MONETARY

ECONOMICS
BSc(Hons) in Banking and
International Finance
ACADEMIC YEAR 2008/2009
Semester 1
 INTRODUCTION TO MONETARY
ECONOMICS

A study of monetary economics must first and foremost be

concerned with analyzing the role of money in the economy.
Money is the stock of assets that can be readily used to make
transactions.

Monetary economics came into usage when the topic of

money came to be co extensive with macroeconomics.
It tries to address the question of why money is a useful
commodity in a rigorous theoretical way.
 CHAPTER 1:
ROLE AND DEFINITIONS OF MONEY

1.1 FUNCTIONS OF MONEY

1.2 DEFINITIONS OF MONEY

 1.1 FUNCTIONS OF MONEY
1. UNIT OF ACCOUNT
It is the common unit by which everyone measures prices
and values.
The introduction of the unit of account to compare values of
different goods and services allows economic efficiency by

Avoiding unnecessary calculations.

To compare 2 commodities X and Y we have only one
calculation. The price of X in terms of Y (or vice versa).
With a third commodity Z we have two more
calculations.(The price of X in terms of Z and the price of Y
in terms of Z).
With numerous commodities the number of calculations will
increase exponentially.
 Permitting rational economic calculations to take place.
A common unit of account renders goods and services
comparable.
Comparability is necessary if we want to have a rational
individual`s choice.

Transmitting economic information

For ex: The market mechanism operates with consumers
money votes informing producers about market
preferences. They will use this information to make decisions.
 1.1 FUNCTIONS OF MONEY
2. MEDIUM OF EXCHANGE
As a medium of exchange the productive role of cash lies in
avoiding the inconveniences and inefficiencies of barter.

Throughout most recorded history barter has been the norm.

Barter is a type of trade where goods or services are
exchanged for a certain amount of other goods or services;
For ex. In medieval times rents were paid in labor or in kind.
What are the advantages of money economy vis--vis
the barter system?
Money simplifies economic transactions
Barter system is more complex as it involves two
economic decisions: sale and purchase.
Money replaces bilateral trading with multilateral
trading.
To obtain a mutually satisfactory barter transaction a
one needs a whole chain of complementary barter
transactions.
Money allows people to sell to one person and buy with
another.
 The use of money increases the number of similar
transactions which enhances competition.

ex: 1000 persons want to buy bread.

With money : similar transactions and creates a competition
on the buying side of the market.

With barter: Smaller and separate groups according to

whether they wished to pay their bread with wine , shoes or
other commodity.
 1.1 FUNCTIONS OF MONEY
3. STORE OF VALUE

Money allows to transfer purchasing power from the

present to the future.

Money is not the only store of value:

Most financial assets and some real assets serve the same
function . But money has the advantage of being liquid.
 4 aspects of liquidity

Marketabilty:
readily and immediately accepted as payment by many
people everywhere.

Predictability:
of the value of an asset at any unspecified moment of time
when it will be used in payment.

Shares whose values fluctuate at the Stock exchange are not

liquid in this sense.
 Reversibility:
It is the value in payment that is little smaller than it was on
receipt.
Real assets lack reversibility.
An extreme example:
A new car loses its value the moment it is driven out of the
dealers showroom.

Divisibility:
Smallest unit in which transactions can take place determines
flexibility of the asset in exchange.
 1.2 DEFINITIONS OF MONEY

Generally we think and talk about income savings, wealth and

so on in money terms.

The official definitions of Money:

Money can be defined narrowly or broadly.
narrow money = Monetary Base
Monetary aggregates M1 M2 and M3
 1.2 DEFINITIONS OF MONEY
1. MONETARY BASE
Narrowest definition of money.
Includes cash held by both non-banks and in the vaults of
commercial banking system.
Monetary base= currency with monetary financial
institutions (MFIs) + MFIs Holdings of deposits with central
bank.
The monetary base forms a highly liquid potential of
reserves.
 1.2 DEFINITIONS OF MONEY
2. MONETARY AGGREGATES (US definitions)
Monetary aggregates are measures of the nations money supply
The normal practice is to attach numbers to these official
magnitudes using the lowest numbers to refer to the
narrowest magnitudes.

M1= Currency in circulation outside MFIs(non interest bearing

checking accounts at commercial banks, excluding deposits of
other banks)
+ non MFIs holdings of sight deposits (ex.Travellers checks).
These can be used to make payment or to exchange for cash on
demand.
 M2= M1
+ savings deposits
+ money market mutual funds (interest earning deposits
that invest in short term assets).
+ money market deposits (MMMF run by banks with an
insurance)
+ small time deposits (interest bearing deposits with a small
specific maturity date)
+ retirement accounts .

M2 can be used with little difficulty to make payments.

 M3= M2
+ Repurchase agreements (transactions in which a bank borrows
from a non bank customer by selling for ex. Treasury bills)
+ Eurodollars deposits (Deposits that pay interest and mature the
next day, typically held by foreign branches of US banks and all
banking offices in UK and Canada).
+Large denominations time deposits

IMPORTANT:
There are NOTABLE differences in the classification of the
Components of monetary aggregates in USA and EUROZONE.
 CHAPTER 2:
THEORIES OF THE DEMAND FOR
MONEY

2.1 THE QUANTITY THEORY OF MONEY

2.2 CAMBRIDGE APPROACH TO MONETARY THEORY

2.3 KEYNESIAN APPROACH TO THE MONETARY THEORY

2.4 POST KEYNESIAN MODIFICATIONS TO THE DEMAND FOR MONEY

2.5 FRIEDMANS MODERN QUANTITY THEORY

2.6 SOME EMPIRICAL EVIDENCE

2.1 THE QUANTITY THEORY OF
MONEY