Chapter 10: Money. Stranded, “Cast Away” style 1 Person 1 Person Desert Island Desert Island Fruit Fruit + Animals to eat + Animals to eat Paradise Paradise

Chapter 10: Money

Stranded, “Cast Away” Stranded, “Cast Away” stylestyle

1 Person1 Person

Desert IslandDesert Island

FruitFruit

+ Animals to eat+ Animals to eat

ParadiseParadise

+ Treasure Chest+ Treasure Chest

Useless Useless TrinketsTrinkets


YouYou Guy 2Guy 2Pick Berries Hunt Fish and Pick Berries Hunt Fish and

AnimalsAnimals


YouYou Guy 2Guy 2Pick Berries Hunt Fish and Pick Berries Hunt Fish and

AnimalsAnimals BarterBarter –– the exchange of one good for another, the exchange of one good for another, without the use of money.without the use of money.


• With more people added to the island, specializations begin to grow.

• There’s more risk, as people trade for items that might not be wanted at the moment, but are traded anyways hoping to trade in the future

• People might not trade for things they want. (Ex. Farmer wants meat but Butcher doesn’t want wheat)

The Invention of MoneyThe Invention of Money

Money – Money – Any commonly accepted good that acts as a medium of exchange, a measure of value, and a store of value.


Money must be Money must be Durable – long

lasting Portable – take it

anywhere Divisible – can

be broken down Homogeneous –

identical Stable – supply

must be in control


Fiat Money – Fiat Money – Paper money that is not backed by or convertible into any good.

Gresham’s LawGresham’s Law

– – Law established by Law established by Sir Thomas Gresham that explains how bad money drives out good.

If there are two different kinds of money, one more expensive than the other but valued the same as quantity, the cheaper kind (bad money) would drive out the more expensive one (good money).

Gresham’s LawGresham’s Law

Example:Example:

If there was a more valuable silver If there was a more valuable silver quarter and a cheaper copper quarter and a cheaper copper quarter circulating in the quarter circulating in the economy, people would over time economy, people would over time hoard the silver quarters, making hoard the silver quarters, making the copper quarters the norm for the copper quarters the norm for quarters. quarters.

Money in the Modern Economy

Currency – Coins and Paper MoneyCurrency – Coins and Paper Money


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

Basically, liquidity is how fast you can convert an asset into money.


Money Supply – Money Supply – The supply of currency, demand deposits, and traveler’s checks used in transactions. Basically, its M1.


M1 Money Supply – M1 Money Supply – The supply of the most immediate form of money. It includes currency, demand deposits, and traveler’s checks.


M2 money supply – M1 money plus savings accounts, mutual funds, deposit accounts, repurchase agreements, and small-denomination time deposits.

M2 is just M1 plus lesser form of liquid assets.


M3 money Supply – M3 money Supply – M2 money plus large-denomination time deposits and large-denomination repurchase agreements.

M3 is M2 plus even less liquid assets.

U.S. MONEY SUPPLY: 2000 ($ BILLIONS)


There is no clear line between money There is no clear line between money and non-money assets. Basically, most and non-money assets. Basically, most assets can be converted into money. assets can be converted into money.

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Money FactsMoney Facts

The largest denomination of currency The largest denomination of currency printed today is $100.printed today is $100.

The Bureau of Engraving and Printing is the agency in charge of printing the currency.

All of the U.S. coins currently printed portray past U.S. presidents.

Currency printed after 1929 is Currency printed after 1929 is 6.14’’ by 2.61’’

Money FactsMoney Facts

The average lifespan of a $1 bill is 12-The average lifespan of a $1 bill is 12-18 months while the life for a $100 bill 18 months while the life for a $100 bill is 8-9 years. is 8-9 years.

To stop counterfeiting, U.S. bills are To stop counterfeiting, U.S. bills are protected by:protected by:• Tiny red and blue fibers in the paperTiny red and blue fibers in the paper• A polyester strip embedded vertically in

the paper• Special inks.

The Quantity Theory of The Quantity Theory of MoneyMoney

Velocity of money – The average number of times per year each dollar is used to transact an exchange.


