# Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 38
Fisher's logic led Milton Friedman to conclude that central banks should simply set money
growth at a constant rate.
Policymakers should strive to ensure that the monetary aggregates grow at a rate equal to the
rate of real growth plus the desired level of inflation.
Knowing that the multiplier is a variable, Friedman suggested changes in regulations that would
Limit banks' discretion in creating money
Tighten the relationship between the monetary aggregates and the monetary base.
However, even with Friedman's recommendations, the central bank would stabilize inflation by
keeping money growth constant only if velocity were constant.
In the long run, the velocity of money is stable, though there can be significant short-run
variations.
From the point of view of policymakers, these fluctuations in velocity are enormous.
Assuming that central bank can accurately control the growth rate of M2 as well as accurately
forecast real growth.
Money Growth + Velocity Growth = Inflation + Real Growth
With an inflation objective of 2% and a real growth forecast of 3.5%, equation of exchange tells
us that policy makers should set money growth 5.5% minus the growth rate of velocity.
If velocity increases by 3% then money growth needs to be 2.5%
If it falls by 3% then money growth needs to be 8.5%
When inflation is low, short run velocity growth can be several times the policy makers'
inflation objectives.
So to use money growth targets to stabilize inflation, policy makers must understand how
velocity changes
Fluctuations in velocity are tied to changes in people's desire to hold money and so in order to
understand and predict changes in velocity; policymakers must understand the demand for
money.
Figure: Velocity of M1 and M2 (on the same vertical scale)
10
___M1 Velocity ____M2 Velocity
9
8
7
6
5
4
3
2
1
0
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
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Money & Banking ­ MGT411
VU
Figure: Velocity of M2 (on its own scale)
2.2
2.1
2.0
1.9
1.8
1.7
1.6
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
Years
Figure: Percentage change in the short-run velocity of M2, 1960-2004
8
6
4
2
0
-2
-4
-6
-8
1975
1980
1985
1990
1995
2000
Years
The Transactions Demand for Money
The quantity of money people hold for transactions purposes depends on
Their nominal income,
The cost of holding money,
The availability of substitutes
Nominal money demand rises with nominal income, as more income means more spending,
which requires more money
Holding money allows people to make payments, but has cost of interest foregone.
There may also be costs in switching between interest-bearing assets and money.
Example
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Money & Banking ­ MGT411
VU
If your monthly earning is Rs.30, 000 (deposited in bank each month) and assuming you spend
Rs.1, 000 each day, after 15 days your checking account balance will decline to Rs.15, 000 and
to zero on 30th day
Your bank offers you a choice of leaving the entire 30,000 in the account or shifting funds back
and forth between checking and a bond fund.
The bond fund pays interest but adds a service charge of Rs.20 for each withdrawal.
How would you manage your funds and what should be your frequency of shifting the funds
between the bond fund and checking account?
Consider the following alternatives.
Two alternatives for managing your cash balance
Strategy 1: Leave entire balance in checking account
Checking account balance
Bond fund
30,000
balance is zero
throughout the
month.
30
0
Day of the month
Strategy 2: Transfer half to bond fund, then transfer back at mid-month
Bond Fund Balance
Checking account
balance
15,000
15,000
15
0
0
30
15
30
Day of the Month
Day of the month
Your choice depends upon the interest rate you receive on the bond fund
If interest income is at least as much as the service charge then you will split your pay check at
the beginning of the month.
Otherwise you will not want to invest in bond fund.
If you shift half your funds once , at the middle of the month, you'll have Rs.15,000 in bond
fund during the first half of the month and Rs.0 during the second half, so your average balance
will be Rs.7,500.
Making shift will cost you Rs.20 so if the interest on Rs.7, 500 is greater than 20, you should
make the shift.
At monthly interest rate of 0.27%, Rs.7, 500 will produce an income of Rs.20
(20 / 7500= 0.0027)
So if bond fund offers a higher rate you should make the shift.
As the nominal interest rate rises, people reduce their checking account balances, which allow
us to predict that velocity will change with the interest rate.
Higher the nominal interest rate, the less money individuals will hold for a given level of
transactions, and higher the velocity of money
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Money & Banking ­ MGT411
VU
The transactions demand for money is also affected by technology, as financial innovation
allows people to limit the amount of money they hold.
The lower the cost of shifting money between accounts, the lower the money holdings and the
higher the velocity.
your old check and debit account
Your take home pay is the same Rs.30, 000. Each time you make a purchase, your bank
automatically shifts the amount of purchase from your bond fund to your checking account
where it remains for one day before being paid to your creditor.
Spending your Rs.30,000 in 30 days, your average money holding will be Rs.1000 far below
Rs.1,500 you would hold if you simply left the 30,000 in your checking account and spent it at a
rate of Rs.1,000 per day
So lower the cost of shifting funds from your bond fund to your checking account, the lower
your money holdings at a given level of income and the higher the velocity of your money
An increase in the liquidity of stocks, bonds, or any other asset reduces the transactions demand
for money.
People also hold money to ensure against unexpected expenses; this is called the precautionary
demand for money and can be included with the transactions demand.
The higher the level of uncertainty about the future, the higher the demand for money and the
lower the velocity of money
The Portfolio Demand for Money
Money is just one of many financial instruments that we can hold in our investment portfolios.
Expectations that interest rates will change in the future are related to the expected return on a
bond and also affect the demand for money.
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