Money

What is Money? Money is any commodity or token that is generally acceptable as the means of payment. A means of payment is a method of settling a debt.

What is Money? Other functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value

What is Money? Medium of Exchange A medium of exchange is an object that is generally accepted in exchange for goods and services. Without money, people would have to exchange goods for goods, or barter.

What is Money? Unit of Account A unit of account is an agreed measure for stating the prices of goods and services. This simplifies value comparisons and purchase decision making if all prices are expressed using a uniform measure.

The Unit of Account Functions of Money Simplifies Price Comparisons Price in Price in units Good money units of another good Movie $6.00 each 2 six-packs of soda Soda $3.00 per six-pack 2 ice-cream cones Ice cream $1.50 per cone 3 packs of jelly beans Jelly beans $0.50 per pack 2 cups of coffee Coffee $0.25 per cup 1 local phone call Instructor Notes: 1) Money as a unit of account: The price of a movie is $6 and the price of a cup of coffee is 25 cents, so the opportunity cost of a movie is 24 cups of coffee ($6.00/25 cents = 24). 2) No unit of account. You go to a movie theater and learn that the price of a movie is 2 six-packs of soda. 3) You go to a candy store and learn that a pack of jelly beans costs 2 cups of coffee. 4) But how many cups of coffee does seeing a movie cost you? 5) To answer that question, you go to the convenience store and find that a six-pack of soda costs 2 ice-cream cones. 6) Now you head for the ice-cream shop, where an ice-cream cone costs 3 packs of jelly beans. 7) Now you get out your pocket calculator: 1 movie costs 2 six-packs of soda, or 4 ice cream cones, or 12 packs of jelly beans, or 24 cups of coffee!

What is Money? Store of Value A store of value is any commodity or token that can be held and exchanged later for goods and services.

What is Money? Money in the United States Today Money in the U.S. consists of: Currency Deposits at banks and other financial institutions

What is Money? Money in the United States Today Currency is the bills and coins that we use. Deposits are also money because they can be converted into currency and are used to settle debts.

What is Money? Official Measures of Money 1) M1 consists of currency and traveler’s checks plus checking deposits. Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government

What is Money? Official Measures of Money 2) M2 consists of M1 plus saving deposits and time deposits

What is Money? Official Measures of Money 3) M3 consists of M2 plus large-scale time deposits and term deposits

Two Measures of Money

What is Money? Are M1 and M2 Really Money? M1 is money The test of whether an asset is money is whether it serves as a means of payment. Currency does so Checking deposits are money because they can be transferred by writing a check. M1 is money

What is Money? Are M1 and M2 Really Money M2 is money Some savings deposits are readily accessible and can be used as a means of payment. Other deposits are less liquid. Liquidity is the property of being instantly convertible into a means of payment with little loss in value. M2 is money

What is Money? Other Points Regarding Money 1) Deposits are money but checks are not. 2) Credit cards are not money.

Financial Intermediaries Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.

Financial Intermediaries Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks and credit unions 4) Money market mutual funds

Financial Intermediaries Commercial Banks A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.

Financial Intermediaries Commercial Banks Their balance sheet lists their assets, liabilities, and net worth. The assets are what the bank owns The liabilities are what the bank owes These include deposits Net worth is the difference between assets and liabilities.

Financial Intermediaries Commercial Banks Their balance sheet is described by the following formula: Liabilities + Net Worth = Assets

Financial Intermediaries Profit and Prudence: A Balancing Act Banks attempt to maximize the net worth of their stockholders They earn profit by lending at a higher interest rate than they borrows Lending is risky Banks must be prudent in how they uses their deposits

Financial Intermediaries Reserves and Loans Banks divide their funds into two parts: Reserves are cash in a bank’s vault plus its deposits at Federal Reserve banks Loans

Financial Intermediaries Three Types of Assets Held by Banks 1) Liquid assets are U.S. government Treasury bills and commercial bills 2) Investment securities are longer-term U.S. government bonds and other bonds 3) Loans are commitments of fixed amounts of money for agreed- upon periods of time

Financial Intermediaries Savings and Loan Associations A savings and loan association is a financial intermediary that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans.

Financial Intermediaries Savings Banks and Credit Unions A savings bank (mutual savings bank) is a financial intermediary owned by its depositors that accepts deposits and makes mostly home-purchase loans.

Financial Intermediaries Savings Banks and Credit Unions A credit union is a financial intermediary owned by its depositors that accepts savings deposits and makes mostly consumer loans. The key difference between savings banks and credit unions is that credit unions are owned by a social or economic group such as a firm’s employees.

Financial Intermediaries Money Market Mutual Funds A money market mutual fund is a financial institution that obtains funds by selling shares and uses these funds to buy highly liquid assets such as U.S. Treasury bills

Financial Intermediaries The Economic Functions of Financial Intermediaries 1) Creating Liquidity 2) Minimizing the cost of borrowing

Financial Intermediaries The Economic Functions of Financial Intermediaries 3) Minimizing the cost of monitoring borrowers 4) Pooling Risk

Financial Regulation, Deregulation, and Innovation Financial Innovation Financial innovation is the development of new ways of borrowing and lending. Primary aim is to increase the profit from financial intermediation

Financial Regulation, Deregulation, and Innovation The three main influences on financial innovation are: 1) Economic environment 2) Technology 3) Regulation

Financial Regulation, Deregulation, and Innovation Financial Innovations Variable interest rate mortgages Widespread credit card usage Rise in the importance of the Eurodollar Paying interest on checkable deposits

How Banks Create Money Reserves: Actual and Required The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Excess reserves are actual reserves minus required reserves.

