The Role of Money in the Macroeconomy

1
The Role of Money in the Macroeconomy

• Introduction of the Concepts

2
Financial Markets/Institutions

• Bringing together of buyers and sellers of
  financial securities to establish prices
• Provides a mechanism for those with excess funds
  (savers) to lend to those who need funds
  (borrowers)
• Includes banks, savings and loans, credit unions,
  investment banks and brokers, mutual funds, stock
  and bond markets

3
Money

• Currency bills and coins
• Includes demand deposits (checking accounts)
  issued by banks
• Plays a key role in influencing the behavior of
  the economy as a whole and the performance of
  financial institutions and markets

4
Monetary Economy

• Facilitates transactions within the economy
• Principal mechanism through which central banks
  attempt to influence aggregate economic activity
• Economic Growth
• Employment
• Inflation

5
Banking

• Place where savers can invest their funds to earn
  interest with a minimum of risk.
• Make loans to individuals and small businesses

6
Banks

• Banks serve as the principal caretaker of the
  economys money supply, and along with other
  financial intermediaries, provide important
  source of funds.
• Banks are intimately involved in how the Federal
  Reserve influences overall economic activity

7
Monetary Policy

• The Fed directly influences the lending and
  deposit creation activities of banks

8
Flow of funds from lenders to borrowers
9
What is the proper amount of money for the
economy?

• Sir William Petty (162387) wrote in 1651
• To which I say that there is a certain measure
  and proportion of money requisite to drive the
  trade of a nation, more or less than which would
  prejudice the same
• Too much money will lead to inflation
• Too little money will result in an inefficient
  economy

10
Functions of Money

• Standard of value
• or unit of account for all the goods and services
  we might wish to trade.
• Medium of exchange
• it is the only financial asset that virtually
  every business, household, and unit of government
  will accept in payment of goods and services.
• Store of value
• reserve of future purchasing power.

11
Liquid Asset

• Something that can be turned into a generally
  acceptable medium of exchange, without loss of
  value
• Liquidity is a continuum from very liquid to
  illiquid
• Currency and checking accounts are most liquid
  assets

12
Monetary Base

• A base amount of money that serves as the
  foundation for a nations monetary system.
• Under a gold standard, the amount of gold
  bullion.
• In a fiat money system, the sum of currency in
  circulation plus reserves of banks and other
  depository institutions.

13
The Monetary Base

• Currency
• Coins and paper money.
• Reserves
• Cash held by depository institutions in their
  vaults or on deposit with the Federal Reserve
  System.
• Monetary Base Currency Reserves

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The Use Of Coins

• Seigniorage
• The difference between the market value of money
  and the cost of its production, which is gained
  by the government that produces and issues the
  money.
• Debasement
• A reduction in the amount of precious metal in a
  coin that the government issues as money.

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Monetary Aggregate

• A grouping of assets sufficiently liquid to be
  defined as a measure of money.

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What is the money supply?

• M1
• currencychecking accounts
• M2
• M1 savings accounts small CDs MMDA MMMF
• M3
• M2 large CDs

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Who Determines Our Money Supply?

• Federal Reserve is responsible for execution of
  national monetary policy
• Created by Congress in 1913
• Twelve district Federal Reserve Banks scattered
  throughout the country
• Board of Governors located in Washington, D.C.

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Who Determines Our Money Supply?

• Fed influences the total money supply, but not
  the fraction of money between currency and demand
  deposits which is determined by public
  preferences
• Fed implements monetary policy by altering the
  money supply and influencing bank behavior

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Barter

• Direct exchange of goods/services for other
  goods/services
• Very inefficient and limited economy
• No medium of exchange or unit of account
• Requires double coincidence of wantsI have
  something you want and you have something I want
• Items must have approximate equal value
• Need to determine the exchange rate between
  different goods/services

20
Money

• Any commodity accepted as medium of exchange can
  be used as money
• Frees people from need to barter
• Makes exchange more efficient
• Permits specialization of laborsell ones labor
  to the market in exchange for money to purchase
  goods/services

21
Money

• Prices, expressed in money terms, permit
  comparison of values between different goods
• Must retain its valuethe value of money varies
  inversely with the price level (inflation)
• If money breaks down as a store of value
  (hyperinflation), economy resorts to barter

