Money and

Interest Rates

Money and Interest Rates

The Meaning and Functions of

Money

The meaning and functions of money

What is money? The stock of financial assets that can

easily be used to make market transactions and that serves

as a medium of exchange, a unit of account, and a store of
value.
People use money to buy and sell , its common measure of

value , you can store the money and the value and use it in
future
Before money introduce to economy it was barter system

and people exchange goods with goods and was difficult to

manage that market so money created as unite of exchange

 The functions of money

medium of exchange (whenever you want to exchange

something this is the common things and value which you use to do
that exchange-barter system) something that is acceptable in
exchange for goods and services

means of storing of value (you can store the money and the
value and use it in future) . People need to be able to store their wealth ,
they wants a means of saving , money can do all this

Unite of value (give you ability to count the value by number

and compare the value )

The meaning and functions of money

What should count as money?

narrow definitions of money includes just cash (notes and coin)

broad definitions of money include various types of bank account

and financial assets

The ideal attributes of money

durability

divisibility

transportability

non-counterfeit ability

The money market

Money market : the market for short term debt instrument ,

such as gov bills in which financial institutions are active participants

Financial deregulation: the removal of or reduction in

legal rules and regulations governing the activities of financial
institutions

Monetary financial institutions (MFIs): deposit

taking institution including banks , building societies and the bank of

England

Liabilities : all legal claim for payment that outsiders have on an

institution

Money and Interest Rates

The Financial System

The financial system

The role of the financial sector

expert advice financial intermediaries can advise their customers on

financial matters on the best way of investing their funds and alternative
ways of obtaining finance , should help to encourage the flow of savings
and efficient use of them

expertise in channelling funds, Have the knowledge to be able to

channel funds to those areas that yield the highest return

maturity transformation, the transformation of deposits into loan

of longer maturity.

risk transformation, the process whereby banks can spread the risks
of lending by having a large number of borrowers

The financial system

The banking system (types of bank)

retail banks: retail deposits and loans, branch telephone ,

postal and internet banking for individuals and businesses at published rates

wholesale banks: wholesale deposits and loans , when

bank deal in large scale deposits and loans mainly with companies and other
banks and financial institutions. Interest rates and charges may be negotiable

universal banks: conducting retail and wholesale

banking

The financial system

Deposit taking and lending, banks are in the business of

deposit taking and landing

liabilities and assets , the customers have the claim on these deposits and
thus the institutions are liable to meet the claims

sterling liabilities

sight deposits, deposits can be withdrawn on demand without penalty

time deposits, deposits that require notice of withdrawal or where a

penalty is charged for withdrawals on demand

certificates of deposit, issued by bank for fixed term interest bearing
deposits . They can be resold by the owner to another party

sterling assets

cash and balances in the central bank

short-term loans
longer-term loans

 Bank get deposit from people but doesn't hold that money

and try to make benefit. Takes money and loans some part
of that money and they don't loan all that money because
sometime customers come back and want to withdraw that
money

The creation of credit

bank deposits multiplier, the number of times greater the

expansion of bank deposits is than the additional liquidity

in banks that causes it 1/reserve ratio ( the inverse of the
liquidity ratio)

Assume that the required reserve ratio is

20% and someone deposit 500$ in a bank,

how much will the money supply increase ??
Answer :Money multiplier 1/0.2= 5
So bank hold 100$ (20%*500) and use
400$ to loan out
so 500$deposited from someone , increases
the money supply by :
400*5=2000$

Q Which of the following arranges a

persons assets in descending order of
liquidity (most liquid first)?
A. bonds; cash; shares; land
B. a house; cash; shares;
savings account deposits
C. shares; land; savings account
deposits; bonds
D. current account deposits;
savings account deposits;
shares; a house
E. cash; savings account
deposits; current account
deposits; bonds

20%

A.

20%

20%

20%

20%

B.

C.

D.

E.

Q Which of the following would be

classified as a liability of a bank?
A. Holdings of toxic debt

20%

20%

20%

20%

B.

C.

D.

20%

B. Current account deposits

C. Reserves in the central
bank
D. Loans to other banks
E. Customers overdrafts

A.

E.

Q Which of the following describes a repo?

A. Where a bank agrees to buy
certain assets from an institution
for cash in return for being able
to borrow from that institution in
the future.

25%

25%

25%

B.

C.

25%

B. Where a bank sells some assets

(e.g. bonds) and agrees to buy
them back at a particular price
after a set period of time.
C. Where bank X lends to bank Y
provided that bank Y is prepared
to lend to bank X in the future.
D. Where a bank sells assets to
person or institution X in return
for buying assets from person or
institution Y.

A.

D.

