Chapter 5 Money is for Lunatics Demanders and Suppliers of Money

1. Chapter 5 Money is for Lunatics Demanders and Suppliers of Money

2. LEARNING OBJECTIVES Functions of money Four forms of money Money creation by the Bank of Canada and chartered banks Relate bond prices and interest rates and explain how money and bond markets determine the interest rate Differentiate the “Yes” and “No” camps’ positions on the monetary transmission mechanism

3. IS IT SMART TO NOT WANT MONEY?DEMAND FOR MONEY People demand money for its liquidity as a medium of exchange, unit of account, store of value. People willingly give up interest on bonds to hold wealth as money.

4. DEMAND FOR MONEY Money anything acceptableas means of payment; money has three functions a) medium of exchangeacceptability solves barter problem of double coincidence of wants b) unit of accountstandard unit for measuring, comparing prices c) store of valuetime machine for moving purchasing power from present to future; earn now, spend later

5. Bondfinancial asset where borrower promises to repay original value, and make fixed interest payments

6. Why hold wealth as money which pays no interest, rather than as bonds which pay interest? money provides liquidity —assets easily convert into medium of exchange money is most liquid asset — acceptable by sellers as means of payment money pays no interest, but has liquidity; bonds pay interest, but do not have liquidity

7. Why hold money as a store of value? “Yes” camphold more wealth as interest-paying bonds, since savings safely invested in loanable funds (bonds) “No” camphold more wealth as money because fundamental uncertainty about future makes bond investments risky

8. Interest rateprice of holding money; what you give up by not holding bonds  determined by demand and supply in both money and bond markets Law of demand for moneyas the price of money — interest rate — rises, quantity demanded of money decreases

9. Fig. 5.1 Macroeconomic Demand for Money

10. Changes in real GDP or average prices cause change in demand for money increase in real GDP increases demand for money; decrease in real GDP decreases demand increase in prices increases demand for money; decrease in prices decreases demand

11. Fig. 5.2: Macroeconomic Demand for Money Before and After Real GDP Increases

12. SUPPLY OF MONEY Forms of money commodity money — saleable product with alternative uses convertible paper money — paper money converted into gold on demand fiat money — currency (government-issued paper bills and coins) with no alternative uses, valuable simply by government decree deposit money — demand deposits — balances in bank accounts depositors withdraw on demand using debit card or cheque

13. Supply of money is currency and deposit money M1= currency in circulation and demand deposits M2= M1 plus all other less liquid deposits Fig. 5.3 The Money Supply BILLIONS OF $ OTHERDEPOSITS M2 $951 b DEMANDDEPOSITS M1 $465 b CURRENCY IN CIRCULATION continued…

14. Bank of Canada is Canada’s central bank — government institution responsible for supervising chartered banks and financial institutions and for regulating the supply of money

15. Bank of Canada roles issuing currency banker to chartered banks — chartered banks pay each other with deposits at Bank of Canada lender of last resort — making loans to banks to preserve stability of financial system banker to government — managing government accounts, foreign currency reserves, national debt conducting monetary policy — changing money supply and interest rates

16. Chartered banks create money (demand deposits) because of fractional reserve banking — banks hold a fraction of deposits as reserves Banks face a tradeoff between profits and prudence smaller fraction of reserves, more loans, and higher-risk loans may yield more profits Supply of money determined by Bank of Canada and chartered banks quantity of money supplied is a fixed amount at a moment in time supply of money does not change when interest rate changes continued…

17. Fig. 5.4 Chartered Banks: Sources and Uses of Funds

18. Fig. 5.5 Supply of Money

19. WHAT IS THE PRICE OF MONEY?INTEREST RATES, MONEY, AND BONDS Bond prices and interest rates are inversely related and determined together in money and bond markets.

20. MONEY AND BONDS a) Interest rate is the price of money opportunity cost of holding money cost of borrowing money b) Bonds promise to pay back original value plus fixed dollar amount of money bonds do notpromise fixed interest percent when interest rates rise, market price of bond falls, vis-à-vis holding a bond until maturity, you receive fixed dollar payments plus original value

21. Fig. 5.6 Macroeconomic Demand and Supply for Money

22. Interest rate determined by demand and supply in money and bond markets at market-clearing interest rate, quantity of money demanded equals quantity of money supplied when interest rate below market-clearing rate, excess demand for money; people sell bonds to get money; increased supply of bonds causes bond prices to fall, interest rate to rise Many different interest rates on financial assets, but most interest rates rise and fall together continued…

23. J.B. SAY AND J.M. KEYNES AS FACEBOOK FRIENDS?MONEY, INTEREST RATES, INVESTMENT, & REAL GDP “Yes” and “No” camps disagree about money’s effect on the frequency of business cycles and on how quickly markets adjust.

24. MONEY AND BUSINESS CYCLES Does money affect key macroeconomic outcomes of real GDP per person, unemployment, inflation? money can affect inflation, according to quantity theory of money money does notdirectly increase aggregate supply or economic growth continued…

25. Money indirectly affects real GDP and unemployment through monetarytransmission mechanism— how impact of money transmitted to real GDP demand & supply of money determine interest rate when interest rate falls, interest-sensitive purchases become cheaper so consumer spending (C) and business investment spending (I) increase increases in C and I increase aggregate demand continued…

26. Fig. 5.7 Transmission Mechanism from Money Demand and Supply to Real GDP

27. lower interest rates are positive demand shock, increasing aggregate demand, increasing real GDP, decreasing unemployment, causing inflation higher interest rates are negative demand shock, decreasing aggregate demand, decreasing real GDP, increasing unemployment, causing deflation continued…

28. Economists disagree on the question “How much does money change the economy when economy is not in equilibrium?” Say and “Yes, markets quickly self-adjust” camp answer “not much.” money does not affect external supply shocks that are main source of business-cycles money allows savings to flow easily through loanable funds market for business borrowing, for investment spending money helps quick adjustments to equilibrium continued…

29. Keynes and “No, markets fail to adjust” camp answer “a lot” money gives people a way to save, creating possibility of financial crises and new internal demand shocks for business cycles money gives people a way not to spend, blocking transmission mechanism so loanable funds market does not match spending to savings money slows market adjustments to equilibrium

30. Fig. 5.8 How Much Does Money Matter for Business Cycles?