© 2005 Thomson C hapter 25 Money

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Barter exchange The characteristics of money Gold-backed and fiat money Liquidity

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The equation of exchange The quantity theory of money The classical view of money The Keynesian view of money Monetarism

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Introduction Barter The exchange of one good for another, without the use of money.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Introduction 1. What is the key problem with barter exchange? To function effectively, barter requires a double coincidence of each party to the exchange wanting precisely what the other has to offer. A double coincidence of wants is difficult to achieve.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e The Invention of Money Money Any commonly accepted good that acts as a medium of exchange, a measure of value, and a store of value.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e The Invention of Money Money must be durable, portable, divisible, homogeneous, and supplies must be stable.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e The Invention of Money Which of the following is most likely to serve as money: a. Strawberries b. Cows c. Gold d. Water

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e The Invention of Money Which of the following is most likely to serve as money: a. Strawberries b. Cows c. Gold d. Water

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e The Invention of Money Strawberries are not durable, cows are not easily divisible, and most of the time the supply of water is too abundant and difficult to control. Which of the following is most likely to serve as money:

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e The Invention of Money Gold makes a good type of money because: a. Gold supplies are fairly stable. b. Gold is homogeneous. c. Gold is durable. d. Gold is divisible. e. Gold is portable.

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e The Invention of Money Fiat money Paper money that is not backed by or convertible into any good.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Fluffy Rabbits and Gresham’s Law People would keep the more valuable silver quarters, and eventually only the less valuable copper-nickel quarters would freely circulate. Suppose more valuable silver quarters and less valuable copper-nickel quarters freely circulate together in the economy. What would happen over time?

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Fluffy Rabbits and Gresham’s Law Suppose more valuable silver quarters and less valuable copper-nickel quarters freely circulate together in the economy. What would happen over time? Sir Thomas Gresham, a 16 th century merchant to the English crown, observed that bad money drives out good.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Money in a Modern Economy Currency Coins and paper money.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Money in a Modern Economy Liquidity The degree to which an asset can easily be exchanged for money.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e Money in a Modern Economy Liquidity is what distinguishes money from any other asset form. Some assets are relatively liquid, and can serve as money. Most assets are highly illiquid and thus far removed from serving as money.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e Money in a Modern Economy Money supply Typically, M1 money. The supply of currency, demand deposits, and traveler’s checks used in transactions.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e Money in a Modern Economy M1 Money supply The supply of the most immediate form of money. It includes currency, demand deposits, and traveler’s checks.

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Money in a Modern Economy M2 Money supply M1 money plus less-immediate forms of money, such as savings accounts, money market mutual fund accounts, money market deposit accounts, repurchase agreements, and small-denomination time deposits.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e Money in a Modern Economy M3 Money supply M2 money plus large-denomination time deposits and large-denomination repurchase agreements.

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e Explaining the Impressive Growth of M2 Money What caused the impressive growth of M2 money? Deregulation of the banking industry led to a large increase in money market accounts (mutual funds and deposit accounts), and increased the liquidity of savings accounts.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e Money in a Modern Economy The dividing line between money and nonmoney assets is blurry. Most any asset is potential money.

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Money in a Modern Economy Are credit cards a form of money? No. They may be accepted as readily as money by stores, but credit cards are loans that must be repaid.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e EXHIBIT 1U.S. MONEY SUPPLY: 2003 ($ BILLIONS) Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, September 2003), p. A13, table 1.21.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Exhibit 1: U.S. Money Supply: 2003 ($ billions) 1. True or false: The largest component of M1 is demand deposits. False. In 2003 currency was over $646 billion of the $1,272.2 billion supply of M1 money.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Exhibit 1: U.S. Money Supply: 2003 ($ billions) 2. True or false: The largest component of M2 is M1. False. In 2003 M1 was $1,272.2 billion, but savings deposits and money market accounts made up $2,227.3 of the $6,046.4 billion supply of M2 money.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Exhibit 1: U.S. Money Supply: 2003 ($ billions) 3. True or false: The largest component of M3 is made up of Eurodollars. False. In 2003 the largest component of M3 was M2. Eurodollars were only a minor part of M3.

