The money market

• Money


  An asset that is generally acceptable in transactions
• Types of money


  • Narrow money (M1)
  • Broad money (M2)
  • M3
• Narrow money (M1)


  • Money balances held to carry out day-to-day spending
• Broad money (M2)


  • Money balances held as a store of value in addition to that held for transaction purposes
• M3


  • Includes currency, deposits with an agreed maturity of up to two years, deposits redeemable at notice of up to three months and repurchase agreements, money market fund shares/units and debt securities up to two years
• Basic functions of money

  • Unit of account
  • Store of value
  • Medium of exchange
  • Standard of deferred payment
• Durability


  • Money needs to be durable to withstand frequent movement from one hand to another as a medium of exchange
• Acceptability


  • Money must be acceptable by all those involved in transactions otherwise it will collapse as a medium of exchange
• Divisibility


  • Money should be divisible to facilitate effective exchange since different goods and services fetch various prices
• Portability


  • Money should not be cumbersome to carry
• Liquidity


  • Money should be liquid i.e. it should be easy to carry out transactions using it
• Types of financial institutions

  • Commercial banks
  • Central bank
  • Non-bank financial institutions
• Commercial banks


  • Accept deposits and give credit, facilitate exchange, provide facilities for savings, distribute credit to business enterprise and consumers
• Central bank


  • Issue of currency, supervision of banks and other financial institutions, bankers' bank, government's bank, represents the country in international monetary meetings
• Non-bank financial institutions (NBFIs)

  • Financial institutions that do not have a full banking license and cannot accept deposits from the public, but facilitate alternative financial services such as investment, risk pooling, financial consulting, brokering, money transmission, and check cashing
• Creation of money


  1. Bank converts liability (deposits) into asset (reserves and loans)

  2. Required reserves - minimum amount of deposits commercial banks must hold by law

  3. Excess reserves - amount commercial banks can loan out
• Limitations on money creation

  • Cash ratio
  • Lack of demand for loans
  • Cash drain
• Transactions demand for money


  Amount of money held for future exchange of goods and services
• Speculative demand for money

  Amount of money held to take advantage of profitable opportunities that may arise in financial markets
• Precautionary demand for money


  Amount of money held to provide for unexpected expenditures
• Transactions demand for money

  Depends on level of income, spending habits, time interval between income receipts
• At very high interest rates and increased income


  People convert some of their idle balances into interest bearing securities
• Transactions and precautionary demand for money are interest inelastic
• Speculative demand for money looks at money as a store of value, unlike transactions and precautionary motives which look at money as a medium of exchange
• Mt


  Combined transaction and precautionary demand for real cash balances
• Classical quantity theory


  Assumes the world is perfect with all receipts and expenditures known
• Keynesian model


  Assumes uncertainty, hence the need for precautionary money balances
• Precautionary motive


  Arises from the need to provide for contingencies that require sudden expenditure and for unforeseen opportunities
• Precautionary demand for money

  Interest inelastic
• Fall in the interest rate

  Leads to an increase in the speculation demand for money
• MSP


  Speculative demand for money, where MSP = Li(r) and Li(r) < 0
• Md


  Aggregate demand for money, where Md = Mt + MSP
• Aggregate demand for money

  • Downward sloping and convex to the origin
  • At a certain level of interest (r*), becomes horizontal (perfectly interest-elastic)
• Liquidity trap


  Situation where further fall in interest has no effect on the speculative demand for money
• r*


  Liquidity trap interest rate, where people prefer to hold their wealth in cash rather than bonds
• Modern quantity theory of money


  Money is just one of the many ways in which wealth can be held
• Md/P


  Real demand for money, where Md/P = f(W, r, w, T)
• W


  Total wealth
• r


  Expected rate of return on various forms of wealth
• w


  Ratio of human wealth to non-human wealth