Let’s see an example of how How Banks Create Money Creating Deposits by Making loans in a One-Bank Economy Let’s see an example of how banks create money.

Creating Money at the One-and-Only Bank Balance sheet on January 1 Assets (millions of dollars) Liabilities (millions of dollars) Reserves $100 Deposits $400 Loans $300 Total $400 Total $400 Instructor Notes: 1) In the table, the One-and-Only Bank has deposits of $400 million, loans of $300 million, and reserves of $100 million. 2) The bank’s required reserve ratio is 25percent. 3) When the banks receives a deposit of $1 million

Creating Money at the One-and-Only Bank Balance sheet on January 2 Assets (millions of dollars) Liabilities (millions of dollars) Reserves $101 Deposits $401 Loans $300 Total $401 Total $401 Instructor Notes: 1) When the banks receives a deposit of $1 million, as shown, it has excess reserves. 2) It lends $3 million and creates a further $3 million of deposits.

Creating Money at the One-and-Only Bank Balance sheet on January 3 Assets (millions of dollars) Liabilities (millions of dollars) Reserves $101 Deposits $404 Loans $303 Total $404 Total $404 Instructor Notes: Deposits increase by $3 million, and loans increase by $3 million.

How Banks Create Money The Deposit Multiplier

banking system creates money How Banks Create Money Creating Deposits by Making Loans with Many Banks Let’s see how the banking system creates money

The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits Deposit $100,000 $75,000 $25,000 Reserve $25,000 Loan $75,000 $25,000 $75,000 $100,000 Deposit $75,000 Instructor Notes: 1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent. 2) The amount lent becomes a new deposit at another bank. 3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves. 4) The running tally tells us the amounts of deposits and loans created at each stage. 5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits. Reserve $18,750 Loan $56,250 $43,750 $131,250 $175,000

The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits Deposit $56,250 $43,750 $131,250 $175,000 Reserve $14,063 Loan $42,187 $57,813 $173,437 $231,250 Deposit $42,187 Instructor Notes: 1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent. 2) The amount lent becomes a new deposit at another bank. 3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves. 4) The running tally tells us the amounts of deposits and loans created at each stage. 5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits.

The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits Reserve $10,547 Loan $31,640 $68,360 $205,077 $273,437 and so on... $100,000 $300,000 $400,000 Instructor Notes: 1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent. 2) The amount lent becomes a new deposit at another bank. 3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves. 4) The running tally tells us the amounts of deposits and loans created at each stage. 5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits.

How Banks Create Money The deposit multiplier in the United States differs from our model economy’s for three main reasons: 1) The actual required reserve ratio is smaller than the 25 percent used here. 2) Banks sometimes choose to hold excess reserves.

How Banks Create Money The deposit multiplier in the United States differs from our model economy’s for three main reasons: 3) Not all loans made by banks return to them in the form of reserves.

Money, Real GDP, and the Price Level We are going to study the effect the money supply has on real GDP, the price level, and the inflation rate.

Money, Real GDP, and the Price Level The Short-Run Effects of a Change in the Quantity of Money Let’s study how a change in the quantity of money effects these factors by examining the aggregate supply-aggregate demand model.

Short-Run Effects of Change in Quantity of Money LAS 140 130 Price level (GDP deflator, 1992 = 100) SAS 120 110 107 Instructor Notes: 1) An increase in the quantity of money increases aggregate demand and shifts the aggregate demand curve rightward from AD0 to AD1. 2) The price level rises to 110, and real GDP expands to $7 trillion. 3) The increase in the quantity of money increases real GDP to potential GDP. 100 AD0 AD1 6.6 6.8 7.0 7.2 7.4 7.6 Real GDP (trillions of 1992 dollars)

Long-Run Effects of Change in Quantity of Money LAS 140 SAS2 130 Price level (GDP deflator, 1992 = 100) SAS1 121 113 110 100 AD2 AD1 6.6 6.8 7.0 7.2 7.4 7.6 Real GDP (trillions of 1992 dollars)

Money, Real GDP, and the Price Level The Quantity Theory of Money The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. This theory is based upon the velocity of circulation and the equation of exchange.

Money, Real GDP, and the Price Level The Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.

Money, Real GDP, and the Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or MV=PY

Money, Real GDP, and the Price Level We can convert the equation of exchange into the quantity theory of money by making two assumptions: 1) The velocity of circulation is not influenced by the quantity of money. 2) Potential GDP is not influenced by the quantity of money.

Money, Real GDP, and the Price Level Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.

Money, Real GDP, and the Price Level This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money. This gives us the quantity theory of money: In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.

Money, Real GDP, and the Price Level The AS-AD model predicts the same outcome as the quantity theory of money. It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.

Money, Real GDP, and the Price Level Historical Evidence on the Quantity Theory of Money The data are broadly consistent with the quantity theory of money, but the relationship is not precise. The relationship is stronger in the long run than in the short run.

Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences This does not represent causation. Does money growth cause inflation, or does inflation cause money growth? Does some other factor cause inflation (deficit spending)?

NEXT: Monetary Policy