short-Run Aggregate Supply
Curve
 The Phillips Curve:

• The negative relationship between unemployment
and
inflation.
• The idea behind the Phillips curve is intuitive: When labor
markets are tight - that is, the unemployment rate is low -
firms may have difficulty hiring qualified workers and may
even have a hard time keeping their present employees.
Because of the shortage of workers in the labor market, firms
will raise wages to attract needed workers and raise their
prices at a more rapid rate.
Figure 1: Inflation and Unemployment in the United States,
1950-1969 and 1970-2014
Figure 2: The Short- and Long-Run Phillips
Curve
Three Important Conclusions
• There is no long-run trade-off between unemployment and inflation.
• There is a short-run trade-off between unemployment and inflation.
• There are two types of Phillips curves, long run and short run.
The Short-Run Aggregate Supply Curve
• To complete our aggregate demand and supply model, we need to

use our analysis of the Phillips curve to derive a short-run
aggregate supply curve, which represents the relationship
between the total quantity of output that firms are willing to
produce and the inflation rate.
• We can translate the modern Phillips curve into a short-run

aggregate supply curve by replacing the unemployment gap (U- Un)
with the output gap, the difference between output and potential
output (Y - YP).
Okun’s Law
Okun's law describes the negative relationship between the

unemployment gap and the output gap
 Okun's law states that for each percentage point that output is
above potential, the unemployment rate is one-half of a
percentage point below the natural rate of unemployment.
Alternatively, for every percentage point that unemployment
is above its natural rate, output is two percentage points
below potential output.
Figure 4: Okun's Law, 1960-2014
IS/LM ANALYSIS
Outline
The IS-LM Model
• Planned Ependiture and Aggregate Demand
• Goods Market Equilibrium
• Factors affecting IS Curve
• IS-LM Curve
The IS Curve
• The IS curve depicts the set of all levels of interest rates and output
(GDP) at which total investment (I) equals total saving (S).
• At lower interest rates, investment is higher, which translates into

more total output (GDP), so the IS curve slopes downward and to
the right.
Planned Expenditure and Aggregate
Demand
• Planned expenditure is the total amount of spending

on domestically produced goods and services that
households, businesses, the government, and foreigners
want to make.
• Aggregate demand is the total amount of output

demanded in the economy.
Components of Aggregate Demand
• The total quantity demanded of an economy’s output is the sum of 4
types of spending:
– Consumption expenditure (C)
– Planned investment spending (I )
– Government purchases (G )
– Net exports (NX )

The Componenets of Aggregate Demand
Income is the most important factor determining consumption

spending Disposable income (YD ) is total income less taxes (Y -
T)
the consumption
The functionto(C
marginal propensity / Y
consume
D
), theis change
(mpc) inof
the slope
consumer that results from an additional dollar of disposable
expenditure
income
a is automonous consumer expenditure, the amount of
consumer expenditure that is independent of disposable income
C (how
 a much
mpc(Y
D
will be spent when disposable income is 0)
)
Planned Investment Spending
• Fixed investment are always planned.
• Inventory investment can be unplanned.
• Planned investment spending

– Interest rates
– Expectations
Net Exports
• Made up of two components: autonomous net
exports and the part of net exports that is affected
by changes in real interest rates.
• Net export function:
NX  N X  xr
Government Purchase and Taxes
• The government affects aggregate demand in
two ways: through its purchases and taxes
• Government purchases:
G  G
• Government taxes:
T  T
Equilibrium in the Goods Market
• Keynes recognized that equilibrium would occur in the economy

when the total quantity of output produced in the economy equals
the total amount of aggregate demand (planned expenditure).
• Solving for goods market equilibrium:

Aggregate Output = Consumption Expenditure +
Planned Investment Spending + Government Purchases + Net
Exports
Understanding the IS Curve
• What the IS curve tells us: traces out the points at which
the goods market is in equilibrium
• Examines an equilibrium where aggregate output equals
aggregate demand
• Assumes fixed price level where nominal and
real
quantities are the same
• IS curve is the relationship between
equilibrium aggregate output and the interest rate.
Figure 1: The IS Curve
Why the Economy Head towards the
Equilibrium?
• Interest rates and planned investment spending
– Negative relationship
• Interest rates and net exports

– Negative relationship
• IS curve: the points at which the total quantity of goods produced

equals the total quantity of goods demanded
• Output tends to move toward points on the curve that satisfies the
goods market equilibrium.
Factors that Shift the IS Curve
• The IS curve shifts whenever there is a change in autonomous

factors (factors independent of aggregate output and the real
interest rate).
• One example is changes in government purchases, as in Figure 2.

