Chapter 25 MONEY Gottheil — Principles of Economics, 6e © 2010 Cengage Learning 1

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 2 Barter exchange The characteristics of money Gold-backed and fiat money Liquidity

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 3 The equation of exchange The quantity theory of money The classical view of money The Keynesian view of money Monetarism

Introduction © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 4 Barter The exchange of one good for another, without the use of money.

Introduction © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 5 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.

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 6 Money Any commonly accepted good that acts as a medium of exchange, a measure of value, and a store of value.

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 7 Money must be durable, portable, divisible, homogeneous, and supplies must be stable.

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 8 Which of the following is most likely to serve as money: a.Strawberries b.Cows c.Gold d.Water

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 9 Which of the following is most likely to serve as money: a.Strawberries b.Cows c.Gold d.Water

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 10 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:

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 11 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.

The Invention of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 12 Fiat money Paper money that is not backed by or convertible into any good.

Fluffy Rabbits and Gresham’s Law © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 13 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?

Fluffy Rabbits and Gresham’s Law © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 14 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.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 15 Currency Coins and paper money.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 16 Liquidity The degree to which an asset can easily be exchanged for money.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 17 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.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 18 Money supply Typically, M1 money. The supply of currency, demand deposits, and traveler’s checks used in transactions.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 19 M1 Money supply The supply of the most immediate form of money. It includes currency, demand deposits, and traveler’s checks.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 20 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.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 21 M3 Money supply M2 money plus large-denomination time deposits and large-denomination repurchase agreements.

Explaining the Impressive Growth of M2 Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 22 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.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 23 The dividing line between money and nonmoney assets is blurry. Most any asset is potential money.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 24 Why would a government lose money “making” money—coins like the penny and nickel? Metal prices have tripled since Because copper, zinc, and nickel are commodities, we have no control over their prices.

Money in a Modern Economy © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 25 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 26 EXHIBIT 1U.S. MONEY SUPPLY: 2008 ($ BILLIONS) Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, September 2008), p. A13, table 1.21.

Exhibit 1: U.S. Money Supply: 2008 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 27 1.True or false: The largest component of M1 is demand deposits. False. In 2008 currency was over $760 billion of the $1,374.8 billion supply of M1 money.

Exhibit 1: U.S. Money Supply: 2006 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 28 2.True or false: The largest component of M2 is M1. False. In 2006 M1 was $1,376.9 billion, but savings deposits and money market accounts made up $3,657.4 of the $6,761.2 billion supply of M2 money.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 29 EXHIBIT 2 GROWTH OF THE MONEY SUPPLY: 1970–2008

Exhibit 2: Growth of the Money Supply: 1970–2008 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 30 M1 money increased from $214 billion in 1970 to $1,374.8 billion in 2008, or by an annual rate of 5.4 percent. The M2 money components (M2, M1) increased by 9.4 percent.

Exhibit 2: Growth of the Money Supply: 1970–2008 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 31 1.True or false: M1 grew more slowly than M2 between 1970 and True. Deregulation of the banking industry increased elements of M2.

Exhibit 2: Growth of the Money Supply: 1970–2008 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 32 1.True or false: By 1992, M2 became larger than M3. False. That cannot occur because M3 includes M2 plus other types of money.

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 33 1.Which of the following counties does not use the dollar as its currency? a.Hong Kong b.Ireland c.Zimbabwe d.Australia

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 34 1.Which of the following counties does not use the dollar as its currency? a.Hong Kong b.Ireland c.Zimbabwe d.Australia

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 35 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

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 36 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

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 37 3.The British currency is the a.Euro b.Pound c.Gold d.Sterling silver

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 38 3.The British currency is the a.Euro b.Pound c.Gold d.Sterling silver

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 39 4.What picture is on the face of the British currency? a.Buckingham Palace b.Queen Elizabeth II c.Princess Diana d.Union Jack

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 40 4.What picture is on the face of the British currency? a. Buckingham Palace b.Queen Elizabeth II c.Princess Diana d.Union Jack

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 41 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

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 42 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

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 43 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.Putin b.Pound c.Franc d.Ruble

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 44 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.Putin b.Pound c.Franc d.Ruble

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 45 7.Which country’s currency is not the peso? a.Brazil b.Mexico c.Argentina d.Philippines

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 46 7.Which country’s currency is not the peso? a.Brazil b.Mexico c.Argentina d.Philippines

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 47 8.China and Japan’s currencies are, respectively, the a.Yak and yang b.Yuan and yen c.Han and edo d.Yin and yan

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 48 8.China and Japan’s currencies are, respectively, the a. Yak and yang b. Yuan and yen c. Han and edo d. Yin and yan

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e India’s currency is the a. Ruble b. Riyal c. Rand d. Rupee

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 50 9.India’s currency is the a.Ruble b.Riyal c.Rand d.Rupee

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e The approximate life of a United States coin is a.5 years b.10 years c.25 years d.50 years

Know Your Currencies? © 2010 Cengage Learning Gottheil — Principles of Economics, 6e The approximate life of a United States coin is a.5 years b.10 years c.25 years d.50 years

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 53 Velocity of money The average number of times per year each dollar is used to transact an exchange.

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 54 Equation of exchange MV = PQ. The quantity of money times its velocity equals the quantity of goods and services produced times their prices.

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 55 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.

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 56 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.

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 57 Quantity theory of money P = MV/Q. The equation specifying the direct relationship between the money supply and prices.

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 58 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 59 EXHIBIT 3HISTORICAL RECORD OF MONEY VELOCITY

Exhibit 3: Historical Record of Money Velocity © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 60 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.

The Quantity Theory of Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 61 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.

The Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 62 Transactions demand for money The quantity of money demanded by households and businesses to transact their buying and selling of goods and services.

The Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 63 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 Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 64 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 65 EXHIBIT 4THE SPECULATIVE DEMAND FOR MONEY

Exhibit 4: The Speculative Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 66 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.

Exhibit 4: The Speculative Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 67 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.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 68 EXHIBIT 5AMONEY AFFECTS REAL GDP

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 69 EXHIBIT 5BMONEY AFFECTS REAL GDP

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 70 EXHIBIT 5CMONEY AFFECTS REAL GDP

Exhibit 5: Money Affects Real GDP © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 71 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.

The Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 72 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.

The Demand for Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 73 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.