Visit UMT online at Page 1 of 30 Chapter 10, ECON125 Version © 2007 Thomson South-Western © 2009 UMT Economics for Managers University of Management and Technology 1901 North Fort Myer Drive Arlington, VA USA Phone: (703) Fax: (703) Website:

Visit UMT online at Page 2 of 30 Chapter 10, ECON125 Version © 2007 Thomson South-Western © 2009 UMT Chapter 10 Money in the U.S. Economy Mastrianna, F.V. Basic Economics (14th ed.) © 2007 Thomson South-Western. ISBN

Page 3 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Copyright Warning Copyright Warning This presentation is the intellectual property of the textbook publisher Thomson South-Western Students are hereby advised that they may not copy or distribute this work to any third party

Page 4 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Learning Objectives Upon successfully completing this module, the student should be able to: Briefly describe the evolution of currency Define money and explain its functions and how it is measured Understand the quantity theory of money and show how changes in M and V affect P and Q Describe the effects of changes in the money supply on total income and output and the price level Illustrate the multiple expansion of the money supply using a given initial checkable deposit and reserve requirement Explain how the Consumer Price Index is constructed and used Distinguish between nominal wages and real wages and explain how to convert nominal wages into real wages

Page 5 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Nature of Money Commodity money Currency in which the commodity itself actually serves as money Gold, stones, shells Representative money Money that is redeemable for a commodity, such as gold or silver Fiat money Money that is not redeemable for a commodity and is accepted on faith

Page 6 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMTMoney Anything generally accepted in exchange for other goods and services

Page 7 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Functions of Money Standard of value Measure of the value of all other goods and services Medium of exchange Used to purchase other goods and services Avoids double coincidence of wants In a barter economy, the need to find a match between what each of two traders wants to obtain and what each wants to offer in exchange Store of value Allows conversion of excess goods into money which can be stored/retained Standard of deferred payment Allows for payment over an extended period of time

Page 8 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Measuring the Money Supply Money stock Quantity of money in existence at any given time Liquidity The ease with which an asset can be converted into the medium of exchange Currency Paper money and coins

Page 9 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT M1 Money Stock Most liquid definition of money; includes currency, travelers checks, and checkable deposits Checkable deposits Checking deposits at banks and other depository institutions including demand deposits (checking accounts), NOW accounts, ATS accounts, and share draft accounts

Page 10 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT M2 Money Stock The total of M1 and savings deposits, small time deposits, and money market funds Savings deposits Interest-bearing funds held in accounts that do not allow for automatic transfer services Time deposits Funds that earn a fixed rate of interest and must be held for a stipulated period of time Money market funds Deposits held in accounts that are invested in a broad range of financial assets, such as government and corporate bonds

Page 11 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT M3 Money Stock The total of M2, plus large negotiable certificates of deposit and Eurodollars Eurodollars U.S. dollars deposited in foreign banks and consequently outside the jurisdiction of the United States

Page 12 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT The Equation of Exchange A relationship between the supply of money and the price level MV = PQ where M= total money supply V = velocity of money P = price level or average price per transaction Q = total transactions in the economy

Page 13 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT The Equation of Exchange The left side of the equation (MV) Represents the total amount spent on goods and services The right hand side of the equation (PQ) Represents the total amount received by sellers The total amount of final purchases in the economy must equal the amount of money in circulation multiplied by the average number of times per year that each dollar changes hands Truism

Page 14 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Transactions Approach An analysis of the equation of exchange that assumes any money received is spent directly or indirectly to buy goods and services

Page 15 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Quantity Theory of Money A classical view of the nature of money Money is passive The price level (P) is exactly proportional to the money supply (M) Based upon two important assumptions: The national economy is inherently stable and tends to operate at full employment of all productive resources The velocity of money is stable because people’s spending habits tend to be constant over time