Fig 2: Shift in the IS Curve from an Increase
in Government Expenditure
Application: The Vietnam War Buildup,
1964-1969
• The United States’ involvement in Vietnam began to escalate in the
early 1960s.
• Usually during a period when government purchases are rising

rapidly, central banks raise real interest rates to keep the economy
from overheating.
• The Vietnam War period, however, is unusual because the Federal

Reserve decided to keep real interest rates constant. Hence, this
period provides an excellent example of how policymakers could
make use of the IS curve analysis to inform policy.
Fig 3: The Vietnam War Build Up
Changes in Taxes
• At any given real interest rate, a rise in taxes causes aggregate

demand and hence equilibrium output to fall, thereby shifting the IS
curve to the left.
• Conversely, a cut in taxes at any given real interest rate increases

disposable income and causes aggregate demand and equilibrium
output to rise, shifting the IS curve to the right.
Figure 4 Shift in the IS Curve from an
Increase in Taxes
Application: The Fiscal Stimulus Package of
2009
• In the fall of 2008, the U.S. economy was in crisis. By the

time the new Obama administration had taken office, the
unemployment rate had risen from 4.7% just before the
recession began in December 2007 to 7.6% in January 2009.
• To stimulate the economy, the Obama administration

proposed a fiscal stimulus package that, when passed by
Congress, included $288 billion in tax cuts for households
and businesses and $499 billion in increased federal
spending, including transfer payments.
Application: The Fiscal Stimulus Package of
2009
• These tax cuts and spending increases were predicted to increase
aggregate demand, thereby raising the equilibrium level of aggregate
output at any given real interest rate and so shifting the IS curve to
the right.
• Unfortunately, most of the government purchases did not kick in

until after 2010, while the decline in autonomous consumption and
investment were much larger than anticipated.
• The fiscal stimulus was more than offset by weak consumption and
investment, with the result that the aggregate demand ended up
contracting rather than rising, and the IS curve did not shift to the
right, as hoped.
Factors That Shift the IS Curve
• Changes in autonomous spending also affect the

IS curve:
– Autonomous consumption
– Autonomous investment spending
– Autonomous net exports

Autonomous Consumption
• A rise in autonomous consumption would raise aggregate demand

and equilibrium output at any given interest rate, shifting the IS
curve to the right.
• Conversely, a decline in autonomous consumption expenditure

causes aggregate demand and equilibrium output to fall, shifting the
IS curve to the left.
Autonomous Investment Spending
• An increase in autonomous investment spending

increases equilibrium output at any given interest rate,
shifting the IS curve to the right.
• On the other hand, a decrease in autonomous investment

spending causes aggregate demand and equilibrium
output to fall, shifting the IS curve to the left.
Autonomous Net Exports And Changes in
Financial Frictions
• An autonomous increase in net exports leads to an increase in
equilibrium output at any given interest rate and shifts the IS curve
to the right.
• Conversely, an autonomous fall in net exports causes aggregate
demand and equilibrium output to decline, shifting the IS curve to
the left.
• Another factor that shifts the IS curve is changes in financial

frictions
– An increase in financial frictions, as occurred during the
financial crisis of 2007-2009, raises the real cost of borrowing to
firms and hence causes investment spending and aggregate
demand to fall
Summary of Factors that affect IS Curve
C I G T
NX f
The LM Curve
• The LM curve depicts the set of all levels of income (GDP) and
interest rates at which money supply equals money (liquidity)
demand.
• The LM curve slopes upward because higher levels of income (GDP)

induce increased demand to hold money balances for transactions,
which requires a higher interest rate to keep money supply and
liquidity demand in equilibrium.
The IS-LM Model
• The intersection of the IS and LM curves models "general

equilibrium" where supposed simultaneous equilibria occur in both
the goods and the asset markets. Yet two equivalent interpretations
are possible:
– first, the IS–LM model explains changes in national

income when the price level is fixed in the short-run;
– second, the IS–LM model shows why an aggregate
demand curve can shift.
• Hence, this tool is sometimes used not only to analyse economic

fluctuations but also to suggest potential levels for appropriate
stabilisation policies.
The IS-LM Model
FINANCIAL CRISIS
What is a Financial Crisis
 A financial crisis occurs when there is a particularly large

disruption to information flows in financial markets, with the result
that financial frictions increase sharply and financial markets stop
functioning.
Dynamics of Financial Crisis
 Stage One: Initiation of a Financial Crisis

• Credit Boom and Bust: Mismanagement of financial
liberalization/innovation leading to asset price boom and bust
• Asset-price Boom and Bust
• Increase in Uncertainty
 Stage two: Banking Crisis
 Stage three: Debt Deflation

Figure 1 Sequence of Events in Financial
Crisis
The Mother of All Financial Crisis: The
Great Depression
 How did a financial crisis unfold during the Great Depression and
how it led to the worst economic downturn in U.S. history?
 This event was brought on by:

