Revision-

Semester test 1
Cyril Ayemele
UNIT 2
Monetary Theory and Policy
Functions of money
• Medium of exchange
• Unit of account
• Store of Value
Money Demand Function: The Quantity Theory of Money(Irving Fisher )-classical
economists
According to the classical economists:
• wages and prices are completely flexible
• Interest rates have no effect on demand for money
• velocity is assumed to be constant
• Demand for money is independent of interest rates
• But-purely a function of income
• Also believed that in normal times level of aggregate output would remain at
full employment level-if we assume that velocity if constant that means change
in money supply is also constant therefore aggregate output would remain at
full employment. Also, changes in P can only be described by changes in M as V
and Y are constants
• In the long-run, changes in the money supply leads to proportional
changes in the price level.
• Money neutrality: (in the long-run) the money supply has no effects
on real variables
• quantity theory of inflation indicates that the inflation rate equals the
growth rate of the money supply minus the growth rate of aggregate
output-π =%∆M- %∆Y
• quantity theory of money to explain movements in price level-
Changes in the quantity of money lead to proportional changes in
price level.
The Theories of Money Demand According to Keynes
• In contrast to the classical monetarists, John Maynard Keynes viewed velocity as
not constant.
• Keynes viewed interest rate as key to demand for money-this is what he referred
to as liquidity preference theory
The three motives behind the demand for money as expounded by Keynes are
• The Transaction Motive: Day-to-day transactions is the main reason people hold
money balances. Negatively related to interest rate
• The Precautionary Motive: Uncertainties are realities of life. Negatively related
to interest rate
• The Speculative Motive: people choose to hold money as a store of wealth.
Positively related to interest rate since increase in interest rate will increase
savings
• Which one of the three (3) functions of money relates best to the Keynesian
views and explain why-As a Store of Value – since money keeps its value money
can earn interest and therefore the interest rate can determine the demand for
money
Note. The more sensitive the demand for money function is to interest rates, the
more unpredictable will be the velocity and the less clear will be the relation between
money supply (M) and aggregate spending (PY ). The quantity theory is less likely to
be true.
Portfolio Theories of Money Demand
Beyond nominal interest rates and income are there other factors that affect our
demand for money?
From the portfolio choice theory, asset demand is determined by
• Wealth: the total resources owned by an individual (including all assets)
• Expected return on one asset relative to alternative assets
• Risk(degree of uncertainty relative to the return) on one asset relative to alternative
assets
• Liquidity (the ease and speed with which an asset can be transformed into cash)
relative to alternative asset
• The theory of portfolio choice can justify the conclusion from the Keynesian
liquidity preference function that the demand for real money balances is positively
related to income and negatively related to the nominal interest rate.
Friedman Model of Portfolio Theory of
Demand for Money
• Milton Friedman’s defined real money demand as a function of
wealth and relative returns of other assets
• Velocity also constant for Friedman
• Money and real goods are seen as substitutes → M has direct effects
on spending (Friedman).
UNIT 3
The risk structure of interest rates. The relationship between interest rates on bonds with
the same term to maturity. i.e bonds may have same maturity but may still differ in terms
of their riskiness.
Why will bonds differ – high risk bonds turn to have high interest rate
• Default risk: Refers to the probability that the issue of the bond (the borrower) will be
unable to make interest payments on the bond or to pay off the face value of the bond
when it matures. The spread between interest rates on bonds with default risk and
interest rates on default free bonds is called the risk premium. Default-free bonds have
lower interest rate.
• Liquidity: The relative ease with which an asset can be converted into cash. liquidity can
also explain fact why corporate bonds tend to have higher interest rates than
government bonds this is because Treasury bonds are more widely and actively traded
than corporate bonds. Hence, government bonds are more liquid than corporate bonds
• Income Tax Considerations. Tax-free advantage increases the demand for municipal bonds
and thereby makes their interest rate lower.
The term structure of interest rates is the relationship between interest rates which
differ only in maturities.
• Fact 1: Interest rates on bonds of different maturities tend to move together over time.
