Aim: What is Money?

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Money

• a concept – an idea we have of something that allows us to recognize specific examples of it

Characteristics of Money

• durable

• portable

• scarce

• divisible

• acceptable (uniformity/recognizable)

Functions of Money

• medium of exchange

• store of value

• standard of measure

Medium of Exchange, Store of Value or Standard of Measure ?

• Ben bought 2 tickets for the movie.• Alex likes to keep a $20 bill stashed

away in his wallet for emergencies.• Kyle was trying to decide whether to buy

three candy bares for $.50 each or one chocolate sundae for $1.65.

• The manager of Apex Stores gave Maria her paycheck.

Our Money• fiat money/token money• intrinsically worthless

Why would anyone accept worthless scraps of paper as money instead of something that has value such as gold, cigarettes or cattle?

The Supply of Money in the Economy

• M1 - transaction money: demand deposits, travelers checks, currency held outside of banks, other checkable deposits

• M2 – broad money, M1 + savings accounts, money market accounts, other near money

• M3 – beyond M1 and M2

What about credit cards?

Aim: How does the U.S control Money?

The Federal Reserve System was set up to bring order to the chaotic finances of the United States

• control inflation

• control the flow of money

• control the flow of credit

Structural Elements of the Fed

• 7 member Board of Governors appointed by the President confirmed by the Senate

• provides financial services to depository institutions – the bankers’ bank – uniform currency, check collection, wire transfers, hold reserves, creditor of last resort

• Supervision of financial community

• FRB serves as the government’s bank – checking, government borrowing

• self-financed

• monetary watchdog

• Federal Open Market Committee (FOMC) sets monetary policy

Significant History

• “Not Worth a Continental”

• McCullough v. Maryland

• Jackson v. Bank

• 1863 National Banking Act

• 1907 JP Morgan saves the banking system

• 1913 Federal Reserve Act

Aim: How does the Fed control the money supply?

• The basic purpose of monetary policy is to manipulate the money supply

• control the amount of money available for loans

Instruments/tools the Fed uses to control the flow of money and credit

• Reserve requirements

• Discount Rate

• Open Market Operations (buy and sell government securities

Expansionary Monetary Policy(bolster a recessionary economy)

• ↓ reserve requirement

• ↓ discount rate

• buy govt securities

Contractionary Monetary Policy(slow/dampen an inflationary economy

• ↑ reserve requirement

• ↑ discount rate

• sell govt securities

Monetary Policy works indirectly

• no guarantee that people will respond the way the Fed wants

• Fed needs to be sure that it is choosing the right action at the right time

Monetarist

• Money supply should grow with GDP

Aim: How does the banking system create money?

Banks cannot print money, so how dothey create it?

The banking system creates money through the money supply multipliera.k.a. the deposit expansion multiplier

Bank

Cash Deposits

20%

Reserve

Potential for New loans

A $1,000.00 $ 200.00 $ 800.00

B 800.00 160.00 640.00

C 640.00 128.00 512.00

D 512.00 102.40 409.60

All others

2,048.00 409.60 1,638.40

TOTAL $5,000.00 $1,000.00 $4,000.00

Money Multiplier

1/ Reserve Requirement

i.e. 1/.20 = 5

Leaks in the System• In the real world, the multiplier is a bit less

than its potential• Any currency that remains outside the

banking system reduces the size of the multiplier

• Money is drained in 2 ways– People put money in a cookie jar or under

their mattress– Banks do not stick strictly to their legal

reserve requirements

Aim: How is money just another commodity that reacts to supply

and demand?

Demand for Money• Interest rates (r) and the national

income (Y) help determine how much money households and firms wish to hold

r = opportunity cost of holding money

↑output → ↑ in the # of transactions → ↑ Md

↑ p → shift in the D curve for M to the right

The real rate of interest is crucial in making investment decisions. Business firms want to know the true cost of borrowing for investment. If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation, and the inflation rate is negative, then the real interest rate will be larger. 

The supply of money is vertical no matter what the interest rate is on the vertical axis, since the Federal Reserve controls the supply of money through its monetary policy tools

The Money Market

Tight Money Policy When the Federal Reserve adopts a tight money policy, the supply of money moves to the left, and the interest rate rises. This discourages investment and interest-sensitive consumption, which decreases the aggregate demand. Price levels fall, while real output decreases.

                                                                                                                       

                                                                                

The Money Market

M↓ → r↑→ I↓ → AE↓ → Y↓

Easy Money Policy When the Federal Reserve adopts an easy money policy, the supply of money moves to the right, and the interest rate falls. This stimulates investment and interest-sensitive consumption, which increases the aggregate demand. Price levels rise, while real output increases.

                                                                                   

 

                                                                                                                      

                                                  

The Money Market

M↑ → r↓ → I↑ → AE↑ → Y↑

Price-level changes will affect the demand curve in the money market diagram. At higher price levels, more money is needed for transactions, so people will choose to hold a greater quantity of money. A higher price level means that the demand curve moves to the right, increasing the nominal interest rate if the supply of money is constant.

Nominal rates are determined in the money market. Money demanded and money supplied determines the equilibrium interest rate. The demand curve will slope downward. The vertical axis (interest rate) is the opportunity cost of holding money. An increase in the interest rate raises the cost of holding money and reduces the quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and increases the quantity of money demanded.

Loanable Funds Market -- Real Interest RatesReal interest rates are determined in the loanable funds market. The loanable funds theory of interest explains the interest rate in terms of the demand and supply of funds available for lending. Equilibrium occurs where the supply (savings) intersects the demand (investment, consumption). Movement to equilibrium is the process of determining the real interest rate in the economy. The supply of loanable funds is all income that people have chosen to save and lend out rather than use for their own consumption. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Loanable Funds Market

 

                                                                                                                       

                                                                                                                               

Loanable Funds Market

 

                                                                                                                        

                                                                                                                           

Loanable Funds Market

 

                                                                                                                        

                                                                                                                                                    

Aim: How does the Classical model of monetary policy “work”?

Quantity theory of money• the theory that price level varies in

response to changes in the quantity of money

• centers around the equation of exchange MV=PQ

M = quantity of moneyV = VelocityP = Price LevelQ = quantity of real goods sold (real GDP)

Classical assumptions

• Velocity of money is the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income – velocity is the amount of income per year generated by a dollar in the economy

• Classical economists assume velocity remains constant

• If velocity remains constant, the quantity theory can be used to predict how much nominal GDP will grow if we know how much the money supply grows

• Classical economists assume that Q (real GDP) is independent of the money supply – Q is autonomous, meaning real output is determine by forces outside the quantity theory – real output is not influenced by changes in the money supply

• Some economists believe that the real quantity of money demanded is proportional to real aggregate spending – if this is true, then the effect of changes in interest rates on real money demanded is reflected in the changes in the velocity of money

• Velocity of money is thought to be stable through the 1980s.

Monetarist

• Money supply should grow with GDP