• Stock market crash
• Bank panics Continuing decline in stock prices
• Debt deflation
Figure 2 Stock Price Data During the Great
Depression
Figure 3 Credit Spreads During the Great
Depression
The Global Financial Crisis of 2007-2009
 Causes of the 2007-2009 Financial Crisis:

 Financial innovations emerge in the mortgage markets
• Subprime mortgage
• Mortgage-backed securities
• Collateralized debt obligations (CDOs)
 Housing price bubble forms

• Increase in liquidity from cash flows
surging to the United States
• Development of subprime mortgage market fueled
housing
demand and housing prices
 Causes of the 2007-2009 Financial Crisis:

 Agency problems arise
• “Originate-to-distribute” model is subject to principal-(investor)
agent (mortgage broker) problem
• Borrowers had little incentive to disclose information about their
ability to pay
• Commercial and investment banks (as well as rating agencies)
had weak incentives to assess the quality of securities
 Information problems surface

 Housing price bubble bursts
FYI Collateralized Debt Obligations (CDOs)
 The creation of a collateralized debt obligation involves a corporate

entity called a special purpose vehicle (SPV) that buys a collection of
assets such as corporate bonds and loans, commercial real estate
bonds, and mortgage-backed securities.
 The SPV separates the payment streams (cash flows) from these
assets into buckets that are referred to as tranches.
FYI Collateral Debt Obligations (CDOs)
 The highest rated tranches, referred to as super senior tranches are

the ones that are paid off first and so have the least risk.
 The lowest tranche of the CDO is the equity tranche and this is the
first set of cash flows that are not paid out if the underlying assets go
into default and stop making payments. This tranche has the
highest risk and is often not traded.
 Effects of the 2007-2009 Financial Crisis

• After a sustained boom, housing prices began a long decline
beginning in 2006.
• The decline in housing prices contributed to a rise in defaults on

mortgages and a deterioration in the balance sheet of financial
institutions.
• This development in turn caused a run on the shadow banking

system.
 Crisis spreads globally

• Sign of the globalization of financial markets
• TED spread (3 months interest rate on Eurodollar minus 3
months Treasury bills interest rate) increased from 40 basis
points to almost 240 in August 2007
 Deterioration of financial institutions' balance sheets:

• Write downs
• Sell of assets and credit restriction
 High-profile firms fail

• Bear Stearns (March 2008)
• Fannie Mae and Freddie Mac (July 2008)
• Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund
(mutual fund) and Washington Mutual (September 2008)
 Bailout package debated

• House of Representatives voted down the $700 billion bailout
package on September 29, 2008.
• It passed on October 3, 2008.
• Congress approved a $787 billion economic stimulus plan on
February 13, 2009.
Figure 4 Housing Prices and the Financial
Crisis of 2007-2009
Figure 5 Stock Prices and the Financial
Crisis of 2007-2009
Inside the Fed: Was the Fed to Blame for the
Housing Price Bubble?
 Some economists have argued that the low rate interest policies of
the Federal Reserve in the 2003-2006 period caused the housing
price bubble.
 Taylor argues that the low federal funds rate led to low mortgage
rates that stimulated housing demand and encouraged the issuance
of subprime mortgages, both of which led to rising housing prices
and a bubble.
Inside the Fed: Was the Fed to Blame for the
Housing Price Bubble?
 Federal Reserve Chairman Ben Bernanke countered this argument,

saying the culprits were the proliferation of new mortgage
products that lowered mortgage payments, a relaxation of lending
standards that brought more buyers into the housing market, and
capital inflows from emerging market countries.
 The debate over whether monetary policy was to blame for the
housing price bubble continues to this day.
Global: The European Sovereign Debt Crisis
 The increase in budget de_x001C_cits that followed the financial

crash of 2007-2009 led to fears of government defaults and a surge
in interest rates.
 The sovereign debt debt, which began in Greece, moved on to

Ireland, Portugal, Spain and Italy.
 The stresses created by this and related events continue to threaten

the viability of the Euro.
 Height of the 2007-2009 Financial Crisis

• The stock market crash gathered pace in the fall of 2008, with
the week beginning October 6, 2008, showing the worst weekly
decline in U.S. history.
• Surging interest rates faced by borrowers led to sharp declines in

consumer spending and investment.
• The unemployment rate shot up, going over the 10% level in late
2009 in the midst of the “Great Recession”, the worst economic
contraction in the United States since World War II.
Figure 6 Credit Spreads and the 2007-2009
Financial Crisis
Government Intervention and the Recovery
 Short-term Responses and Recovery

• Financial Bailouts: In order to save their financial sectors and to
avoid contagion, financial support was provided by many
governments to bail out banks, other financial institutions, and
even the so-called “too-big-to-fail” firms that were severely
affected by the financial crisis.
• Fiscal Stimulus Spending: To boost their individual economies,

most governments used fiscal stimulus packages that combined
government expenditure and tax cuts.
Government Intervention and the
Recovery(contd)
 Short-term Responses and Recovery
• Japan's consecutive stimulus packages, totaling $568 billion,

were among the highest during the crisis, but these proved
largely ineffective
• European nations showed moderate success.