The financial system

Liquidity and profitability

Profitability , made by lending money out at a

higher rate of interest than that paid to depositors

Liquidity, the ease with which an asset can be

convert into cash without loss

Q Which of the following would be

classified as liquid asset of a bank?
A. Sight deposits

20%

20%

20%

20%

B.

C.

D.

20%

B. Time deposits
C. Personal loans
D. Certificates of deposit
in other banks
E. Repos with the
central bank

A.

E.

Q If a bank discovers that it has more

toxic assets on its books than previously
thought, it is likely to:
A. increase its liquidity ratio and
thus cut back on lending.

25%

25%

25%

B.

C.

25%

B. decrease its liquidity ratio

and thus cut back on lending.
C. increase its liquidity ratio and
thus increase lending.
D. decrease its liquidity ratio
and thus increase lending.

A.

D.

The financial system

The central bank all countries with their own

currency have a central bank

note issue

banking functions

management of governments borrowing programme

provider of liquidity to banks

oversees the activities of banks and other financial

institutions

operates monetary policy

operates exchange rate policy and manages reserves

Money and Interest Rates

The Supply of Money

The supply of money

Definitions of the money supply

monetary base , notes and coin outside the central bank

broad money, cash in circulation plus retail and
wholesale bank and building society deposits

Definitions in the UK

cash in circulation
in UK this measure of broad money is known as M4
In most other European countries and the USA it is
known as M3

Q If an extra 100m is deposited in

the banking system and the bank
deposits multiplier is 5, by how much
can credit expand?
25%

25%

25%

B.

C.

25%

A. 80m
B. 180m
C. 400m
D. 500m
A.

D.

Q In an economy where all commercial banks

keep ten per cent of their deposits in liquid assets,
total bank assets would be increased by 100
million if bank holdings of cash increased by:
20%

20%

20%

20%

B.

C.

D.

20%

A. 10,000 million
B. 1000 million
C. 100 million
D. 10 million
E. 1 million
A.

E.

The supply of money

The creation of credit in the real world

banks liquidity ratio may vary

banks may hold a higher level of liquid assets when

they perceive increased risk

customers may not take up all the credit on offer

banks may not operate a simple liquidity ratio

how much of the extra cash will be withdrawn by

the public?

The supply of money

Causes of increases in money supply

banks reduce liquidity ratio

households and firms choose to hold less cash

currency flow surplus on the balance of payments

public-sector deficit

Q Which of the following methods of

financing an increase in the
public-sector net cash requirement will
lead to an increase in the money supply?
A. Sales of securities to
overseas purchasers

20%

20%

20%

20%

B.

C.

D.

20%

B. Sales of bonds to the nonbank private sector

C. Sales of Treasury bills to the
non-bank private sector
D. Sales of Treasury bills to the
banking sector
E. Sales of bonds to the
banking sector

A.

E.

The supply of money

Flow-of-funds equation
The various items making up an increase (or

decrease) in money supply

Exogenous money supply: money supply that does

not depend on the demand for money but is set by
the authorities

The supply of money curve: (a) exogenous money supply

Rate of interest

MS

Money supply
determined
independently of the
demand for money
and interest rates

O
Quantity of money

The supply of money curve: (b) endogenous money supply

Rate of interest

MS

Money supply
depends (in part)
on the demand for
money and
interest rates

O
Quantity of money

Q Which of the following would NOT cause a

rise in money supply (assume ceteris paribus)?
A.

20% 20% 20% 20%

An increase in government
spending financed by borrowing
from the banking sector.
B. An increase in the proportion of
the national debt financed by bills
rather than by bonds.
C. The central bank imposes a
statutory liquidity ratio on banks
(above their current ratio).
D. A rise in demand for money and
the central bank does not change
interest rates.
E. The government finances the
budget deficit by selling securities
to the central bank.
A.
B.
C.
D.

20%

E.

Money and Interest Rates

The Demand for Money

 Definition of M1, M2, M3, M4.

Different measures of money supply. Not all of them are widely used

and the exact classifications depend on the country.

M1 called narrow money, normally include coins and notes in
circulation and other money equivalents that are easily convertible into
cash.
M2 includes M1 plus short-term time deposits in banks and 24-hour
money market funds.
M3 includes M2 plus longer-term time deposits and money market
funds with more than 24-hour maturity.
The exact definitions of the three measures depend on the country. M4
includes M3 plus other deposits. The term broad money is used to
describe M2, M3 or M4, depending on the local practice.

Q What do we mean by the term

the demand for money? Is it:
A. the proportion of peoples
income held as wealth?

20%

20%

20%

20%

B.

C.

D.

