MoneyMoneyAP EconomicsAP EconomicsCoach KnightCoach Knight

Money DefinedMoney Defined• Money is anything that can be used as:Money is anything that can be used as:

– A medium of exchangeA medium of exchange– A store of valueA store of value– A unit of account / Standard of ValueA unit of account / Standard of Value

• Money works best when it meets these criteria:Money works best when it meets these criteria:– PortablePortable– DurableDurable– DivisibleDivisible– AcceptableAcceptable– StableStable

Money DefinedMoney Defined• Money is anything that can be used as:Money is anything that can be used as:

– A medium of exchangeA medium of exchange– A store of valueA store of value– A unit of account / Standard of ValueA unit of account / Standard of Value

• Money works best when it meets these criteria:Money works best when it meets these criteria:– PortablePortable– DurableDurable– DivisibleDivisible– AcceptableAcceptable– StableStable

The Supply of MoneyThe Supply of Money• In the United States, the Federal Reserve In the United States, the Federal Reserve

System is the sole issuer of currency.System is the sole issuer of currency.– This means the Fed has monopoly control over This means the Fed has monopoly control over

the money supply.the money supply.• There are two important measures of the There are two important measures of the

Money Supply today.Money Supply today.– M1M1– M2M2

M1M1• M1 serves primarily M1 serves primarily

as a medium of as a medium of exchange. It exchange. It includes:includes:– Currency and CoinCurrency and Coin– Demand DepositsDemand Deposits

M2M2• M2 serves as a M2 serves as a

store of value. It store of value. It includes:includes:– The M1The M1– Time DepositsTime Deposits– Money Market Money Market

Mutual FundsMutual Funds– Overnight Overnight

EurodollarsEurodollars

M1 & M2M1 & M2• As we go from M1 to M2As we go from M1 to M2

– The The measure measure becomesbecomes largerlarger– MoneyMoney beco becomes mes lless liquidess liquid

• As we go from M2 to M1As we go from M2 to M1–TheThe measuremeasure becomesbecomes smaller smaller– MoneyMoney bec becoomesmes moremore liquidliquid

Time Value of MoneyTime Value of Money• Is a dollar today worth more than a dollar Is a dollar today worth more than a dollar

tomorrow?tomorrow?– YESYES

• Why?Why?– Opportunity cost & InflationOpportunity cost & Inflation– This is the reason for charging and paying interestThis is the reason for charging and paying interest

Time Value of MoneyTime Value of Money• Let v = future value of $Let v = future value of $

p = present value of $p = present value of $r = real interest rate (nominal rate – inflation rate) r = real interest rate (nominal rate – inflation rate) expressed as a decimalexpressed as a decimaln = yearsn = yearsk = number of times interest is credited per yeark = number of times interest is credited per year

• The Simple Interest FormulaThe Simple Interest Formula

v = ( 1 + r )v = ( 1 + r )nn ** pp

• The Compound Interest FormulaThe Compound Interest Formula

v = ( 1 + v = ( 1 + rr//kk ) )nknk ** p p

Time Value of MoneyTime Value of MoneyIllustratedIllustrated

• Assume that inflation is expected to be 3% and that the Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest savings is 1%. nominal interest rate on simple interest savings is 1%. Calculate the future value of $1 after 1 year.Calculate the future value of $1 after 1 year.

• Step 1: Calculate the real interest rateStep 1: Calculate the real interest rater% = i% - r% = i% - %%r% = 1% - 3% = r% = 1% - 3% = -2% or -.02-2% or -.02

• Step 2: Use the simple interest formula to Step 2: Use the simple interest formula to calculate the future value of $1calculate the future value of $1

v = ( 1 + r )v = ( 1 + r )nn ** ppv = ( 1 + (-.02))v = ( 1 + (-.02))1 1 ** $ $11v = (.98) v = (.98) ** $ $11v = $0.98v = $0.98

Time Value of MoneyTime Value of MoneyIllustratedIllustrated

• Assume that inflation is still expected to be 3% but that Assume that inflation is still expected to be 3% but that the nominal interest rate on simple interest savings is the nominal interest rate on simple interest savings is 4%. Calculate the future value of $1 after 1 year.4%. Calculate the future value of $1 after 1 year.

• Step 1: Calculate the real interest rateStep 1: Calculate the real interest rater% = i% - r% = i% - %%r% = 4% - 3% = r% = 4% - 3% = 1% or .011% or .01

• Step 2: Use the simple interest formula to Step 2: Use the simple interest formula to calculate the future value of $1 calculate the future value of $1

v = ( 1 + r )v = ( 1 + r )nn ** ppv = ( 1 + .01)v = ( 1 + .01)1 1 ** $ $11v = $1.01v = $1.01

Time Value of MoneyTime Value of MoneyFUN!!!FUN!!!

• Assume that annual inflation is expected to be 2.5% and that the Assume that annual inflation is expected to be 2.5% and that the annual nominal interest rate on a 10 year certificate of deposit is annual nominal interest rate on a 10 year certificate of deposit is 5% compounded monthly. Calculate the future value of $1,000 5% compounded monthly. Calculate the future value of $1,000 after 10 years.after 10 years.

• Step 1: Calculate the real interest rateStep 1: Calculate the real interest rater% = i% - r% = i% - %%r% = 5% - 2.5% = r% = 5% - 2.5% = 2.5% or .0252.5% or .025

• Step 2: Use the compound interest formula to Step 2: Use the compound interest formula to calculate calculate the future value of $1,000the future value of $1,000

v = ( 1 + v = ( 1 + rr//kk ) )nknk ** ppv = ( 1 + v = ( 1 + .025.025//1212))10*12 10*12 ** $1,000$1,000v = ( 1 + 0.002083)v = ( 1 + 0.002083)120 120 ** $1,000$1,000v = $1,283.69v = $1,283.69

Relating Money to GDPRelating Money to GDP• Economist, Irving Fisher Economist, Irving Fisher

postulated that :postulated that :

Nominal GDP = The Money Supply Nominal GDP = The Money Supply * Money’s Velocity* Money’s Velocity

The Monetary Equation of The Monetary Equation of ExchangeExchange

• MV = PQMV = PQ

– M = money supply (M1 or M2)M = money supply (M1 or M2)– V = money’s velocity (M1 or M2)V = money’s velocity (M1 or M2)– P = price level (PL on the AS/AD diagram)P = price level (PL on the AS/AD diagram)– Q = real GDP ( sometimes labeled Y on the AS/AD Q = real GDP ( sometimes labeled Y on the AS/AD

diagram)diagram)– PP**Q or PQ = Nominal GDPQ or PQ = Nominal GDP

The Monetary Equation of The Monetary Equation of ExchangeExchange

• MV=PQMV=PQ– M1=$2 trillionM1=$2 trillion– V of M1 = 7V of M1 = 7– PQ = $14 PQ = $14

trilliontrillion

GDPR

PL

AD

SRASLRAS

QF

P