© 2005 Thomson 29 EXHIBIT 2 GROWTH OF THE MONEY SUPPLY: 1970–2003

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Exhibit 2: Growth of the Money Supply: True or false: M1 grew more slowly than M2 and M3 between 1970 and True. Deregulation of the banking industry increased elements of M2, which in turn increased M3.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e Exhibit 2: Growth of the Money Supply: True or false: By 1992, M2 became larger than M3. False. That cannot occur because M3 includes M2 plus other types of money.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Know Your Currencies? 1. Which of the following counties does not use the dollar as its currency? a. Hong Kong. b. Ireland. c. Zimbabwe. d. Australia.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Know Your Currencies? 1. Which of the following counties does not use the dollar as its currency? a. Hong Kong. b. Ireland. c. Zimbabwe. d. Australia.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Know Your Currencies? 2. Each of the European Union countries— with the exception of the United Kingdom— switched in 1999 from their national currencies to a common one. The name of this common currency is the a. EU. b. Dollar. c. Euro. d. Common.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e Know Your Currencies? 2. Each of the European Union countries— with the exception of the United Kingdom— switched in 1999 from their national currencies to a common one. The name of this common currency is the a. EU. b. Dollar. c. Euro. d. Common.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Know Your Currencies? 3. The British currency is the a. dollar. b. pound. c. gold. d. sterling silver.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e Know Your Currencies? 3. The British currency is the a. dollar. b. pound. c. gold. d. sterling silver.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Know Your Currencies? 4. What picture is on the face of the British currency? a. Buckingham Palace. b. Queen Elizabeth II. c. Queen Victoria. d. Union Jack.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e Know Your Currencies? 4. What picture is on the face of the British currency? a. Buckingham Palace. b. Queen Elizabeth II. c. Queen Victoria. d. Union Jack.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Know Your Currencies? 5. In 1977, the Israelis switched their currency from the pound to the currency that was used in biblical Israel. That currency is the a. lira. b. shekel. c. dinar. d. kroner.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e Know Your Currencies? 5. In 1977, the Israelis switched their currency from the pound to the currency that was used in biblical Israel. That currency is the a. lira. b. shekel. c. dinar. d. kroner.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e Know Your Currencies? 6. Russia was once part of the U.S.S.R.—the Union of Soviet Socialist Republics—and the currency of the U.S.S.R. then was the ruble. Today, Russia’s currency is the a. czar. b. pound. c. franc. d. ruble.

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e Know Your Currencies? 6. Russia was once part of the U.S.S.R.—the Union of Soviet Socialist Republics—and the currency of the U.S.S.R. then was the ruble. Today, Russia’s currency is the a. czar. b. pound. c. franc. d. ruble.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Know Your Currencies? 7. Which country’s currency is not the peso? a. Brazil. b. Mexico. c. Argentina. d. Philippines.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e Know Your Currencies? 7. Which country’s currency is not the peso? a. Brazil. b. Mexico. c. Argentina. d. Philippines.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Know Your Currencies? 8. China and Japan’s currencies are, respectively, the a. yak and the yang. b. yuan and the yen. c. han and the edo. d. edo and the han.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Know Your Currencies? 8. China and Japan’s currencies are, respectively, the a. yak and the yang. b. yuan and the yen. c. han and the edo. d. edo and the han.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Know Your Currencies? 9. India’s currency is the a. ruble. b. riyal. c. rand. d. rupee.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Know Your Currencies? 9. India’s currency is the a. ruble. b. riyal. c. rand. d. rupee.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Know Your Currencies? 10. The approximate life of a United States coin is a. 5 years. b. 10 years. c. 25 years. d. 50 years.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Know Your Currencies? 10. The approximate life of a United States coin is a. 5 years. b. 10 years. c. 25 years. d. 50 years.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e The Quantity Theory of Money Velocity of money The average number of times per year each dollar is used to transact an exchange.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e The Quantity Theory of Money Equation of exchange MV = PQ. The quantity of money times its velocity equals the quantity of goods and services produced times their prices.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e The Quantity Theory of Money The classical view: Real GDP (Q in the equation of exchange) depends on the amount of resources in the economy, which are fixed. Prices are flexible. Velocity is fixed.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e The Quantity Theory of Money 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.

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e The Quantity Theory of Money Quantity theory of money P = MV/Q. The equation specifying the direct relationship between the money supply and prices.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e The Quantity Theory of Money 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.

© 2005 Thomson 58 EXHIBIT 3HISTORICAL RECORD OF MONEY VELOCITY

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e Exhibit 3: Historical Record of Money Velocity How might the use of credit cards have explained the change in M1 velocity from the 1950s to the 1980s? Increased use of credit cards during this period allowed people to buy more goods and services with less cash and lower demand deposit balances relative to nominal GDP.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e The Quantity Theory of Money Keynesians reject the monetarist’s idea that V is either stable or predictable, and that Q always reflects full-employment GDP. In this case, changes in M will affect more than just P—they may also change Q.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e The 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.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e The Demand for Money 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.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e The Demand for Money 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.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e EXHIBIT 4THE SPECULATIVE DEMAND FOR MONEY

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e Exhibit 4: The Speculative Demand for Money According to the speculative motive, why does the quantity of money demanded increase as interest rates decrease? People shift out of interest-paying accounts into holding money because the opportunity cost of holding money has fallen.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e Exhibit 4: The Speculative Demand for Money According to the speculative motive, why does the quantity of money demanded increase as interest rates decrease? This reduces the cost of speculatively having money immediately available to take advantage of unforeseen good purchasing opportunities that may suddenly arise.

© 2005 Thomson 67 EXHIBIT 5AMONEY AFFECTS REAL GDP

© 2005 Thomson 68 EXHIBIT 5BMONEY AFFECTS REAL GDP

© 2005 Thomson 69 EXHIBIT 5CMONEY AFFECTS REAL GDP

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Exhibit 5: Money Affects Real GDP According to the Keynesian view, how does a change in the money supply affect real GDP? An increase in the money supply reduces interest rates. Lower interest rates increase investment spending. Increased investment spending increases aggregate demand.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e The Demand for Money What is the shape of the aggregate supply curve when a change in the money supply affects real GDP but not the price level? The segment of the aggregate supply curve over which aggregate demand shifts is horizontal.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e The Demand for Money How do classical economists and monetarists see the shape of the aggregate supply curve? 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.