1. Chapter 10: Money

2. Stranded, “Cast Away” style
1 Person
Desert Island
Fruit
+ Animals to eat
Paradise
+ Treasure Chest
Useless Trinkets

3. Stranded, “Cast Away” style
You Guy 2
Pick Berries Hunt Fish and
Animals

4. Stranded, “Cast Away” style
You Guy 2
Pick Berries Hunt Fish and
Animals
Barter – the exchange of one good for another, without the use of money.

5. Stranded, “Cast Away” style
With more people added to the island, specializations begin to grow.
There’s more risk, as people trade for items that might not be wanted at the moment, but are traded anyways hoping to trade in the future
People might not trade for things they want. (Ex. Farmer wants meat but Butcher doesn’t want wheat)

6. 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.

7. The Invention of Money Money must be Durable – long lasting
Portable – take it anywhere
Divisible – can be broken down
Homogeneous – identical
Stable – supply must be in control

8. The Invention of Money
Fiat Money – Paper money that is not backed by or convertible into any good.

9. Gresham’s Law
– Law established by Sir Thomas Gresham that explains how bad money drives out good.
If there are two different kinds of money, one more expensive than the other but valued the same as quantity, the cheaper kind (bad money) would drive out the more expensive one (good money).

10. Gresham’s Law Example:
If there was a more valuable silver quarter and a cheaper copper quarter circulating in the economy, people would over time hoard the silver quarters, making the copper quarters the norm for quarters.

11. Money in the Modern Economy
Currency – Coins and Paper Money

12. Money in the Modern Economy
Liquidity – The degree to which an asset can easily be exchanged for money.
Basically, liquidity is how fast you can convert an asset into money.

13. Money in the Modern Economy
Money Supply – The supply of currency, demand deposits, and traveler’s checks used in transactions. Basically, its M1.

14. Money in the Modern Economy
M1 Money Supply – The supply of the most immediate form of money. It includes currency, demand deposits, and traveler’s checks.

15. Money in the Modern Economy
M2 money supply – M1 money plus savings accounts, mutual funds, deposit accounts, repurchase agreements, and small-denomination time deposits.
M2 is just M1 plus lesser form of liquid assets.

16. Money in the Modern Economy
M3 money Supply – M2 money plus large-denomination time deposits and large-denomination repurchase agreements.
M3 is M2 plus even less liquid assets.

17. U.S. MONEY SUPPLY: 2000 ($ BILLIONS)

18. Money in the Modern Economy
There is no clear line between money and non-money assets. Basically, most assets can be converted into money. =

19. Money Facts
The largest denomination of currency printed today is $100.
The Bureau of Engraving and Printing is the agency in charge of printing the currency.
All of the U.S. coins currently printed portray past U.S. presidents.
Currency printed after 1929 is 6.14’’ by 2.61’’

20. Money Facts
The average lifespan of a $1 bill is months while the life for a $100 bill is 8-9 years.
To stop counterfeiting, U.S. bills are protected by:
Tiny red and blue fibers in the paper
A polyester strip embedded vertically in the paper
Special inks.

21. The Quantity Theory of Money
Velocity of money – The average number of times per year each dollar is used to transact an exchange.

22. The Quantity Theory of Money
Equation of exchange – The quantity of money times its velocity equals the quantity of goods and services produced times their prices.
MV = PQ

23. The Quantity Theory of Money
The Classical view:
Real GDP (Q) depends on the amount of resources in the economy, which are fixed.
Prices are flexible.
Velocity is fixed.
MV = PQ

24. 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.
Flexible
Fixed
Fixed
MV = PQ

25. The Quantity Theory of Money
Quantity Theory of Money – The equation specifying the direct relationship between the money supply and prices.
P = MV/Q

26. 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.

27. EXHIBIT 3 HISTORICAL RECORD OF MONEY VELOCITY

28. Historical Record of Money Velocity
(from previous graph)
Increased use of credit cards from the 50’s to the 80’s allowed people to buy more goods and services with less cash and lower demand deposit balances relative to nominal GDP.

29. 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. Because of this, changes in M will affect more than just P—they may also change Q.

30. 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.
Amount of money needed for a household/business to survive

31. 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.

32. 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.

33. The Demand for Money Classical
Transactions demand for money is the only motive for demanding money
Keynesian
There is a precautionary and a speculative motive for demanding money, when added to the transaction demand

34. EXHIBIT 4 THE SPECULATIVE DEMAND FOR MONEY

35. The Speculative Demand for Money
The quantity of money demanded increase as interest rates decrease because people shift out of interest-paying accounts into holding money because the opportunity cost of holding money has fallen.

36. EXHIBIT 5A MONEY AFFECTS REAL GDP

37. EXHIBIT 5B MONEY AFFECTS REAL GDP

38. EXHIBIT 5C MONEY AFFECTS REAL GDP

39. Money Affects Real GDP
According to the Keynesian view, a change in the money supply affects Real GDP by:
An increase in the money supply reduces interest rates.
Lower interest rates increase investment spending.
Increased investment spending increases aggregate demand.

40. The Demand for Money
The shape of the aggregate supply curve when a change in the money supply affects real GDP and not the price level will look horizontal, where the aggregate demand curve shifts.