Equation of exchange – The quantity of money times its velocity equals the quantity of goods and services produced times their prices.

MV = PQ


The Classical view: Real GDP (Q) depends on the

amount of resources in the economy, which are fixed.

Prices are flexible. Velocity is fixed.

MV = PQ


The Classical View:Since Q and V are fixed, while P is flexible, the classical view holds that there is a direct relationship between M and P.

MV = PQFixed

FixedFlexibl

e


Quantity Theory of Money – The equation specifying the direct relationship between the money supply and prices.

P = MV/Q


Monetarists attempted to rescue the classical view from evidence showing that M1 velocity is not constant. They argue that if velocity is stable and predictable, and if Q is at full-employment GDP, then the direct relationship between M and P remains intact.

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EXHIBIT 3 HISTORICAL RECORD OF MONEY VELOCITY

Historical Record of Historical Record of Money VelocityMoney Velocity

(from previous graph)

Increased use of credit cards from the 50’s to the 80’s allowed people to buy more goods and services with less cash and lower demand deposit balances relative to nominal GDP.

Quantity Theory of Quantity Theory of MoneyMoney

Keynesians reject the monetarist’s idea that V is either stable or predictable, and that Q always reflects full-employment GDP. Because of this, changes in M will affect more than just P—they may also change Q.

The Demand for MoneyThe Demand for Money

Transactions demand for money – The quantity of money demanded by households and businesses to transact their buying and selling of goods and services.

Amount of money needed for a household/business to survive


The Classical view is that the transactions demand for money is the only motive for demanding money. If P or Q rises, the transactions demand for money will also rise.


The Keynesian view is that in addition to the transactions demand for money, there is also a precautionary motive and a speculative motive for demanding money.


ClassicalClassicalTransactions

demand for money is the only motive for demanding money

KeynesianKeynesianThere is a

precautionary and a speculative

motive for demanding

money, when added to the

transaction demand

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EXHIBIT 4 THE SPECULATIVE DEMAND FOR MONEY

The Speculative Demand The Speculative Demand for Moneyfor Money

The quantity of money demanded increase as interest rates decrease because people shift out of interest-paying accounts into holding money because the opportunity cost of holding money has fallen.

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EXHIBIT 5A MONEY AFFECTS REAL GDP

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EXHIBIT 5B MONEY AFFECTS REAL GDP

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EXHIBIT 5C MONEY AFFECTS REAL GDP

Money Affects Real GDPMoney Affects Real GDP

According to the According to the KeynesianKeynesian view, view, a change in the money supply a change in the money supply affects affects Real GDP Real GDP by:by:– An increase in the money supply

reduces interest rates.– Lower interest rates increase

investment spending.– Increased investment spending

increases aggregate demand.


The shape of the aggregate supply curve when a change in the money supply affects real GDP and not the price level will look horizontal, where the aggregate demand curve shifts.


Classical economists and Monetarists see the shape of the aggregate supply curve as the segment of the aggregate supply curve over which aggregate demand shifts is vertical, and occurs at the full-employment level of real GDP. Thus only prices change, not real GDP.

Chapter

Review

Chapter Review #1Chapter Review #1

Barter exchanges requires a double Barter exchanges requires a double coincide of wants. As the number of coincide of wants. As the number of people and the number of goods people and the number of goods increase, barter becomes increasingly increase, barter becomes increasingly more difficult. One good then becomes more difficult. One good then becomes chosen as the barter form. The chosen as the barter form. The characteristics of a good money are characteristics of a good money are durability, portability, divisible, durability, portability, divisible, homogeneity, and stability. Gold is an homogeneity, and stability. Gold is an exemplary money form.exemplary money form.


Money serves three functionsMoney serves three functions1.1. It is a medium of exchange It is a medium of exchange

2.2. A measure of valueA measure of value

3.3. A store of valueA store of value

Paper (or fiat) money can substitute Paper (or fiat) money can substitute for gold as long as it is universally for gold as long as it is universally accepted as the medium of accepted as the medium of exchange.exchange.


The difference measure of our money The difference measure of our money supply depends upon the degree of supply depends upon the degree of liquidity we use. liquidity we use.

