Unit 1 Money

I. Money

A.Definition of money and review of money’s history. a)Money is defined as anything that is generally acceptable in payment for goods and services, or in discharge of debts. b) In the past, many things have served their turn as money, such as decorative shells, beads, stone axes, bronze, gold and silver.

c) Nowadays, for our daily point of view, money refers to notes, coins, checks, traveling checks and deposits. d) The difference between currency and money: Currency refers to notes and coins, while money covers more than currency, such as checks, traveling checks and deposits.

B. Reasons for using money: a) The use of money enriches economic life by broadening the scope of exchange, production and consumption. It broadens the scope of exchange by eliminating the need for a “double coincidence of wants” necessity in barter trade. b) It amplifies the range of goods and services people can produce by making possible a wider specialization and division of labor. c) Money adds flexibility to economic consumption. It enables each consumer to distribute his spending as he wishes (He can choose to spend all his incomes immediately or choose to exercise the option of transferring some his consumption to future when he may enjoy it more.)

II. Functions of Money

A. Medium of Exchange ( 流通手段） — basic function B. Standard of Value ( 价值尺度） — basic function C. Store of Value ( 价值储藏） D. Standard of Deferred Payment ( 延期支付标准） F. World Currency ( 世界货币） Due to the development of international trade, some currencies have crossed border and played the role of world currency, such as US dollars, Euro, Japanese Yen, and British pounds.

III. Money Supply

A. The available quantity of money at a moment is called the money supply. ( 是指货币存量，是一个国家或一个地区在某一时点上的 现金存量和银行存款的总和，其中银行存款占的比例较大。） B. Based on the liquidity of financial assets (liquidity of financial assets 指存款和信用工具转化为现金的速度和成本 ), the central bank computes 3 series of money supply: i) International explanation of money supply: M1=C+Dd M2=C + Dd + Dt M3=C + Dd + Dt + Dn (Non-banking financial institutions) ii) Chinese explanation of money supply : M0 = Cash M1 = Cash + Dd M2 = M1 + Quasi-Money (including Dt + margins of securities firms + other deposits)

C. Broadly-defined money （广义货币） & narrowly-defined money （狭义货币） M1 constitutes a narrowly-defined money supply, while M2 and M3 are broadly-defined money supply. D. Knowing Money supply is the basis for learning monetary policy ( 货币政策）. Monetary policy: i) When the central bank increases money supply, more money is pumped into the economic system and it promotes the economic growth and may cause inflation ( and then increase interest rate to curb inflation); ii) When the central bank decreases money supply, less money is in the economic system and it slows down the economic growth and may cause deflation (and then lower interest rate to stimulate the economy). costs and barriers to trade (such as tariffs), identical products sold in different countries must be sold for the same price when their prices are expressed in terms of the same currency, for example, if $ 1 = FFr 5, then, a jacket sold for $ 50 in NY should be sold for FFr 250 in Paris. If the law of one price were true for all goods and services, the PPP exchange rate would be found from any individual set of price. So, by comparing the prices of identical products in different currencies, it would be possible to determine the “real” or “PPP” exchange rate. For instance, it takes $1 to buy one dozen of apples in NY and 2.5 DM to buy the same apples in Frankfurt, so the exchange rate between US dollars and DM is $ 1 = DM 2.5. If prices of apples double in NY while the prices in Frankfurt remain the same, then, the purchasing power of a dollar in NY drop 50 percent. Consequently, the exchange rate is $ 1 = DM 1.25.

a. Inflation b) The currency exchange rate is determined by the ratio and change of their respective purchasing powers in each country. This is called purchasing power parity theory. When the inflation rate differential between 2 countries, the exchange rate also adjust to correspond to the relative purchasing powers of the countries. That is, Domestic inflation value of domestic currency (compared with foreign countries) (compared with that of foreign country)

Exchange Rate of Purchasing Power Parity Real Exchange rate

Big Mac Index

b. Productivity If one country becomes more productive than other countries, businesses in that country can lower the prices (costs) of domestic goods relative to foreign goods. As a result, the foreign demand for domestic goods rises, and the domestic currency tends to appreciate against foreign currency. If its productivity lags behind that of other countries, its goods become relatively more expensive and less foreign demand for those goods, and the currency tends to depreciate. So, in the long run, as a country becomes more productive relative to other countries, its currency will appreciate.

c. Interest Rate Investment capital flows in the direction of higher yield for a given level of risk. Hence, if investors can earn 6% interest rate per year domestically and 10 % in country X, they will prefer to invest in country X, provided the inflation rate and risk are the same in both countries. It causes more demands for country X’s currency, so the country X’s currency will appreciate against domestic currency. The interplay between interest rates and exchange rates is called interest rate parity theory.

d. Government Policies Monetary and fiscal policies also affect the currency value in foreign exchange markets. Expansionary monetary policy and excessive government spendings are prime causes of inflation, and continue use of such policies eventually reduce the value of the country’s currency. (Supplements: Adjustments of government spendings:) i) increase of government spending increase of production and income consumers buy more (when consumers receive extra income from increasing production) stimulates economy price level inflation; ii) spendings cutbacks reduce production and income levels consumption falls (as consumers’ income decline with decline in production levels.) price level deflation.

e. Other Factors a) An extended stock market rally in a country attracts investment capital from other countries, thus creating a huge demand by foreigners for that country’s currency. This increase demand is expected to increase the value of that country’s currency; b) A significant drop in demand for a country’s principal exports worldwide is expected to result in a corresponding decline in the value of its currency; c) A political turmoil in a country often drives capital out of the country into stable countries. A mass outflow of capital due to fear of political risk, undermines the value of a country’s currency in the foreign exchange markets.

Notes Although there is a wide variety of factors that can influence exchange rates, all of these variables will not influence the currency to the same degree. Some factors may have an overriding influence on the currency’s value, while others have less influences.