1. Macroeconomics - ECO 2013 Fall 205 – 1 Term August 24 – December 16, 2005

2. Chapter 13: Money & Banking When working properly, the monetary system provides lifeblood of the circular flows of income & expenditure. Well-operating monetary system helps economy achieve full employment & efficient use of resources. Malfunctioning monetary system creates severe fluctuations in the economy’s levels of output, employment & prices, distorting the allocation of resources

3. The Functions of Money 1. Mediums of Exchange for buying & selling goods & services 2. Unit of Account, yardstick for measuring the relative worth of a variety of goods, services & resources. Price of each item stated only in terms of the monetary unit Money aids rational decision making by enabling buyers & sellers to easily compare the prices of various goods, services, and resources. 3. Store of value enables transfer of purchasing power from present to future Store some of wealth as money

4. The Supply of Money Money Definition M1 Money Definition M2 Money Definition M3

5. Money Definition M1 Narrowest definition Consists of: Currency (coins & paper money) in hands of public  Coins are token money: Intrinsic value (of the metal contained in the coin) < face value All checkable deposits (in commercial banks & “thrifts” or savings on which checks can be drawn) Money, M1 = Currency + Checkable Deposits

6. Money Definition M2 Broader definition Near-monies are certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits Savings deposits, including money market deposit accounts (MMDA) Small time deposits (<$100,000) Money market mutual funds (MMMF) Money, M2 = M1 + Savings Deposits including MMDAs + Small time Deposits (<$100,000) + MMMFs)

7. Money Definition M3 Includes large time deposits (>$100,000) Certificates of deposit Money, M3 = M2 + large time deposits (>$100,000)

8. Credit Cards Not really money Means of obtaining a short-term loan from commercial bank or other financial institution that issued the card Means of deferring or postponing payment for a short period

9. What “backs” the money supply? Government’s ability to keep its value stable provides the backing Money is debt; paper money is a debt of Federal Reserve Banks & checkable deposits are liabilities of banks & thrifts b/c depositors own them Value of money arises not from intrinsic value, but its value in exchange for goods & services

10. Value of Money Acceptable as a medium of exchange Currency is legal tender or fiat money; must be accepted by law Relative scarcity of money compared to goods & services will allow money to retain its purchasing power Money’s purchasing power determines its value. Higher prices mean less purchasing power.

11. Inflation & Acceptability Excessive inflation may make money worthless & unacceptable Worthless money leads to use of other currencies that are more stable Worthless money may lead to barter exchange system.

12. Stabilization of Money’s Value The government tries to keep supply stable w/ appropriate fiscal policy Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow

13. The Demand for Money: Two Components Transactions demand, D t is money kept for purchases, will vary directly w/ GDP Asset demand, D a is money kept as store of value for later use, varies inversely w/ interest rate, since that is price of holding idle money Total demand, D m will equal quantities of money demanded for assets & transactions

14. The Money Market S m represents money supply Vertical line b/c monetary authorities & financial institutions have provided the economy w/ particular stock of money Intersection of demand & supply determines equilibrium price

15. The Federal Reserve Bank & The Banking System Board of Governors of the Federal Reserve System (“the Fed”) Board directs 12 Federal Reserve Banks which control lending activity of nation’s banks & thrift institutions Federal Open Market Committee (FOMC) Sets Fed’s monetary policy & directs purchase & sale of government securities in the open market, “open-market operations”

16. Fed Functions & The Money Supply Issuing currency Setting reserve requirements & holding reserves Lending money to banks Providing for check collection Acting as fiscal agent Supervising banks Controlling money supply

17. Federal Reserve Independence Protects Fed from political pressures to effectively control money supply & maintain price stability Political pressures on Congress & Executive Branch result in inflationary fiscal policy, including tax cuts & special-interest spending, but Fed can take actions to increase interest rates when higher rates are needed to stem inflation Countries w/ independent central banks have lower rates of inflation, on average, than countries w/ little or no independence

18. Recently Developments in Money & Banking Relative decline of banks & thrifts Consolidation among banks & thrifts Convergence of services provided by financial institutions Globalization of financial markets Electronic transactions

19. Last Word: The Global Greenback Two-thirds of all U.S. currency is circulating abroad U.S. profits when dollars stay overseas Black markets & illegal activity overseas are usually conducted in dollars b/c are such a stable form of currency The dollar is a reliable medium of exchange, measure, & store of value that facilitates transactions everywhere All dollars will not return to the U.S.

20. Chapter 13 Study Questions 1: Functions of Money 5: Backing Money

21. Next Class Chapter 14: How Banks and Thrifts Create Money Chapter 15: Monetary Policy

22. Quiz on Ch. 9 – 12, 16