Chapter 1: Introduction to Monetary Economics

1.1 What is Monetary Economics?

Monetary economics studies the role of money in the economy. It investigates how money influences economic
activities such as output, employment, inflation, and interest rates.

1.2 Functions of Money

 Medium of Exchange – Facilitates transactions without needing a barter system.

 Unit of Account – Provides a standard measure for pricing goods/services.
 Store of Value – Holds purchasing power over time.
 Standard of Deferred Payment – Allows for contracts over time (loans, credit).

1.3 Properties of Good Money

 Durability
 Divisibility
 Portability
 Uniformity
 Limited Supply
 Acceptability

1.4 Evolution of Money

Barter → Commodity Money → Metallic Money → Paper Money → Bank Money → Electronic Money (Digital currencies,
e-payments)

Chapter 2: The Supply of Money

2.1 Balance Sheet View of the Economy

Central Bank Balance Sheet: Assets (securities, loans), Liabilities (currency in circulation, reserves).

Commercial Bank Balance Sheet: Loans as assets, deposits as liabilities.

Monetary Base (High-Powered Money) = Currency + Reserves

2.2 Determination of Money Supply

Determined by central bank policies, public behavior, and banking system operations.

Affected by reserve requirements, open market operations, and discount rate.

2.3 Deposit Expansion Mechanism

Banks keep a portion of deposits as reserves and lend the rest.

This creates new deposits and increases total money in circulation.

2.4 Money Multiplier

1
Formula: Money Multiplier=
Reserve RATIO
Shows how an initial change in reserves leads to a multiplied change in the money supply.

2.5 Graphical Exposition

Illustrates supply and demand for reserves.

Demonstrates how interest rates and reserve ratios affect the supply.

2.6 Sources and Uses of Reserves

Sources: Borrowing from central bank, reserve deposits.

Uses: Required reserves, excess reserves for lending.

2.7 Portfolio Approach

Banks manage assets including cash, loans, and securities to maximize returns.

Their choices affect money supply indirectly.

2.8 Empirical Estimation

Regression models and statistical tools are used to analyze actual determinants of money supply in practice.

Chapter 3: The Demand for Money

3.1 Classical & Cambridge Quantity Theory of Money

Equation: 𝑀𝑉=𝑃𝑌

𝑀: Money supply
𝑉: Velocity of money


𝑃: Price level


𝑌: Output



Money demand is proportional to income.

3.2 Keynes’ Liquidity Preference Theory

People demand money for:

 Transactions motive
 Precautionary motive
 Speculative motive

Interest rate plays a major role.

3.3 New Quantity Theory of Money

Builds on classical ideas but includes rational expectations and microeconomic foundations.

3.4 Micro-foundations of Liquidity Preference

Consumers maximize utility by choosing between holding money (liquidity) and interest-bearing assets.

3.5 Baumol’s Model

Shows that individuals optimize cash balances by balancing transaction costs and interest lost from not investing.

3.6 Brunner-Metzler Model

Considers wealth effects and the role of expectations in money demand.

3.7 Tobin’s Model

Portfolio choice model where individuals balance between risk-free money and risky assets.

3.8 Empirical Estimation

Involves testing money demand equations using economic data to estimate income and interest rate elasticities.

Chapter 4: Monetary Policy and the Reserve Market

4.1 Equilibrium in the Reserve Market

 Where demand for reserves equals supply, determining the federal funds rate (interbank rate).
 Influenced by central bank actions and liquidity needs of banks.

4.2 Instruments of Monetary Control

1. Open Market Operations (OMO) – Buying/selling government securities to control liquidity.

2. Discount Rate (Lending Rate) – Rate at which banks borrow from central bank.
3. Reserve Requirements – Portion of deposits that banks must hold in reserve.

4.3 Policy Targets

 Final Targets: Inflation, employment

 Intermediate Targets: Money supply, interest rate
 Operational Targets: Reserve balances, short-term interest rates

4.4 Conduct of Monetary Policy

 Central banks set rules or use discretion to meet targets.