• Fact 2: The yield curve can slope up or down. It tends to slope up when short-term
interest rates are low, and tends to slope down when short-term interest rates are
high.
• Fact 3: Yield curves almost always slope upward
Theories of the Term Structure
1. Expectation Hypothesis: Key assumption of this theory: Investors regard bonds with
different maturities to be perfect substitutes. Buyers of bonds do not prefer bonds
of one maturity over another; they will not hold any quantity of a bond if its
expected return is less than that of another bond with a different maturity
• The expectations hypothesis can explain Fact 1. Given the market expectations, if the
short-term interest rates increase (if 𝑖_𝑡 increases) long-term interest rates (𝑖_𝑛𝑡) will
also tend to increase. If the short-term interest rates decrease, long-term interest rates
will also decrease. So, the expectation theory can explain the fact that interest rates of
different maturities tend to move together (in the same direction
 The expectations hypothesis can also explain Fact 2. The expectations
theory can also explain the fact that when short-term interest rates are
low, yield curves are more likely to have an upward slope; and when
short-term rates are high, yield curves are more likely to slope
downward and be inverted.
2. Segmented Markets Theory. Unlike the expectations hypothesis, this
theory assumes that investors regard markets for bonds of different
maturities as completely separate, or segmented. That is, bonds of
different maturities are not substitutes at all.
• Segmented markets theory can explain Fact 3. If most investors prefer
short-term bonds, the demand for short-term bonds will be greater
than the demand for long-term bonds. Hence, the interest rate on
short-term bonds will be lower than the interest rate on long-term
bonds.
• That is, the yield curve will typically slope upward.
Why most Investors Prefer Short-Term Bonds
• Uncertainties in future inflation, Interest Rates Risk, Interest Rates
Risk,
• Liquidity Premium or Preferred Habitat Theory – a combination of the
first two theories –
• explains all three facts
Unit 4-Exchange Rates and the Foreign
Exchange Market: An Asset Approach
Definitions of Exchange Rates. Exchange rates are quoted as foreign currency
per unit of domestic currency or domestic currency per unit of foreign currency.
• Exchange rates allow us to denominate the cost or price of a good or service in
a common currency-How much can be exchanged for one dollar?
Depreciation is a decrease in the value of a currency relative to another
currency. A depreciated currency is less valuable
• A depreciated currency lowers the price of exports relative to the price of
imports.
Appreciation is an increase in the value of a currency relative to another
currency. An appreciated currency is more valuable
 A depreciated currency means that imports are more expensive and
domestically produced goods and exports are less expensive.
Foreign Exchange Markets. The set of markets where foreign currencies and
other assets are exchanged for domestic ones.
The participants:
• Commercial banks and other depository institutions: transactions involve
buying/selling of deposits in different currencies for investment purposes.
• Non-bank financial institutions (mutual funds, hedge funds, securities firms,
insurance companies, pension funds) may buy/sell foreign assets for investment.
• Non-financial businesses conduct foreign currency transactions to buy/sell goods,
services and assets.
• Central banks: conduct official international
reserves transactions.
Spot rates are exchange rates for currency exchanges “on the spot,” or when
trading is executed in the present.
Forward rates are exchange rates for currency exchanges that will occur at a
future (“forward”) date.
Effect of a Rise in the
Dollar Interest Rate

A rise in the interest rate

offered by dollar
deposits causes the
dollar to appreciate
from point 1 to point 2.
Effect of a Rise in the Euro
Interest Rate

• A rise in the interest rate paid

by euro deposits causes the
dollar to depreciate from
point 1 to point 2. (This figure
also describes the effect of a
rise in the expected future
$/€ exchange rate.)
The Effect of an Expected Appreciation of the
Euro
• If people expect the euro to appreciate in the future, then euro-denominated
assets will pay in valuable euros, so that these future euros will be able to buy
many dollars and many dollar-denominated goods.
• The expected rate of return on euros therefore increases.
• An expected appreciation of a currency leads to an actual appreciation (a self-
fulfilling prophecy).
• An expected depreciation of a currency leads to an actual depreciation (a self-
fulfilling prophecy).
• Note. A rise in the expected future exchange rate causes a rise in the current
exchange rate
• An increase in the interest rate paid on deposits of a currency causes that
currency to appreciate against foreign currencies.