Money

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Money
2
What is Money?

• Money is any commodity or token that is generally
  acceptable as the means of payment.
• A means of payment is a method of settling a debt.

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What is Money?

• Other functions of Money
• 1) Medium of exchange
• 2) Unit of account
• 3) Store of value

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What is Money?

• Medium of Exchange
• A medium of exchange is an object that is
  generally accepted in exchange for goods and
  services.
• Without money, people would have to exchange
  goods for goods, or barter.

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What is Money?

• Unit of Account
• A unit of account is an agreed measure for
  stating the prices of goods and services.
• This simplifies value comparisons and purchase
  decision making if all prices are expressed using
  a uniform measure.

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The Unit of Account Functions of Money Simplifies
Price Comparisons
Price in Price in units Good money units of
another good

• Movie 6.00 each 2 six-packs of soda
• Soda 3.00 per six-pack 2 ice-cream cones
• Ice cream 1.50 per cone 3 packs of jelly beans
• Jelly beans 0.50 per pack 2 cups of coffee
• Coffee 0.25 per cup 1 local phone call

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What is Money?

• Store of Value
• A store of value is any commodity or token that
  can be held and exchanged later for goods and
  services.

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What is Money?

• Money in the United States Today
• Money in the U.S. consists of
• Currency
• Deposits at banks and other financial institutions

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What is Money?

• Money in the United States Today
• Currency is the bills and coins that we use.
• Deposits are also money because they can be
  converted into currency and are used to settle
  debts.

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What is Money?

• Official Measures of Money
• 1) M1 consists of currency and travelers
  checks plus checking deposits.
• Includes accounts held by individuals and
  businesses, but does not include currency held by
  banks, or currency and checking deposits owned by
  the U.S. government

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What is Money?

• Official Measures of Money
• 2) M2 consists of M1 plus saving deposits and
  time deposits

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What is Money?

• Official Measures of Money
• 3) M3 consists of M2 plus large-scale time
  deposits and term deposits

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Two Measures of Money
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What is Money?

• Are M1 and M2 Really Money?
• The test of whether an asset is money is whether
  it serves as a means of payment.
• Currency does so
• Checking deposits are money because they can be
  transferred by writing a check.
• M1 is money

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What is Money?

• Are M1 and M2 Really Money
• Some savings deposits are readily accessible and
  can be used as a means of payment.
• Other deposits are less liquid.
• Liquidity is the property of being instantly
  convertible into a means of payment with little
  loss in value.
• M2 is money

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What is Money?

• Other Points Regarding Money
• 1) Deposits are money but checks are not.
• 2) Credit cards are not money.

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Financial Intermediaries

• Financial intermediaries are firms that take
  deposits from households and firms and makes
  loans to other households and firms.

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Financial Intermediaries

• Four Types of Financial Intermediaries
• 1) Commercial banks
• 2) Savings and loan associations
• 3) Savings banks and credit unions
• 4) Money market mutual funds

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Financial Intermediaries

• Commercial Banks
• A commercial bank is a firm, licensed by the
  Comptroller of the Currency or by a state agency
  to receive deposits and make loans.

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Financial Intermediaries

• Commercial Banks
• Their balance sheet lists their assets,
  liabilities, and net worth.
• The assets are what the bank owns
• The liabilities are what the bank owes
• These include deposits
• Net worth is the difference between assets and
  liabilities.

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Financial Intermediaries

• Commercial Banks
• Their balance sheet is described by the following
  formula

Liabilities Net Worth Assets
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Financial Intermediaries

• Profit and Prudence A Balancing Act
• Banks attempt to maximize the net worth of their
  stockholders
• They earn profit by lending at a higher interest
  rate than they borrows
• Lending is risky
• Banks must be prudent in how they uses their
  deposits

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Financial Intermediaries

• Reserves and Loans
• Banks divide their funds into two parts
• Reserves are cash in a banks vault plus its
  deposits at Federal Reserve banks
• Loans

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Financial Intermediaries

• Three Types of Assets Held by Banks
• 1) Liquid assets are U.S. government Treasury
  bills and commercial bills
• 2) Investment securities are longer-term U.S.
  government bonds and other bonds
• 3) Loans are commitments of fixed amounts of
  money for agreed- upon periods of time

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Financial Intermediaries

• Savings and Loan Associations
• A savings and loan association is a financial
  intermediary that receives checking deposits and
  savings deposits and that makes personal,
  commercial, and home-purchase loans.

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Financial Intermediaries

• Savings Banks and Credit Unions
• A savings bank (mutual savings bank) is a
  financial intermediary owned by its depositors
  that accepts deposits and makes mostly
  home-purchase loans.

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Financial Intermediaries

• Savings Banks and Credit Unions
• A credit union is a financial intermediary owned
  by its depositors that accepts savings deposits
  and makes mostly consumer loans.
• The key difference between savings banks and
  credit unions is that credit unions are owned by
  a social or economic group such as a firms
  employees.

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Financial Intermediaries

• Money Market Mutual Funds
• A money market mutual fund is a financial
  institution that obtains funds by selling shares
  and uses these funds to buy highly liquid assets
  such as U.S. Treasury bills

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Financial Intermediaries

• The Economic Functions of Financial
  Intermediaries
• 1) Creating Liquidity
• 2) Minimizing the cost of borrowing

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Financial Intermediaries

• The Economic Functions of Financial
  Intermediaries
• 3) Minimizing the cost of monitoring
  borrowers
• 4) Pooling Risk

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Financial Regulation, Deregulation, and Innovation

• Financial Innovation
• Financial innovation is the development of new
  ways of borrowing and lending.
• Primary aim is to increase the profit from
  financial intermediation

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Financial Regulation, Deregulation, and Innovation

• The three main influences on financial innovation
  are
• 1) Economic environment
• 2) Technology
• 3) Regulation

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Financial Regulation, Deregulation, and Innovation

• Financial Innovations
• Variable interest rate mortgages
• Widespread credit card usage
• Rise in the importance of the Eurodollar
• Paying interest on checkable deposits

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How Banks Create Money

• Reserves Actual and Required
• The reserve ratio is the fraction of a banks
  total deposits that are held in reserves.
• The required reserve ratio is the ratio of
  reserves to deposits that banks are required, by
  regulation, to hold.
• Excess reserves are actual reserves minus
  required reserves.