M1M1, the most liquid form of money, is , the most liquid form of money, is essentially currency and checkable deposits essentially currency and checkable deposits such as NOW and ATS accounts. such as NOW and ATS accounts.

M2M2 includes M1 plus small-denomination time includes M1 plus small-denomination time deposits, such as MMDAs, and savings accounts.deposits, such as MMDAs, and savings accounts.

M3M3 include M2 plus large-denomination time include M2 plus large-denomination time deposits and overnight repurchase agreements. deposits and overnight repurchase agreements.


The equation of exchange is written The equation of exchange is written as as MV = PQMV = PQ. Classical economists . Classical economists believe that because output, Q, is believe that because output, Q, is constant at full-employment constant at full-employment equilibrium, and because the equilibrium, and because the velocity of money, V, is constant, velocity of money, V, is constant, then the price level in the economy, then the price level in the economy, P, varies directly with the money P, varies directly with the money supply, M. supply, M.


Monetarists accept the classical idea Monetarists accept the classical idea that the economy operates at full-that the economy operates at full-employment equilibrium, but unlike employment equilibrium, but unlike the Classicist, they believe that the the Classicist, they believe that the velocity of money is not constant velocity of money is not constant but nonetheless stable and but nonetheless stable and predictable enough to ensure the predictable enough to ensure the usefulness of the equation of usefulness of the equation of exchange linking prices to the exchange linking prices to the money supply. money supply.


Keynesian believe that because Keynesian believe that because output and velocity are neither output and velocity are neither constant nor stable and constant nor stable and predicable, changes in the money predicable, changes in the money supply can affect real GDP as well supply can affect real GDP as well as pricesas prices


According to to classical economist, According to to classical economist, the demand for money is strictly the demand for money is strictly a transaction demand. Keynesian, a transaction demand. Keynesian, on the other hand, use the on the other hand, use the transactions, precautionary, and transactions, precautionary, and speculative motives as speculative motives as determinants of money demand. determinants of money demand.

Questions Questions

&& Answers Answers

Why does barter exchange Why does barter exchange become increasing less useful as become increasing less useful as the number of people engaged the number of people engaged increases?increases?

Barter requires the double Barter requires the double coincidence of wants in which each coincidence of wants in which each party to an exchange wants what the party to an exchange wants what the other has. other has. With more people trading, the With more people trading, the chances of achieving a double chances of achieving a double coincidence of wants decreases.coincidence of wants decreases.

Question #1Question #1


What are the essential What are the essential properties of money?properties of money?

Money should be:Money should be:– DurableDurable– DivisibleDivisible– PortablePortable– HomogeneousHomogeneous– Scarce.Scarce.


What are the 3 principle functions of What are the 3 principle functions of money?money?

Money serves as Money serves as 1.1. A A medium of exchangemedium of exchange; it is anything ; it is anything

generally acceptable in payment for generally acceptable in payment for goods and services. goods and services.

2.2. It also serves as a It also serves as a measure of valuemeasure of value, or , or yardstick, for measuring the value of yardstick, for measuring the value of other goods. other goods.

3.3. Finally, it serves as a Finally, it serves as a store of valuestore of value, or a , or a means of holding wealth over time.means of holding wealth over time.


What are the principle components What are the principle components of M1, M2, and M3 money?of M1, M2, and M3 money?

M1M1 consists of currency, traveler’s consists of currency, traveler’s checks, and checking accounts. checks, and checking accounts.

M2M2 consists of M1 plus savings consists of M1 plus savings deposits, money market mutual fund deposits, money market mutual fund balances, and small time deposits. balances, and small time deposits.

M3M3 consists of M2 plus large time consists of M2 plus large time deposits, term repurchase agreements deposits, term repurchase agreements and institutional money market fund and institutional money market fund balances. balances.


What is the relationship What is the relationship between money and liquidity?between money and liquidity?

Liquidity is the ease with which an Liquidity is the ease with which an asset can be used as immediate asset can be used as immediate money. money.


What is “Near” money?What is “Near” money?