 Influence money supply and interest rate through daily market operations.

4.5 Reserve Targeting Techniques

 Aggregate targeting: Maintain target level of reserves.

 Interest rate targeting: Adjust supply to hit a desired rate.

4.6 Corridor System

Creates a band for short-term interest rates:

 Upper limit: Lending facility rate
 Lower limit: Deposit facility rate
 Mid-point: Policy rate

Chapter 5: Theory of Income Determination

5.1 Static Models of Income Determination

 Based on Keynesian cross model and IS-LM model.

 Shows how equilibrium output is determined by aggregate demand.
 Multiplier effect: Small change in investment → larger change in output.

5.2 Fiscal and Monetary Multipliers in Static Model

 Fiscal multiplier: Change in output due to change in government spending or taxation.

 Monetary multiplier: Change in output due to change in money supply via interest rate impact.

5.3 Dynamic Models of Income Determination

 Adds time and expectations to the model (e.g., adjustment lags, consumption smoothing).
 Often uses difference equations or dynamic IS-LM frameworks.

5.4 Fiscal and Monetary Multipliers in Dynamic Models

 Examines how policies affect output over time.

  Multiplier effects may be larger or smaller depending on expectations and policy credibility.

5.5 Policy Lags

 Inside lag: Time between shock and policy response.

 Outside lag: Time for policy to affect the economy.

5.6 Policy under Uncertainty

 Policymakers face uncertainty in data, model structure, and public behavior.

 Requires robust and sometimes conservative strategies.

5.7 Government Budget Constraint

 Government can finance spending via taxes, debt, or money creation (seigniorage).
 Excessive reliance on seigniorage may lead to inflation.

Chapter 6: Inflation, Expectations, and Monetary Policy

6.1 Adaptive Expectations Hypothesis

 People form future expectations based on past inflation.

 Leads to lagged responses in inflation control.

6.2 Phillips Curve and Expectations-Augmented AS

 Short-run Phillips Curve: Trade-off between inflation and unemployment.

 Long-run: No trade-off—vertical curve at natural unemployment.
 Expectations-augmented model incorporates inflation expectations.

6.3 Monetary Policy with Adaptive Expectations

 Policymakers can exploit short-run trade-offs but face credibility problems.

6.4 Monetarism and the Fixed Money Growth Rule

 Proposed by Milton Friedman.

 Central bank should increase money supply at a constant rate to ensure stable inflation.

6.5 Rational Expectations Hypothesis

 People use all available information (not just past data).

 Implies policy is less effective unless it changes real variables.

6.6 Policy with Rational Expectations

 Surprise-based models: Only unexpected policy affects output.

 Predictable policies are neutralized by rational agents.

6.7 Lucas Critique

 Traditional models fail because they don’t consider changing expectations.

 Policy evaluation must use models with micro-foundations.

6.8 Monetary Policy in New Keynesian Model

 Combines rational expectations with price and wage rigidities.

 Focus on rules like inflation targeting or Taylor rule.

6.9 Seigniorage and Inflation

  Seigniorage: Revenue from money creation.
 Inflation tax: Cost to public from reduced purchasing power.

Chapter 7: Theory of Monetary Policy

7.1 Rules vs. Discretion Debate

 Rules: Pre-set guidelines (e.g., money growth rules).

 Discretion: Flexible response to current economic conditions.
 Rules promote predictability, discretion allows flexibility.

7.2 Time Inconsistency Problem

 Policymakers may promise low inflation but later choose to boost employment.
 Leads to credibility loss and higher inflation.

7.3 Announcement Effects

 Market responds to policy statements, not just actions.

 Emphasizes importance of central bank communication.

7.4 Credibility and Reputation

 Successful policy requires public belief in central bank's commitment.

 Institutions may build reputation or use independent central banks.

7.5 Taylor Rule

Simple rule to guide interest rate policy:

i=r∗+ π +a ¿
where:

 i : nominal interest rate

 π : inflation
 y : output
 r∗, π∗, y∗¿: targets
Links interest rate to inflation and output gap.

