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Principles of Economics by Fred M Gottheil PowerPoint Slides prepared by Ken Long Chapter 25, Money

What is Money?

Note that money is a man made invention: before money, people used barter 2

What is Barter?

The exchange of one good for another, without the use of money

When can Barter work?

When people are basically self sufficient and there is a double coincidence of wants

What is a Double Coincidence of wants?

A situation in which two traders both have what the other person wants

Inefficiency of Barter  Time consuming due to the need for the double coincidence of wants 6

What is Money?

 Any commonly accepted good that acts as a:  medium of exchange  a measure of value (unit of account)  a store of value 7

What is commodity money?

 Actual products that became acceptable as money, thus had 2 purposes to it: to be used as a product or as money 8

What are the Properties of Money? It must be ...

• durable • • • • • portable divisible identical scarce stable in supply

One commodity that meets most of the requirements of money was of course...

GOLD

What is Fiat Money?

Paper money that is not backed by or convertible into any good

What is an example of Fiat Money?

Currency

- coins & paper money

What is Legal Tender?

Anything that creditors are required to accept as payment for debts

Does gold or silver back up our money?

No, our money is not backed up by anything

Why does Fiat Money have value?

Because it is useful and relatively scarce, and due to its acceptability

What does the term Liquidity mean?

The degree to which an asset can easily be exchanged for money

Which form of money is most Liquid?

It depends on the circumstances, in our economy, currency is most liquid

For a history of money: http://www.ex.ac.uk/~RDavies/ arian/llyfr.html

What is our Money Supply?

Typically, M1 money

What is M1 Money?

• • • •

Currency (held outside of banks) Demand Deposits Traveler’s checks Other checkable deposits

What is M2 Money?

M1 plus less-immediate forms of money, such as savings accounts, money market mutual funds, money market deposit accounts, and small denomination time deposits

What is M3 Money?

M2 plus large-denomination time deposits and large denomination repurchase agreements

• Large time deposits

• Money market accounts • Savings deposits • Small time deposits • Miscellaneous moneys

• Checkable deposits • Travelers checks • Currency

M3 M2 MI 23 23

What is Near Money?

Financial assets that can be converted into money such as savings bonds and corporate bonds

Are Credit Cards Money?

No!

Because merchants expect to be paid by the credit card company

For an insight of why credit cards are not money visit: http://www.mastercard.com

http://www.visa.com

Monetary Theory • How does monetary policy affect the economy?

• Differing views on this 27

Begin with the old quantity theory of money, based on the equation of exchange 28

How does the Money Supply effect prices?

The Equation of Exchange relates the economy’s price level, the quantity of goods, and the money supply

What is the Equation of Exchange?

Money Velocity Prices Quantity

MV = PQ

30 30

Note that Q = real GDP, PQ equals nominal GDP 31

What is Velocity?

The average number of times per year each dollar is used to transact an exchange

Example, suppose PQ, nominal GDP = 8 trillion •If the money supply equals 1 trillion, what is velocity?

•Answer: 8 33

What is the Classical View of Money?

Classical economists believe that the velocity and quantity of output are constant in short-run equilibrium

Conclusion of the old quantity theory If V and Q treated as constants, then M affects only P-price level is proportional to the money supply 35

If V is constant, and if Q is not affected by M, then M can only affect P--this is the conclusion of old classical theory Money Velocity Prices Quantity

MV = PQ

3 36 6

What does the Quantity Theory of Money illustrate?

Money does not influence how much we produce but it does influence prices

Monetarism, a modern version of the classical quantity theory  Monetarists, V not constant , but stable or predictable  Q tends in the long run to move to its full employment level  Monetarists tend to be critical of allowing the money supply to be too volatile 38

Milton Friedman, best known monetarist Argues that bad monetary policy worsened the great depression Calls for a monetary rule on the part of the Fed, constant growth in the money supply regardless of what is going on in the economy 39

What is the Keynsian View of Money?

They reject the idea that V is constant and that Q always reflects full employment GDP

How do the Keynsians view Velocity?

Even though they agree that spending and saving are basically stable, velocity is also effected by interest rates and expectations 41

What factors can lead to a rise in velocity?

• Increased use of electronic banking • Use of credit cards • Getting paid more frequently • Higher rates of inflation • Higher interest rates 42

Must look at the demand for money Why hold money instead of other assets?

According to the Classical Economist, why do people demand money?

People demand money to make transactions

What is the Transactions Demand for Money?

The quantity of money demanded by households and businesses to transact their buying and selling of goods and services

• According to the Keynsians, why do people demand money?

Transactions motive • Precautionary motive • Speculative motive

Speculative Motive

Individuals may choose to hold bonds over money: Because the market value of interest-bearing bonds is inversely related to the interest rate, investors may wish to hold bonds when the interest rates are high with the hope of selling them when interest rates fall.

Due to speculative motive, money demand varies inversely with interest rates 48

Money demand curve i 1 i 2 M1 M2

D 4 49 9

Now put in a money supply curve, have equilibrium 50

Money supply and demand S1 i 1 D M 1 5 51 1

According to the Keynsians, how does money affect GDP?

An increase in the money supply increases GDP and not necessarily prices, especially in a recession

The Keynesian Transmission Mechanism Increased money supply reduces interest rates, raising planned investment, and thus a multiplier expansion of GDP 53

Increase in money from S1 to S2 S1 S2 i1 i2 D M1 M2

5 54 4

An increase in Investments i1 i2 I1 I2

I 5 55 5

Aggregate

Supply Curve AS AD6 AD5 AD3 AD4 AD1 AD2

GDP 56 56

http://www.frbatlanta.org/ http://woodrow.mpls.frb.fed.us/ec oned/curric/money.html

http://www.treas.gov/ http://www.usmint.gov

5 57 7

•

What is Barter?