The Money Market

The Money Market

Money is defined as those assets that are widely used and accepted in payment. There are several different measures of money, referred to as monetary aggregates. Their precise definitions vary from country to country but the following definitions can be taken as a rough guide: M1 is currency plus balances held by individuals in current accounts; M2 is M1 plus time depositsand short term foreign currency deposits, and M3 is M2 plus Euro-deposits, short term bank securities and certificates of domestic and foreign money market funds.


Money Supply
The money supply is the amount of money available in an economy. As the equation below shows, this amount is only partly under the control of the central bank.

Money Supply: MS = mH

Where m is the bank multiplierand H is high powered money or the monetary base. The monetary base (H) is that part of the money supply that is under the control of the central bank. The bank or money multiplier (m) indicates the ability of commercial banks to add to the money in circulation through their lending operations.

The amount of notes and coins that the central bank can issue depends on level of domestic credit[1](DC) the central bank possesses and its holdings of foreign currencies (FR): H = DC + FR

The monetary base is added to when the central bank acquires assets and pays for them by creating liabilities. There are two main types of liabilities: currency and bank deposits at the central bank. The method by which central banks most frequently change the monetary base is through open marketoperations (OMOs). These OMOs involve either the purchase or sale of assets by the central bank.

An open market purchase occurs when the central bank purchases an asset, let’s say, 3m euro worth of government bonds, from a private institution. This purchase will increase the monetary base. To pay for the bond, the central bank writes a cheque made out to the institution selling the asset. Theinstitution’s bank will cash the cheque, pay the institution and deposit the cheque in its account at the central bank. This deposit can be used to make payments to other banks or it can be exchanged for foreign currency. Open market operations usually involve purchases and sales of short-term instruments in the secondary market. However, central banks can also issue securities themselves. The Europeancentral bank, for example, can create exchequer bills with a maximum maturity of twelve months.

Money Supply and Price Stability
By changing the monetary base, the central bank can control the money in circulation in the economy. This enables the central bank to control inflation; that is, to ensure price stability. For most central banks, price stability is their main aim. How do changes in moneysupply affect inflation?

Changes in money supply will affect the price of money, the interest rate. If the central bank reduces money supply, the interest rate will rise (assuming demand for money remains unchanged.). In the diagram below, the money supply curve is a vertical straight line, implying that the central bank has complete control over the amount of money in the economy. Inpractice, this may not be the case.

Interest Rate MS2 MS1



MS


Quantity of Money



One theoretical framework used to show the relationship between money supply and price is the quantity theory of money. It makes use of the following identity:

Quantity Theory of Money: M x V ( P x Y

where,
M is the money supply,
V is the velocity of circulation(speed at which money moves around the economy),
P is the general price level
Y is national income or GDP.

This equation is an identity, i.e. it always holds. However, it is converted into a theory about the impact of money on the market for goods and services by the assumptions made about the values of the various variables within it. Monetarists argue that in the long run an...