Chapter 1The Financial System – Money and Prices

• What is Money?– The Origins of Money• Shells, stones, whiskey, tobacco, livestock• Precious metals – Gold and Silver

Chapter 1The Financial System – Money and Prices

• Characteristics of Money• Scarcity• Durability• Divisibility

Chapter 1The Financial System – Money and Prices

• Characteristics of Money– Medium of Exchange• Trade money for goods and services

– Store of Value• Non-perishable

– Unit of Account• A means of measuring wealth and value

Chapter 1The Financial System – Money and Prices

• Physical Money– Full-bodied Money• Gold and Silver Coins• Intrinsic Value– Purity and weight

• Debased Coinage

Chapter 1The Financial System – Money and Prices

• Physical Money– Representative Money• Redeemable for a defined amount of full-

bodied money• The U.S. Dollar prior to the 1930’s• U.S. Silver Certificates

Chapter 1The Financial System – Money and Prices

• Physical Money– Fiat Money• Value by government decree• Legal tender Laws• Federal Reserve Notes (FRN’s)

Chapter 1The Financial System – Money and Prices

• Deposit Money– A means to facilitate large transaction– Store safely large deposits– Transfers are facilitated by the country’s

financial mechanism (commercial banks,etc.)

Chapter 1The Financial System – Money and Prices

• Money Definitions– M1• Currency and Checkable Deposits

– M2• M1 + noncheckable deposits, MMMF’s

– M3• M2 + large denomination time deposits,

institutional MMF’s

Chapter 1The Financial System – Money and Prices

• Money Definitions– L• All liquid Assets as money

– MZM• Zero Maturity Money• Liquid Long term money

– DIVISIA MONEY• Liquidity and At handedness• A degree of measure based on liquidity

Chapter 1The Financial System – Money and Prices

• Money Substitutes– Debit Cards• Represent some deposited amount• Are money

– Credit Cards• Are not money until we make a transaction

– Money Market Mutual Funds• Checkable deposits managed in an asset pool• Part of M2

Chapter 1The Financial System – Money and Prices

• Quantity of Money and Monetarist Views– “Too Much Money Chasing too few goods”• Causing inflation

– Velocity of Money (Level of Activity/ MS)• V = Y / M, where Y is GDP, M is Money Supply

– Y = p * y, price level and output

• Rearranged we see:–MV=Y

Chapter 1The Financial System – Money and Prices

• Quantity of Money and Monetarist Views– Say’s Law• Production creates its own demand

• People would not work if they didn’t intend to buy anything

• At full employment there will be a link between changes in the money supply and the price level

• “Inflation if everywhere and always a monetary phenomenon” – Milton Friedman

Chapter 1The Financial System – Money and Prices

• The Keynesian View– Attempt to regulate aggregate output

through changes in interest rates, since velocity is difficult to measure

– Changes in interest rates are hoped to effect Consumption and Savings/Investment

– Ultimately change in the money supply effects the availability of money and the level of interest rates

Chapter 1The Financial System – Money and Prices

• Effects of Money on the Economy– Reduction in the supply of money reduces

overall spending, which slows the economy– Increases in the money stock lead to lower

short term interest rates (this effect may not last long)

– Too little money hampers growth, but finding the right mix is difficult

Chapter 1The Financial System – Money and Prices

• Effects of Money on the Economy– The effect on the economy may differ

depending on the type of money used in policy decisions

– Example: the new tax cut will increase the level of what type of money when checks are received

Chapter 1The Financial System – Money and Prices

• Inflation and Money – Store of Value– Value of money is viewed in relative terms as

compared to other the broad spectrum of goods

Chapter 1The Financial System – Money and Prices

• Inflation and Money – Store of Value– Inflation: A general rise in the level of

prices– Alternative definition: An increase in the

money supply which cause the value of money to decline relative to the price of other goods• This is a commodity view of money

Chapter 1The Financial System – Money and Prices

• Inflation and Money – Store of Value– Inflation creates a wealth transfer effect as

some benefit at the expense of others– Inflation may be seen as a tax generally on

those who can least afford to pay it

Chapter 1The Financial System – Money and Prices

• Price Indexes– Are used to measure the general change in

the value of money based on a comparison of a selection of goods and services• This is generally referred to as a Market Basket

of goods and services

Chapter 1The Financial System – Money and Prices

• Price Indexes

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Chapter 1The Financial System – Money and Prices

• Price Indexes– To compare price indexes the bases (base

year values) must be equivalent– Types of indexes• CPI – Consumer Price Index

– Base 1982-1984

• PPI – Producer Price Index– Base 1982

• GDP Deflator – A total economy index– Base 1992

Chapter 1The Financial System – Money and Prices

• Price Indexes– To analyze changes in purchasing power

look at the reciprocal of the index– Index equal 1.642– Reciprocal equal 0.61

Chapter 1The Financial System – Money and Prices

• Price Indexes– Price Indexes are built using regression

models– A shift in the intercept of the regression

model between different time periods indicates the overall change in the price level