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How Banks Create Money

• Creating Deposits by Making loans in a One-Bank
  Economy

Lets see an example of how banks create money.
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Creating Money at theOne-and-Only Bank
Balance sheet on January 1
Assets (millions of dollars)
Liabilities (millions of dollars)

• Reserves 100 Deposits 400
• Loans 300
• Total 400 Total 400

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Creating Money at theOne-and-Only Bank
Balance sheet on January 2
Assets (millions of dollars)
Liabilities (millions of dollars)

• Reserves 101 Deposits 401
• Loans 300
• Total 401 Total 401

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Creating Money at theOne-and-Only Bank
Balance sheet on January 3
Assets (millions of dollars)
Liabilities (millions of dollars)

• Reserves 101 Deposits 404
• Loans 303
• Total 404 Total 404

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How Banks Create Money

• The Deposit Multiplier

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How Banks Create Money

• Creating Deposits by Making Loans with Many Banks
• Lets see how the
• banking system creates money

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The Multiple Creationof Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit 100,000
75,000
25,000
Loan 75,000
Reserve 25,000
25,000
75,000
100,000
Deposit 75,000
Loan 56,250
Reserve 18,750
43,750
131,250
175,000
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The Multiple Creationof Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit 56,250
43,750
131,250
175,000
Loan 42,187
Reserve 14,063
57,813
173,437
231,250
Deposit 42,187
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The Multiple Creationof Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Loan 31,640
Reserve 10,547
68,360
205,077
273,437
and so on...
100,000
300,000
400,000
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How Banks Create Money

• The deposit multiplier in the United States
  differs from our model economys for three main
  reasons
• 1) The actual required reserve ratio is
  smaller than the 25 percent used here.
• 2) Banks sometimes choose to hold excess
  reserves.

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How Banks Create Money

• The deposit multiplier in the United States
  differs from our model economys for three main
  reasons
• 3) Not all loans made by banks return to them
  in the form of reserves.

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Money, Real GDP, andthe Price Level

• We are going to study the effect the money supply
  has on real GDP, the price level, and the
  inflation rate.

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Money, Real GDP, andthe Price Level

• The Short-Run Effects of a Change in the Quantity
  of Money
• Lets study how a change in the quantity of money
  effects these factors by examining the aggregate
  supply-aggregate demand model.

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Short-Run Effects ofChange in Quantity of Money
LAS
140
130
Price level (GDP deflator, 1992 100)
SAS
120
110
107
100
AD0
AD1
6.6
7.0
7.2
7.6
6.8
7.4
Real GDP (trillions of 1992 dollars)
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Long-Run Effects ofChange in Quantity of Money
LAS
140
SAS2
130
Price level (GDP deflator, 1992 100)
SAS1
121
113
110
100
AD2
AD1
6.6
7.0
7.2
7.6
6.8
7.4
Real GDP (trillions of 1992 dollars)
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Money, Real GDP, andthe Price Level

• The Quantity Theory of Money
• The quantity theory of money is the proposition
  that in the long run, an increase in the quantity
  of money brings an equal percentage increase in
  the price level.
• This theory is based upon the velocity of
  circulation and the equation of exchange.

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Money, Real GDP, andthe Price Level

• The Quantity Theory of Money
• The velocity of circulation is the average number
  of times a dollar of money is used annually to
  buy goods and services that make up GDP.

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Money, Real GDP, andthe Price Level

• The equation of exchange states that the quantity
  of money (M) multiplied by the velocity of
  circulation (V) equals GDP, or

MVPY
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Money, Real GDP, andthe Price Level

• We can convert the equation of exchange into the
  quantity theory of money by making two
  assumptions
• 1) The velocity of circulation is not
  influenced by the quantity of money.
• 2) Potential GDP is not influenced by the
  quantity of money.

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Money, Real GDP, andthe Price Level

• Assuming this is true, the equation of exchange
  tells us that a change in the quantity of money
  causes an equal proportional change in the price
  level.

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Money, Real GDP, andthe Price Level

• This equation shows that the proportionate change
  in the price level equals the proportionate
  change in the quantity of money.
• This gives us the quantity theory of money
• In the long run, the percentage increase in the
  price level equals the percentage increase in the
  quantity of money.

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Money, Real GDP, andthe Price Level

• The AS-AD model predicts the same outcome as the
  quantity theory of money.
• It also predicts a less precise relationship
  between the quantity of money and the price level
  in the short run than in the long run.

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Money, Real GDP, andthe Price Level

• Historical Evidence on the Quantity Theory of
  Money
• The data are broadly consistent with the quantity
  theory of money, but the relationship is not
  precise.
• The relationship is stronger in the long run than
  in the short run.

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Money, Real GDP, andthe Price Level

• Correlation, Causation, and Other Influences
• The evidence shows that money growth and
  inflation are correlated.

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Money, Real GDP, andthe Price Level

• Correlation, Causation, and Other Influences
• This does not represent causation.
• Does money growth cause inflation, or does
  inflation cause money growth?
• Does some other factor cause inflation (deficit
  spending)?

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Monetary Policy
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