20%

B. a means of controlling the

money supply?
C. a term used by the Bank of
England to refer to the
demands placed upon it by
the banking sector?
D. the desire by individuals
and firms to spend, given
their level of income?
E. the demand to hold assets
in money form?

A.

E.

The demand for money

The motives for holding money (M4): to keep

your wealth in the form of money rather than

spending it on goods and services or using in
purchase financial assets such as bonds or
shares. Note that we are talking here about
broad money M4 in the UK

transactions and precautionary demand for money

is L1, L is liquidity preference. that is the demand
for holding assets in the form of money

 The major determinant of L1 is nominal

national income (national income at current

prices) the bigger peoples money income , the
greater their expenditure and the bigger their
demand for active balances
Active balances : money held for
transactions and precautionary purposes.

Rate of interest

The transactions-plus-precautionary demand for money: L1

L1
O
Active balances

 speculative (assets) demand for money: L2

Money balances held for this purpose are called idle

balance . People who possess wealth , whether they are

wealthy or simply small savers , have to decide the vest
form in which to hold that wealth , do they keep it in
cash in piggy bank or in a current account in a real
band or do they put it in some interest bearing time
account , or do they buy stocks and shares or
government bonds or do they buy some physical asset
such as a car or property ??
In making these decisions people will have to weight
up the relative advantage and disadvantage of the
various alternative assets

Rate of interest

The speculative demand for money: L2

L2
O
Idle balances

 The higher the rate of return on assets , such as shares

and bonds , the greater the opportunity cost of holding

money and therefore the lower the speculative demand
for money .
If people believe that share prices are about to rise
rapidly on the stock market , they will buy shares and
hold smaller speculative balances of money , if they
think that shares prices will fall they will sell them and
hold money instead .
If the rate of interest is high then L2 is likely to be low .
To take advantage of high rate of return on securities,
people buy them now instead of holding on to their
money

 the total demand for money: L1 + L2

Any factor other than a change in interest rates

that causes the demand for money to rise will

shift the L curve to the right. e.g. a rise in
national income will cause L1 to increase and
thus L will shift to the right

Rate of interest

The total demand-for-money curve: L (= L1 + L2)

L ( = L 1 + L 2)
L2
L1
O
Total money balances

Q Which one of the following would NOT

increase the demand for money?
A. People are paid less
frequently.
B. People decide to holder
larger precautionary
balances of money.
C. Property prices are
expected to rise.
D. Speculators believe that
interest rates will rise.
E. Speculators believe that
the exchange rate index
will rise.

20%

A.

20%

20%

20%

B.

C.

D.

20%

E.

Money and Interest Rates

Equilibrium in the Money Market

Monetary equilibrium
Equilibrium in the money market is where the demand for

money L is equal to the supply of money Ms. This equilibrium

will achieved through changes in the rate of interest (re)
If the rate of interest were above (re) people would have money

balances surplus to their needs . They would use these to buy

shares , bonds and other assets . This would drive up the price
of these assets and drive down the rate of interest . As the rate
of interest fell , so there would be a contraction of money supply
a movement down along the Ms and an increases in the demand
for money balances specially speculative balances . The interest
rate would go on falling until it reached (re). Equilibrium would
then be achieved

Equilibrium in the money market

Rate of interest

MS

re

L
O

Me

Money

Q Which of the following will lead to

an increase in interest rates?
A. A decreased holding of
transactions balances

20%

20%

20%

20%

B.

C.

D.

20%

B. An increase in narrow
money (cash in circulation)
C. A belief that bond and other
security prices will fall
D. Banks choose to operate
with a lower liquidity ratio.
E. A reduction in the PSNCR

A.

E.

 Equilibrium in foreign exchange market

Change in the money supply also affect the

foreign exchange market . In a free foreign

exchange market equilibrium will be achieved
by changes in the exchange rate. It has 3 direct
effects

effect on interest rates

effect on exchange rates

effect on imports and exports

Q Assuming ceteris paribus, an increase

in national income will:
A. increase the transactions demand
for money and thereby push up
interest rates.
B. increase the supply of money and
thereby push down interest rates.
C. decrease the speculative demand
for money and thereby push up
interest rates.
D. increase both the demand and
supply of money and thus leave
interest rates unchanged.
E. decrease savings in the economy
and thereby push down interest
rates.

20%

A.

20%

20%

20%

B.

C.

D.

20%

E.

quantity theory of money

MV = PQ
M: Money supply (cash money in economy )
V: Velocity of money ( average of time money spend and re

spend in economy
P: price level in economy
Q: real output or real GDP
PQ : nominal GDP , increase in Money supply of V , will
increase Nominal GDP
If V & GDP is constant , when money supply increase , P
will increase also. If GOV increase supply Money and
doesnt increase GDP or output ,will effect in economy and
price will increase so high