““Near” money is a relatively illiquid Near” money is a relatively illiquid financial asset, such as a corporate financial asset, such as a corporate bond, that can be readily converted on bond, that can be readily converted on a financial assets market, such as a a financial assets market, such as a bond market, to immediate money. bond market, to immediate money. The intended purpose or utility of The intended purpose or utility of “near” money, however, is not to “near” money, however, is not to serve as a money form.serve as a money form.


Are Visa and MasterCard balances Are Visa and MasterCard balances part of M1? Why or why not?part of M1? Why or why not?

Credit card balances are Credit card balances are notnot part of M1. part of M1. They are plastic “checkbooks” that can They are plastic “checkbooks” that can be used, as checks can, to buy goods. be used, as checks can, to buy goods. Credit cards are simply convenient Credit cards are simply convenient instruments that allow you to use your instruments that allow you to use your checking account at the bank. Your checking account at the bank. Your checking account is the M1 money. checking account is the M1 money.


What is money velocity?What is money velocity?

Velocity measures the Velocity measures the serviceability of the money serviceability of the money supply. It is the average number supply. It is the average number of times per year a dollar is used of times per year a dollar is used to transact an exchange.to transact an exchange.


How do the Classical and How do the Classical and Keynesian views of money Keynesian views of money velocity differ?velocity differ?

In the classical view, velocity is In the classical view, velocity is assumed to be constant. Keynesians assumed to be constant. Keynesians reject this idea, arguing that velocity reject this idea, arguing that velocity varies with changes in people’s varies with changes in people’s expectations.expectations.


In the classical view, what is In the classical view, what is the principle reason for the principle reason for people demanding money?people demanding money?

To classical economists, there is To classical economists, there is only one motive for demanding only one motive for demanding money. It is demanded because it money. It is demanded because it is needed in making transactions.is needed in making transactions.


InIn the Keynesian view, what are the the Keynesian view, what are the principle reasons for people principle reasons for people demanding money?demanding money?1.1. First, they First, they accept the classical economists’ accept the classical economists’

transactions motivetransactions motive. . 2.2. Second, they believe there is a Second, they believe there is a precautionary precautionary

motivemotive. People hold money as an insurance . People hold money as an insurance against unexpected needs. against unexpected needs.

3.3. Third, there is a Third, there is a speculative motivespeculative motive. People . People also hold money in preference to holding also hold money in preference to holding interest-bearing financial assets. The quantity interest-bearing financial assets. The quantity of money they hold to satisfy the speculative of money they hold to satisfy the speculative motive depends on the interest rate and their motive depends on the interest rate and their expectations of changes in that rate.expectations of changes in that rate.


Why does a quantity demanded of interest Why does a quantity demanded of interest yielding assets fall in the quantity yielding assets fall in the quantity demanded of money increase when the demanded of money increase when the interest rate falls?interest rate falls?

When the interest rate falls, people are less When the interest rate falls, people are less willing to hold interest-bearing financial willing to hold interest-bearing financial assets, such as bonds, because the return is assets, such as bonds, because the return is less (shown as a decrease in the quantity less (shown as a decrease in the quantity demanded of those interest-bearing bonds). demanded of those interest-bearing bonds). Instead, people increase their holding of Instead, people increase their holding of money (shown as an increase in the quantity money (shown as an increase in the quantity demanded of money) in anticipation of more demanded of money) in anticipation of more attractive opportunities in the future. attractive opportunities in the future.


Explain graphically how the interest Explain graphically how the interest rate affects the Keynesian rate affects the Keynesian demand for money?demand for money?

When the interest rate falls, people are When the interest rate falls, people are less willing to hold interest-bearing less willing to hold interest-bearing financial assets, such as bonds, financial assets, such as bonds, because the return is less. Instead, because the return is less. Instead, people increase their holding of people increase their holding of money (shown as an increase in the money (shown as an increase in the quantity demanded of money) in quantity demanded of money) in anticipation of more attractive anticipation of more attractive opportunities in the future. opportunities in the future.

ActivitiesActivities

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Chapter 10: Money. Stranded, “Cast Away” style 1 Person 1 Person Desert Island Desert Island Fruit Fruit + Animals to eat + Animals to eat Paradise Paradise