MONEY• Definition of money

– the part of wealth used to facilitate transactions

• Note that in economics, money has a different meaning than expressions like:• “She makes a lot of money”• “We’re cash. We’re cash. We’re money”• “We’re cash. We’re cash. We’re money” • “We’re cash. We’re cash. We’re money” • “We’re cash. We’re cash. We’re money”

• Consider some examples of money

– examples: commodity money and paper money–

Stone money of Yap Island

Ancient Chinese bronze money

A100 billion mark note!! German Reichsbank, 1923

Most of money today consists of deposits at banks

• Money supply = currency + deposits

• M1 = currency plus checking deposits

• M2 = M1 plus time deposits, savings deposits

• difficult to determine which is the best measure of money

Three functions of money

• medium of exchange

• store of value

• unit of account

General principle of monetary economics

• A higher rate of money growth ultimately causes higher inflation, ceteris paribus– check intuition with case of commodity money

Quantity equation of money

• MV = PY

• where M = money supply, P = price level, Y = real GDP, and V = velocity = PY/M

• growth rate form of quantity equation• money growth + velocity growth

= inflation + real GDP growth

– examples 4 + .5 = 2 + 2.5– Change 8 + .5 = 6 + 2.5

What is the empirical evidence?

Does the quantity equation of money work? • Very well for big changes of over long run

– The German hyperinflation,1923 (see graph)– American revolutionary war– Great Inflation of the 1970s (see graph)– Russia, Argentina and Brazil – Take a careful look at the G-7 graph

• Less reliable in the short run– Difficult to measure money– Changes in M will affect Y

Inflation in Germany, 192324_07

INFLATION RATE (PERCENT PER WEEK)

Jan 6 Mar 7 May 7 Jul 7 Sep 7 Nov 7

300

250

200

150

100

50

0

-50

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1800 186018401820 192019001880 198019601940

1,000

100

10

War of 1812

Deflationafter CivilWar

WWI

Fedcreated

GreatInflation

WWII

GreatDepression

GreatDisinflation

2000

PRICE INDEX

Money growth and inflation1973-1991

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8 1264 10 1420

18

16

14

12

10

8

6

4

2

MONEY GROWTH

(PERCENT PER YEAR)

INFLATION(PERCENT PER YEAR)

Germany

Japan

U.K.

Italy

United States

Canada

France

Long run versus short run effect of changes in money growth

• Inflation does not usually increase right away– takes more than a year

• In the meantime, other things are affected– employment, production

• Makes money a difficult public policy issue, – money has long been central in political debates, as

the following video nicely illustrates

When he gets to Washingtonhow the Democrats will run.For Republicans McKinley leads the way.What a glory that will be.We’ll regain prosperity, when McKinley and protection win the day

We will answer their demands for a gold standard by saying to them:You shall not press down upon the brow of labor this crown of thorns.You shall not crucify mankind on a cross of gold.

Sound the good old bugle with the bimetallic ring.Silver free from sea to sea with lusty voices sing.Our banner with its silver stars, the waving breezes fling.Marching with Bryan to victory.

Lessons from this piece of American history

• An economic issue became a great political issue to run on

• Increasing money growth by coining silver would be more inflationary than the gold standard--and people knew it!

• Increase in inflation was attractive to some Democrats (debtors versus creditors)

• Several years later legislation was passed to establish a central bank in the United States

The Central Bank

• The agency of government given responsibility of controlling the money supply--we will see how next time.

• In the United States, the central bank is the Federal Reserve System: – Simply called the Fed– Has a great degree of independence

• Let’s check it out on the web

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• Seven governors appointed by the president and confirmed by the Senate

Board of Governors

• One governor appointed to be chair

• A staff of professional economists and statisticians

• Makes decisions about the money supply and the federal funds interest rate

Federal Open Market Committee (FOMC)

• Consists of the Board of Governors and district bank presidents (only five presidents vote at a time)

• Meets about eight times per year in Washington plus telephone conferences when needed

• Banks located in 12 districts throughout the country

District Federal Reserve Banks

• Each district bank headed by a president chosen by commer- cial bankers and others in the district but approved by the Board of Governors

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New York

PhiladelphiaFederal Reserve Board, Washington, D.C.

Boston

1

2

Richmond

5

7

4

6Atlanta

Kansas City

11

Dallas

9

10

12

San Francisco

Minneapolis

Chicago

3

8

St. Louis

Cleveland

END OF

LECTURE