41. The Demand for Money
Classical economists and Monetarists see the shape of the aggregate supply curve as 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.

42. Chapter
Review

43. Chapter Review #1
Barter exchanges requires a double coincide of wants. As the number of people and the number of goods increase, barter becomes increasingly more difficult. One good then becomes chosen as the barter form. The characteristics of a good money are durability, portability, divisible, homogeneity, and stability. Gold is an exemplary money form.

44. Chapter Review #2 Money serves three functions
It is a medium of exchange
A measure of value
A store of value
Paper (or fiat) money can substitute for gold as long as it is universally accepted as the medium of exchange.

45. Chapter Review #3
The difference measure of our money supply depends upon the degree of liquidity we use.
M1, the most liquid form of money, is essentially currency and checkable deposits such as NOW and ATS accounts.
M2 includes M1 plus small-denomination time deposits, such as MMDAs, and savings accounts.
M3 include M2 plus large-denomination time deposits and overnight repurchase agreements.

46. Chapter Review #4
The equation of exchange is written as MV = PQ. Classical economists believe that because output, Q, is constant at full-employment equilibrium, and because the velocity of money, V, is constant, then the price level in the economy, P, varies directly with the money supply, M.

47. Chapter Review #5
Monetarists accept the classical idea that the economy operates at full-employment equilibrium, but unlike the Classicist, they believe that the velocity of money is not constant but nonetheless stable and predictable enough to ensure the usefulness of the equation of exchange linking prices to the money supply.

48. Chapter Review #6
Keynesian believe that because output and velocity are neither constant nor stable and predicable, changes in the money supply can affect real GDP as well as prices

49. Chapter Review #7
According to to classical economist, the demand for money is strictly a transaction demand. Keynesian, on the other hand, use the transactions, precautionary, and speculative motives as determinants of money demand.

50. Questions
& Answers

51. Question #1
Why does barter exchange become increasing less useful as the number of people engaged increases?
Barter requires the double coincidence of wants in which each party to an exchange wants what the other has. With more people trading, the chances of achieving a double coincidence of wants decreases.

52. Question #2 What are the essential properties of money?
Money should be:
Durable
Divisible
Portable
Homogeneous
Scarce.

53. Question #3 What are the 3 principle functions of money?
Money serves as
A medium of exchange; it is anything generally acceptable in payment for goods and services.
It also serves as a measure of value, or yardstick, for measuring the value of other goods.
Finally, it serves as a store of value, or a means of holding wealth over time.

54. Question #4 What are the principle components of M1, M2, and M3 money?
M1 consists of currency, traveler’s checks, and checking accounts.
M2 consists of M1 plus savings deposits, money market mutual fund balances, and small time deposits.
M3 consists of M2 plus large time deposits, term repurchase agreements and institutional money market fund balances.

55. Question #5 What is the relationship between money and liquidity?
Liquidity is the ease with which an asset can be used as immediate money.

56. Question #6 What is “Near” money?
“Near” money is a relatively illiquid financial asset, such as a corporate bond, that can be readily converted on a financial assets market, such as a bond market, to immediate money. The intended purpose or utility of “near” money, however, is not to serve as a money form.

57. Question #7
Are Visa and MasterCard balances part of M1? Why or why not?
Credit card balances are not part of M1. They are plastic “checkbooks” that can be used, as checks can, to buy goods. Credit cards are simply convenient instruments that allow you to use your checking account at the bank. Your checking account is the M1 money.

58. Question #8 What is money velocity?
Velocity measures the serviceability of the money supply. It is the average number of times per year a dollar is used to transact an exchange.

59. Question #9
How do the Classical and Keynesian views of money velocity differ?
In the classical view, velocity is assumed to be constant. Keynesians reject this idea, arguing that velocity varies with changes in people’s expectations.

60. Question #10
In the classical view, what is the principle reason for people demanding money?
To classical economists, there is only one motive for demanding money. It is demanded because it is needed in making transactions.

61. Question #11
In the Keynesian view, what are the principle reasons for people demanding money?
First, they accept the classical economists’ transactions motive.
Second, they believe there is a precautionary motive. People hold money as an insurance against unexpected needs.
Third, there is a speculative motive. People also hold money in preference to holding interest-bearing financial assets. The quantity of money they hold to satisfy the speculative motive depends on the interest rate and their expectations of changes in that rate.

62. Question #12
Why does a quantity demanded of interest yielding assets fall in the quantity demanded of money increase when the interest rate falls?
When the interest rate falls, people are less willing to hold interest-bearing financial assets, such as bonds, because the return is less (shown as a decrease in the quantity demanded of those interest-bearing bonds). Instead, people increase their holding of money (shown as an increase in the quantity demanded of money) in anticipation of more attractive opportunities in the future.

63. Question #13
Explain graphically how the interest rate affects the Keynesian demand for money?
When the interest rate falls, people are less willing to hold interest-bearing financial assets, such as bonds, because the return is less. Instead, people increase their holding of money (shown as an increase in the quantity demanded of money) in anticipation of more attractive opportunities in the future.

64. Activities 34 35