Money and Monetary Policy: Study Notes for Macroeconomics

Money and Monetary Policy

Money and Its Uses

Money is a fundamental concept in macroeconomics, serving as the backbone of modern economies. It is defined as anything that is generally accepted as a means of payment. Money fulfills three principal functions:

• Medium of Exchange: Money is used to purchase goods and services, facilitating transactions.

• Unit of Account: Money provides a common measure for valuing goods and services, enabling price comparisons.

• Store of Value: Money can be held and saved for future use, retaining purchasing power over time.

Modern money, such as currency and bank deposits, is called fiat money—objects that are money because the law declares them as such.

Measures of Money: M1 and M2

• M1: Includes currency in circulation, demand deposits (checkable deposits), and traveler’s checks. These are highly liquid and can be used instantly for payments.

• M2: Includes all of M1 plus savings deposits, small time deposits, money market funds, and other near money (such as government T-Bills and bank CDs). M2 assets are usable for payments but may be less convenient or incur opportunity costs.

Example: If you transfer money from a savings account (M2) to a checking account (M1), M1 increases but M2 remains unchanged.

Money Demand and Supply

The demand and supply of money are central to understanding monetary policy and its effects on the economy.

Money Demand

• Definition: The relationship between the nominal interest rate (i) and the quantity of money demanded (MD) by individuals.

• Quantity of Money Demanded: The amount of money households and firms choose to hold, balancing the ability to make payments against the opportunity cost of forgone interest.

• Money Demand Function: $MD = L(Y, i)$ where Y is income and i is the nominal interest rate.

• Inverse Relationship: As the nominal interest rate increases, the demand for money decreases.

Example: Higher GDP or price levels increase money demand; improved financial technology may decrease it.

Money Supply

• Definition: The total amount of money available in the economy, regulated by the central bank through monetary policy.

• Central Bank Tools:

  • Required Reserve Ratio: Determines banks’ loan capacity and affects money supply.

  • Open Market Operations: Buying or selling government bonds to change the monetary base.

  • Exchange Rate Policy: Buying or selling foreign currencies to influence the monetary base.

  • Capital Recycling: Short-term loans to commercial banks to adjust bank reserves.

Bank Deposits and Reserves

• Bank Deposits: Money deposited by customers at commercial banks.

• Bank Reserves: Cash and similar assets held by banks to meet withdrawals and payments.

• Required Reserves: Minimum reserves mandated by the central bank.

• Excess Reserves: Reserves above the required minimum.

Formula:

• $\text{Bank Reserves} = \text{Required Reserves} + \text{Excess Reserves}$

• $\text{Reserve Ratio} = \frac{\text{Bank Reserves}}{\text{Bank Deposits}}$

Monetary Base and Money Supply

• Monetary Base: The amount of cash in circulation plus bank reserves.

• Formula: $\text{Monetary Base} = \text{Currency in Circulation} + \text{Bank Reserves}$

• Money Supply: Includes non-cash assets such as bank deposits.

• Formula: $\text{Money Supply} = \text{Currency in Circulation} + \text{Bank Deposits}$

• Money Multiplier: $m = \frac{\text{Currency in Circulation} + \text{Bank Deposits}}{\text{Currency in Circulation} + \text{Bank Reserves}}$

• Expanded Formula: $\text{Money Supply} = m \times \text{Monetary Base}$

Example: If the reserve ratio is 0.25 and bank reserves are $1000, then$ \text{Money Supply} = \frac{1000}{0.25} = 4000 $.

Monetary Policies

Monetary policy refers to actions by the central bank to influence the money supply and interest rates.

Required Reserve Ratio (RRR)

• Definition: The share of a bank’s total deposits that must be held in reserve.

• Policy Purpose: Changing the RRR alters the money multiplier and thus the money supply.

• Expansionary Policy: Lower RRR increases money supply.

• Contractionary Policy: Raise RRR decreases money supply.

Open Market Operations

• Definition: Central bank buys or sells financial instruments (bonds, bills) in the open market.

• Expansionary Policy: Open-market purchase increases monetary base and money supply.

• Contractionary Policy: Open-market sale decreases monetary base and money supply.

Exchange Rate Policy

• Definition: Central bank buys or sells foreign currencies to meet targeted exchange rates.

• Expansionary Policy: Buy foreign currencies increases monetary base and money supply.

• Contractionary Policy: Sell foreign currencies decreases monetary base and money supply.

Capital Recycling

• Definition: Central bank makes short-term loans to commercial banks.

• Expansionary Policy: Raise capital recycling increases bank reserves and money supply.

• Contractionary Policy: Lower capital recycling decreases bank reserves and money supply.

Money Market

The money market is where the demand and supply for money interact to determine the equilibrium nominal interest rate.

Money Demand Curve

• Shape: Downward sloping; as nominal interest rate decreases, opportunity cost of holding money decreases, so money demand increases.

• Shifts:

  • Real GDP: Higher GDP shifts demand right.

  • Price Levels: Higher prices shift demand right.

  • Financial Technology: Improved technology may shift demand left.

Money Supply Curve

• Shape: Vertical line; fixed by central bank at targeted level.

• Shifts: Expansionary or contractionary monetary policy.

Equilibrium

• Occurs where money demand equals money supply.

• Determines the equilibrium nominal interest rate.

Applications and Examples

• Function of Money: Buying goods (medium of exchange), comparing prices (unit of account), saving cash (store of value).

• Money Supply Changes: Transferring funds between accounts affects M1 and M2 differently.

• Central Bank Actions: Open market purchases increase monetary base and money supply; sales decrease them.

• Interest Rate Effects: Lower interest rates increase money demand; higher rates decrease it.

Key Formulas and Relationships

• $\text{Money Demand Function}: MD = L(Y, i)$

• $\text{Reserve Ratio}: \frac{\text{Bank Reserves}}{\text{Bank Deposits}}$

• $\text{Monetary Base}: \text{Currency in Circulation} + \text{Bank Reserves}$

• $\text{Money Supply}: \text{Currency in Circulation} + \text{Bank Deposits}$

• $\text{Money Multiplier}: m = \frac{\text{Currency in Circulation} + \text{Bank Deposits}}{\text{Currency in Circulation} + \text{Bank Reserves}}$

• $\text{Money Supply} = m \times \text{Monetary Base}$

Comparison Table: M1 vs. M2

Component	M1	M2
Currency in Circulation	✔	✔
Demand Deposits	✔	✔
Traveler’s Checks	✔	✔
Savings Deposits		✔
Small Time Deposits		✔
Money Market Funds		✔
Other Near Money		✔

Summary

• Money is essential for exchange, accounting, and storing value.

• M1 and M2 are key measures of money supply, with different liquidity levels.

• Money demand and supply interact to determine interest rates and economic activity.

• Central banks use various tools to regulate money supply and influence macroeconomic outcomes.

Additional info: Academic context and formulas have been expanded for clarity and completeness.