Global: Lativia’s Different and Controversial
Response
 Latvia's independence from the USSR in 1991 and its fiscal

policies helped it join the EU, 2004; and the Eurozone, 2014.
 Latvia's economic policies had a low budget deficit and a fixed

exchange rate against the Euro.
 In 2007, the country's second-largest bank, Parex Bank,

collapsed. Latvia needed 7.5 billion Euro to recapitalize
and meet external financing requirements.
Global: Lativia’s Different and
Controversial Response
 Austerity program: citizens voluntarily endured the layoff of 25% of
state workers, 40% salary cuts, and social expenditure reductions.
 After a contraction of over 25%, the country's GDP started to grow to

its near pre-crisis levels.
 Expansionary Contraction: Success in Latvia, but maybe

inapplicable in other countries because of the political motivations
involved.
Long-Term Responses
 With the individual emergency national bailouts to rescue national

economies and _x001C_nancial sectors, global leaders looked to
building a more stable and robust global financial system.
Steps taken by governments included

• Implement sound macroeconomic policies
• Enhance their financial infrastructure
• Develop financial education and consumer protection rules
• Enact macro and microprudential regulations.
Long-Term Responses (contd)
 At the international level

• Proactive globally-binding supervision was designed
• Financial market discipline enforced
• Systemic risk managed
 To avoid collective action problems and to ensure that policy

actions are mutually consistent with national growth
objectives, aggregate plans began to be drafted
simultaneously. The first ever of these is the Mutual
Assessment Process launched in 2009 by the G20.

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FINC 402: Monetary Theory

FINC 402: MONETARY

Offi ce Hours: Thursdays 10:00am - 1:00 pm (UGBS Main

• Majority of us are going to be working with financial

Financial intermediaries: institutions that borrow

Banks: institutions that accept deposits and make loans.

And therefore it is important to understand how financial

•Also, importantly, to understand the role of money in

Money, also referred to as the money supply, is defined as

Money plays a key role in generating Business

• Business Cycles are upward and downward movement

• Thus, recession (unemployment) and economic booms affect

• If you follow the news, you would have observed

• What effect might this have on the interest rate of

•Does it mean that a house will be more or less affordable

•Will it make it easier or harder for you to get a job

• To enhance students understanding of the role and nature of

• Walsh, Carl E. Monetary theory and policy. MIT press, 2010

•To understand the effects of money on the economy, we must

•We will explore the functions of money, looking at why and

• As the word money is used in everyday conversation, it

• Economists define money (also referred to as the money

•Because cheques are also accepted as payment for

•Thus while “currency” is too narrow a definition of money,

• People also use the word money to describe what

• Income is a flow of earnings per unit of time. Money, by

• Keep in mind that the money discussed here is distinct from

•Whether money is kola or shells or rocks or gold or paper, it

• In almost all market transactions in our economy,

HOW?? Let's take a case of an Economics Professor, who

• How good a store of value money depends on the price

• A doubling of all prices, for example, means that the

• Money loses value rapidly, and people will be more

•A bond is a debt security that promises to

•An interest rate is the cost of borrowing or the price paid

•Prior to 1980, the rate of money growth and the interest

•Since then, the relationship is less clear but the rate of

•The foreign exchange rate is the price of one currency in

• Fiscal policy deals with government spending

• Budget surplus is the excess of revenues over expenditures for

•Direct finance: borrowers borrow funds directly from lenders in

•Financial markets are also essential to promoting economic

•They also directly improve the well-being of consumers

•In essence, financial markets that are operating

•Foreign Bonds: sold in a foreign country and denominated

•Lower transaction costs (time and money spent in carrying

• Gather information about potential borrower.

Sign a contract with restrictive covenants

• To increase the information available to investors:

Restrictions on entry (chartering process)

• Formulate and implement monetary policy aimed at

through the deposit creation process

•The Central Bank controls the supply of

• The main ones are:

•The open market here refers to dealers in government

•The Central Bank(Bank of Ghana) has complete

• When the money market is in the equilibrium

• University of Ghana Business School, Department of

• Office Hours: Thursdays 10:00am - 1:00 pm

1. Introduction: The Money Supply Process