22
How Large Should the Money Supply Be?

• Purchase goods/services economy can produce, at
  current prices
• Generate level of spending on Gross Domestic
  Product (GDP) that produces high employment and
  stable prices
• Monetary Policy is used as a countercyclical
  toolvary the money supply to influence economic
  activity

23
Increases in the Money Supply Alters Publics
Liquidity and Influences Spending

• Direct Impactexcess liquidity is spent on
  goods/services
• Indirect Impactpurchase financial assets which
  lowers interest rates which stimulates business
  investment and consumer spending
• However, changes in liquidity may alter demand
  for money and not influence GDPpeople hoard the
  additional money
• Publics reaction to changes in liquidity is not
  consistent, so Fed cannot always judge impact of
  a change in money supply

24
Velocity

• When the Fed increases the money supply,
  recipients of this additional liquidity probably
  will spend some on GDP
• Over time there will be a multiple increase in
  spending

25
Velocity of Money

• The number of times the money supply turns over
  in a period of time to support spending on output
• The Fed has no control over the velocity of money
  since this is dependent on behavior of the public
• It is possible the public will choose to hold
  onto the additional liquidity (hoarding of money)
• Ultimately, the Fed needs to be concerned whether
  the additional spending which results from
  increased money supply will result in higher
  production or higher prices

26
Velocity of Money

• Velocity is the way in which the quantity of
  money is related to economic activity.
• The speed with which money is spent.
• Velocity changes in spending/quantity of money
  ?GDP/?M.
• If Velocity 5, then if M increases by 10
  billion, GDP will rise by 50 billion.

27
Money and Inflation

• InflationPersistent rise of prices
• HyperinflationPrices rising at a fast and
  furious pace
• DeflationFalling prices, usually during severe
  recessions or depressions
• Inflation reduces the real purchasing power of
  the currencycan buy fewer goods/services with
  the same nominal amount of money

28
Money, The Economy, and Inflation

• Economists generally agree that, in the long-run,
  inflation is a monetary phenomenoncan occur only
  with a persistent increase in money supply
• Increase in money supply is a necessary
  condition for persistent inflation, but it is
  probably not a sufficient condition

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Examples

• Case 1Economy in a recession.
• Expanding money supply may lead to more
  employment and higher output
• Case 2Economy near full employment/output.
• Expanding money supply can lead to higher
  output/employment, but also higher prices
• Case 3Economy producing at maximum.
• Expanding money supply will most likely lead to
  increasing inflation.

30
Money and Inflation

• To return to the 1940s, the smallest bill would
  be 10 and the smallest coin would be a dime.

31
Hyperinflation Example

• Hyperinflation occurred in Germany after World
  War I, with inflation rates sometimes exceeding
  1000 percent per month. By the end of
  hyperinflation in 1923, the price level had risen
  to more than 30 billion times what it had been
  just two years before. The quantity of money
  needed to purchase even the most basic items
  became excessive. Near the end of the
  hyperinflation, a wheelbarrow of cash would be
  required to pay for a loaf of bread. Money was
  losing its value so rapidly that workers were
  paid and given time off several times during the
  day to spend their wages before the money became
  worthless. No one wanted to hold on to money,
  and so the use of money to carry out transactions
  declined and barter became more and more dominant.

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Who creates money?

• The Federal Reserve
• Depository Institutions
• The Public

33
Fractional Reserve System

• Required Reserves
• Excess Reserves

34
How a bank creates money

• Assets Claims
• Reserves Transactions Deposits
• Securities Savings Deposits
• Loans CDs
• Equity

35
Money and Banking in the Digital Age

• Cybertechnologies
• Technologies that connect savers, investors,
  traders, producers, and governments via computer
  linkages.
• Electronic money (e-money)
• Money that people can transfer directly via
  electronic impulses.
• Wire transfers
• Payments made via telephone lines or through
  fiber-optic cables.

36
Money in the Digital Economy

• Electronic Payments
• Automated clearinghouses
• Institutions that process payments electronically
  on behalf of senders and receivers of those
  payments.
• Point-of-sale (POS) transfer
• Electronic transfer of funds from a buyers
  account to the firm from which a good or service
  is purchased at the time the sale is made.
• Automated bill payment
• Direct payment of bills by depository
  institutions on behalf of their customers.