7.6 Term Structure of Interest Rates

 Explains relationship between short- and long-term interest rates.

 Influenced by expectations of future rates, risk premiums.

Chapter 8: Monetary Policy, Interest Rates, and Exchange Rate

8.1 Mundell-Fleming Model (IS-LM-BP)

 Open economy extension of IS-LM model.

 Shows how monetary and fiscal policy work under different exchange rate regimes.

8.2 Monetary Policy with Fixed Exchange Rates

 Central bank intervenes in forex market to maintain rate.

 Loses control over domestic interest rates and money supply.

8.3 Monetary Policy with Flexible Exchange Rates

 No intervention; exchange rate adjusts to market forces.
 Central bank can fully use monetary policy to target inflation or output.
Important that teacher suggest
1. Money demand theories,
2. (Instruments & Conduct Monetary Policy). (Graphs).
3. (Conduct MS)→ Money Supply?
4. Comparisons of Money Demand Theory under and Conclusion.
5. (Monetarist Money Demand Function) = (Keynes Money Demand Junction).
6. Derive Money Demand function.
7. Implications of Maretaist Money Demand and Classical function? Demand & Classical (Mihail they Implies).
8. No Numerical be of Money Demand function) Comparison of Quantity – theory Old Quantity or New Quantity
theory?
9. Done all Money Demand & Money Supplies Theory.
10. Mishkens Book (Money Demand Theory), (Money Supply Theory).
11. Instrument of monetary Policy (Mishkins Book).
12. Conduct of M.P.
13. Money Supply (Reserve ratio)?
14. Money Multiplies (Reserve Approach)?
- Monetary stats (Numerical)?
15. Define of M on M2 (formula).
16. Conduct all graphically (Demand or Supply Shock) Comparison.
17. Fixing (i) or (MS). Both Cases can b Mined?
18. Verbally Question (Objective and Indicators or Instruments of Monetary Policy).
19. (Trick these)
20. T- Accounts Bills.
21. Portfolio Approach
22. Behavioral Approach
23. Reserve Approach.
24. Base Money (B)
FINAL STUDY SEQUENCE (Organized by Exam Sections)

SECTION 1: Money Demand Theories (Without Derivations)

1. Definition and Purpose of Money Demand

 Why people hold money: transaction, precautionary, speculative motives.
2. Keynesian Money Demand (Liquidity Preference Theory)
 Interest elasticity.
 Three motives explained in words.
 Graph: Downward sloping Md curve (L(i)).
3. Monetarist View (Friedman’s Money Demand)
 Money as a stable function of income and prices.
 Emphasis on long-run price stability.
 Compare with Keynesian view.
 Graph: Stable Md function, less sensitive to interest rate.
4. Classical Money Demand
 Based on Quantity Theory (MV = PY).
 Md = kPY (Cambridge equation).
 Money as medium of exchange only.
 No role of interest rate.
5. Portfolio Approach to Money Demand (Short Verbal Idea)
 Choice between money and other assets.
 Risk-return concept.
6. Behavioral Approach to Money Demand
 Focus on actual consumer behavior.
 Modifies traditional theories.
7. Comparison of Money Demand Theories
 Classical vs Keynesian vs Monetarist.
 Role of interest rates, stability, implications for policy.
 Graphical summary.
8. Implications of Different Theories
 Monetary policy effectiveness under different theories.
 Stability of Md curve.

SECTION 2: Money Supply Process

9. Definitions of Money (M1, M2)

 What’s included in each.
 Formula-based differences.
10. Money Supply and the Reserve Ratio
 How central banks control money via required reserves.
 Currency-deposit ratio.
11. Money Multiplier (Verbal and Formula)
 m = (1 + c) / (r + c)
 c = currency ratio, r = reserve ratio.
 How small changes in reserve ratio affect supply.
12. Base Money (High-Powered Money, B)
 B = Currency + Reserves.
 Directly under control of central bank.
 Affects Ms via money multiplier.
13. Reserve Approach & T-Accounts (No Algebra)
  Simple bank balance sheets showing creation of deposits.
 Reserve changes → loan creation → Ms changes.
14. Money Supply Shock (Graphical Explanation)
 Shift in Ms curve.
 Result on interest rates and output.