Page 16 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Quantity Theory of Money Based upon these two assumptions, quantity theorists concluded that: If total output (Q) and velocity (V) are relatively constant, any increase in the money supply (M) should lead to a directly proportionate increase in the price level (P) Not all economists accept the validity of the quantity theory of money because they question the basic assumptions of full employment and stable velocity

Page 17 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Conditions Tending Toward Stable Total Output and Stable Price Level Conditions Tending Toward Decrease in Total Output and/or Decline in Price Level Conditions Tending Toward Increase in Total Output and/or Increase in Price Level Planned I = Planned S Planned I < Planned SPlanned I > Planned S Balanced government budget Surplus government budget Deficit government budget Exports = ImportsNet importsNet exports Stable money supply Decrease in money supply Increase in money supply Money and the Circular Flow: Relationships of Investment, Savings, the Government Budget, and the Money Supply

Page 18 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Creation of Money Bank deposits are made Banks provide loans Reserve requirements Multiple expansion of the money supply Contraction of the money supply

Page 19 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Money Multiplier The reciprocal of the reserve ratio

Page 20 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Expansion of the Money Supply 10% Reserve Requirement 20% Reserve Requirement Bank Deposit Reserve Loan A $1,000 $100 $900 A $1,000 $200 $800 B B C C D D E E F F G G H H I I J J etc. etc. etc. etc. $10,000 $1,000 $9,000 $5,000 $1,000 $4,000

Page 21 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Price Index A measuring system for comparing the average price of a group of goods and services in one period of time with the average price of the same group of goods and services in another period

Page 22 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMTExample Based upon the information in Table 10-4, the price index in 1989, with 1983 as the base year, would be computed as: PI = ($1,000/807) × 100% = 124  the price of this market basket of goods and services has increased by 24% between 1983 and 1989 Table 10-4 also illustrates the impact of changing the base period used in computing the price index

Page 23 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Consumer Price Index (CPI) An index that compares the price of a group of basic goods and services as purchased by urban residents Weighted according to the percentage of total spending that is applied to each of several categories, including food, rent, apparel, transportation, and medical care Components of the CPI Food and beverages (16.4%), housing (40.5%), apparel (4.2%), transportation (16.7%), medical care (6.0%), recreation (5.9%), education and communication (5.4%), and other goods and services (4.9%)

Page 24 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Limitations of the CPI Measures relative change in the cost of living Does not measure the actual cost of living Not a completely pure price index Quality improvements problem Upward bias of between 1 and 2 percentage points annually

Page 25 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT COLA Clauses Cost-of-living adjustment clauses Collective bargaining agreements Social Security payments Federal income tax Can be inflationary, because they increase wages or salaries without necessarily increasing productivity

Page 26 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT CPIs of Other Countries Maintained in developed nations Vary from one country to another Use caution when comparing Bureau of Labor Statistics: Foreign CPI conversions

Page 27 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Other Price Indexes Producer Price Index, PPI A measure of the average prices received by producers and wholesalers GDP Implicit Price Deflator A broadest measure of price changes than either the CPI or the PPI Takes into account the prices of all final goods and services produced by the economy An index of the price level of aggregate output

Page 28 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT The Value of Money Price indexes are useful for determining the value of money Based on the goods and services that a given amount of money can buy Value of dollar = ($1.00/PI) × 100 For example, the PI for 2005 was computed as 192, thus the dollar was valued at $0.52 ($1.00/192) × 100 A 2005 dollar would purchase only 52 cents worth of goods as measured in 1982–1984 dollars

Page 29 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Real Income The constant dollar value of goods and services produced The purchasing power of money income

Page 30 of 30 Chapter 10, ECON125 Visit UMT online at Version © 2007 Thomson South-Western © 2009 UMT Effects of Changes in Price Level Inflation is: an advantage to those whose incomes increase faster than the price level a disadvantage to those whose incomes decrease faster than the price level a disadvantage to those whose incomes remain stable when price level increases an advantage to debtors a disadvantage to creditors