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Macroeconomics IDr Tu Thuy AnhFaculty of International Economics

Money Market

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  Functions of Money 

1 Medium of exchange ◦ Buying and selling goods and services◦ Money eliminates need for a coincidence of

wants required for trade to occur in a bartereconomy.

2 Unit of account ◦ Assist the measurement of the relative worth of

various goods, services and resources.

3 Store of value ◦ A form in which to store wealth due to its

liquidity and convenience

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Transactions Demand Asset Demand

Demand for money as amedium of exchange. Dependson money (nominal) GDP.

Demand for money as afinancial asset and store ofwealth.

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rMt

Quantity of

money

r

Ma

Quantity ofmoney

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Consider an individual who is faced with a choice between

holding their wealth in the form of money or in the form of other

financial assets. ◦ Advantage of holding money: liquidity

◦ Advantage of holding financial assets (bonds): interest return

◦ If the interest rate or opportunity cost of holding money asan asset is low, the public will choose to hold a large amount

of their wealth in the form of money. When the interest rate

is high, it is costly to ‘be liquid’ and the amount of assets

held in the form of money will be small.◦ Thus the asset demand for money varies inversely with the

rate of interest.

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r

MD

Quantity of money

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The quantity of money circulating is called the money supply: 

• Currency: the paper bills and coins in the hands of the public.

• Current deposits: balances in bank accounts that depositors can

access on demand by using a debit card or writing a cheque.

• Credit cards are not a form of money (deferred payment)

• Non-Bank Financial Institution deposits

The supply of money will be vertical, determined by the Central Bank. 

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r Ms

Quantity of Money 

• Ms determined exogenously

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Quantity ofMoney

r

MD

r0

MS

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•If the interest rate is below the equilibrium, then an excess demand

 for money, or a shortage of money, exists.

•  Attempts to obtain more money  convert other assets, such as

bonds, into money by selling them. As everyone tries to sell their

bonds, they flood the market with bonds. This pushes bond prices

down, which raises the interest rate.

• When the interest rate rises, the opportunity cost of holding

money increases, and therefore the quantity of money demanded

declines, represented by movement up along demand curve.

• The process stops when bond prices have fallen far enough to

raise the interest rate to r0, eliminating the excess demand for

money.

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Lower bond prices are associated with higher interest rates.

Suppose a bond with no expiration date pays a fixed $50

annual interest payment and is selling for its face value of

$1000. The interest yield on this bond is 5%.

Suppose the price of this bond falls to $667 because of an

increase in the supply of bonds. The $50 fixed annual

interest payment will now yield 7½% to whomever buys the

bond:

5%

$1000

$50

7.5%$667

$50

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Banks Concerned With

Providing safekeeping facilities.

Making a profit.

A Fractional Reserve Banking System describesthe practice of holding a fraction of money

deposited as reserves and lending out the rest.

Reserve Ratio (R): fraction of total deposits thatthe bank holds as reserves

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Assume the required reserve ratio is 10% and

$1,000 is deposited into Bank A.Bank A

 Assets Liabilities

Reserves $100 Deposits $1,000

Loans $900

Bank B

 Assets LiabilitiesReserves $90 Deposits $900

Loans $810

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Banks and Money Creation

Bank C

 Assets LiabilitiesReserves $81 Deposits $810

Loans $729

Bank D

 Assets Liabilities

Reserves $72.90 Deposits $729

Loans $656.10

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  Original deposit = $1,000

Bank A = $900Bank B = $810

Bank C = $729

Total money supply = $10,000

To Calculate: Initial Deposit x Money Multiplier =

$10,000

Money Multiplier (m)

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R

1m

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The deposit multiplier calculated as the

reciprocal of the R assumes that banks are fullyloaned up. However ...

◦ Leakage into excess reserves: extra reserves may be

kept by banks for liquidity purposes.◦ Leakage due to cash withdrawal: not all loaned funds

may be deposited into banks.

◦ Variation in the willingness to lend and borrow:

consumers may not wish to borrow and banks may not

wish to lend

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