SECTION 3: Instruments & Conduct of Monetary Policy

15. Instruments of Monetary Policy (Mishkin)

 Open Market Operations
 Reserve Requirements
 Discount Rate
 Interest on Reserves
 Define each and explain impact on reserves/Ms.
16. Objectives and Indicators of Monetary Policy
 Objectives: price stability, employment, growth.
 Indicators: interest rate, inflation rate, money growth.
17. Conduct of Monetary Policy
 Rules vs discretion.
 Inflation targeting, Taylor rule (concept only).
 Real-world central bank behavior (brief explanation).
18. Fixing Interest Rate (i) vs Money Supply (Ms)
 Graphical explanation.
 Implications of choosing one over the other.
 Use of LM curve or money market graph.
19. Demand Shock vs Supply Shock (Graphical)
 Effect on interest rates and money market.
 Short explanation of policy response.
FINAL EXAM STUDY SEQUENCE (Updated with New Instructions)
SECTION 1: Money Demand Theories (NO algebra here, theory + graphs only)
1. Purpose of Money Demand
 Transaction, Precautionary, Speculative motives
2. Keynesian Money Demand
 Interest sensitivity (Liquidity preference)
 Graph of Md curve (L(i) downward sloping)
3. Monetarist Money Demand (Friedman)
 Stable Md as function of income, wealth
 Weak interest sensitivity
 Graph: flatter Md, compared to Keynesian
4. Classical Money Demand (Quantity Theory)
 Md = kPY (Cambridge Equation)
 Money demand driven by output & prices
5. Behavioral & Portfolio Approach
 Verbal explanation only
 Money as part of asset portfolio
6. Comparison & Implications of All Theories
 Classical vs Keynesian vs Monetarist
 Role of interest, policy implications
 Graphical comparison
 True/False with Justification likely
7. Numericals on Velocity, Interest Rate, Bond Price
 Income Velocity: V = PY / M
 If interest rate, M, or P given, calculate missing variable
 Basic price of bond vs yield calculation
 (Simple numerical form only)

SECTION 2: Money Supply Process & Monetary Statistics (Some algebra, some numerical — allowed and
expected)
8. Definition of M1, M2
 Components of narrow and broad money
 Verbal and formula explanation
 Graph: Shift in Ms curve
9. Monetary Base (B = C + R)
 High-powered money
 Role of central bank
10. Money Supply Determinants & Reserve Ratio
 How RR influences Ms
 Conduct of Ms via reserves
 Graph of change in supply due to reserves
11. Money Multiplier (Reserve Approach only)
 Use m = (1 + c) / (r + c)
 Algebra derivation of this is included
 Conceptual understanding
12. T-Accounts and Reserve-Based Explanation (No Tables)
 Just simple single bank balance sheet
 Show how reserves → deposits → Ms
13. Numericals on Monetary Statistics
 Base money, reserve ratio, currency ratio
 Use formulas: M = m × B
 Derivations are allowed here (as per teacher)

SECTION 3: Instruments & Conduct of Monetary Policy

14. Instruments of Monetary Policy
 From Mishkin’s book
 Open Market Operations
 Discount Rate
 Reserve Requirements
 Interest on Reserves
 Graphs showing effect on i or Ms
15. Objectives & Indicators
 Inflation, growth, employment
 Indicators: inflation rate, output gap, interest rates
16. Conduct of Monetary Policy
 Rules vs discretion
 Inflation targeting
 Taylor Rule (concept only)
17. Fixing Interest Rate (i) vs Fixing Money Supply (Ms)
 LM curve-style graph
 Pros/cons of each policy instrument
 Monetary control vs rate targeting
18. Demand vs Supply Shock
 Graph: Shift in Md or Ms
 Show impact on equilibrium i, quantity of money