The Role of Money in the The Role of Money in the MacroeconomyMacroeconomy

Introduction of the ConceptsIntroduction of the Concepts

Financial Markets/InstitutionsFinancial Markets/Institutions

Bringing together of buyers and sellers of Bringing together of buyers and sellers of financial securities to establish pricesfinancial securities to establish prices

Provides a mechanism for those with Provides a mechanism for those with excess funds (savers) to lend to those excess funds (savers) to lend to those who need funds (borrowers)who need funds (borrowers)

Includes banks, savings and loans, credit Includes banks, savings and loans, credit unions, investment banks and brokers, unions, investment banks and brokers, mutual funds, stock and bond marketsmutual funds, stock and bond markets

MoneyMoney

Currency – bills and coinsCurrency – bills and coins

Includes demand deposits (checking Includes demand deposits (checking accounts) issued by banksaccounts) issued by banks

Plays a key role in influencing the behavior Plays a key role in influencing the behavior of the economy as a whole and the of the economy as a whole and the performance of financial institutions and performance of financial institutions and marketsmarkets

Monetary EconomyMonetary Economy

Facilitates transactions within the Facilitates transactions within the economyeconomy

Principal mechanism through which Principal mechanism through which central banks attempt to influence central banks attempt to influence aggregate economic activityaggregate economic activity– Economic GrowthEconomic Growth– EmploymentEmployment– InflationInflation

BankingBanking

Place where savers can invest their funds Place where savers can invest their funds to earn interest with a minimum of risk.to earn interest with a minimum of risk.

Make loans to individuals and small Make loans to individuals and small businessesbusinesses

BanksBanks

Banks serve as the principal caretaker of Banks serve as the principal caretaker of the economy’s money supply, and along the economy’s money supply, and along with other financial intermediaries, provide with other financial intermediaries, provide important source of funds.important source of funds.

Banks are intimately involved in how the Banks are intimately involved in how the Federal Reserve influences overall Federal Reserve influences overall economic activityeconomic activity

Monetary PolicyMonetary Policy

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

Flow of funds from lenders to Flow of funds from lenders to borrowersborrowers

What is the proper amount of What is the proper amount of money for the economy?money for the economy?

Sir William Petty (1623Sir William Petty (1623––87) wrote in 165187) wrote in 1651““To which I say that there is a certain To which I say that there is a certain measure and proportion of money requisite to measure and proportion of money requisite to drive the trade of a nation, more or less than drive the trade of a nation, more or less than which would prejudice the same”which would prejudice the same”– Too much money will lead to inflationToo much money will lead to inflation– Too little money will result in an inefficient economyToo little money will result in an inefficient economy

Functions of MoneyFunctions of Money

Standard of valueStandard of value – or unit of account for all the goods and services we or unit of account for all the goods and services we

might wish to trade.might wish to trade.

Medium of exchangeMedium of exchange – it is the only financial asset that virtually every it is the only financial asset that virtually every

business, household, and unit of government will business, household, and unit of government will accept in payment of goods and services.accept in payment of goods and services.

Store of valueStore of value– reserve of future purchasing power.reserve of future purchasing power.

Liquid AssetLiquid Asset

Something that can be turned into a generally Something that can be turned into a generally acceptable acceptable medium of exchangemedium of exchange, , without loss without loss of valueof valueLiquidity is a continuum from very liquid to illiquidLiquidity is a continuum from very liquid to illiquidCurrency and checking accounts are most liquid Currency and checking accounts are most liquid assetsassets

Monetary BaseMonetary Base

A “base” amount of money that serves as A “base” amount of money that serves as the foundation for a nation’s monetary the foundation for a nation’s monetary system.system.

Under a gold standard, the amount of gold Under a gold standard, the amount of gold bullion.bullion.

In a fiat money system, the sum of In a fiat money system, the sum of currency in circulation plus reserves of currency in circulation plus reserves of banks and other depository institutions.banks and other depository institutions.

The Monetary Base The Monetary Base

Currency:Currency:– Coins and paper money.Coins and paper money.

Reserves:Reserves:– Cash held by depository institutions in their Cash held by depository institutions in their

vaults or on deposit with the Federal Reserve vaults or on deposit with the Federal Reserve System.System.

Monetary Base = Currency + ReservesMonetary Base = Currency + Reserves

The Use Of CoinsThe Use Of Coins

Seigniorage:Seigniorage:– The difference between the market value of The difference between the market value of

money and the cost of its production, which is money and the cost of its production, which is gained by the government that produces and gained by the government that produces and issues the money.issues the money.

Debasement:Debasement:– A reduction in the amount of precious metal in A reduction in the amount of precious metal in

a coin that the government issues as money.a coin that the government issues as money.

Monetary AggregateMonetary Aggregate

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

What is the money supply?What is the money supply?

M1M1– currency+checking accountscurrency+checking accounts

M2M2– M1 + savings accounts + small CDs +MMDA M1 + savings accounts + small CDs +MMDA

+MMMF+MMMF

M3M3– M2 + large CDsM2 + large CDs

Who Determines Our Money Who Determines Our Money Supply?Supply?

Federal Reserve is responsible for Federal Reserve is responsible for execution of national monetary policyexecution of national monetary policy– Created by Congress in 1913Created by Congress in 1913– Twelve district Federal Reserve Banks Twelve district Federal Reserve Banks

scattered throughout the countryscattered throughout the country– Board of Governors located in Washington, Board of Governors located in Washington,

D.C.D.C.

Who Determines Our Money Who Determines Our Money Supply? Supply?

Fed influences the total money supply, but Fed influences the total money supply, but not the fraction of money between not the fraction of money between currency and demand deposits which is currency and demand deposits which is determined by public preferences determined by public preferences

Fed implements monetary policy by Fed implements monetary policy by altering the money supply and influencing altering the money supply and influencing bank behaviorbank behavior

BarterBarter

Direct exchange of goods/services for Direct exchange of goods/services for other goods/servicesother goods/services– Very inefficient and limited economyVery inefficient and limited economy– No medium of exchange or unit of accountNo medium of exchange or unit of account– Requires Requires double coincidence of wantsdouble coincidence of wants—”I —”I

have something you want and you have have something you want and you have something I want”something I want”

– Items must have approximate equal valueItems must have approximate equal value– Need to determine the “exchange rate” Need to determine the “exchange rate”

between different goods/servicesbetween different goods/services

MoneyMoney

Any commodity accepted as Any commodity accepted as medium of medium of exchangeexchange can be used as money can be used as money

Frees people from need to barterFrees people from need to barter

Makes exchange more efficientMakes exchange more efficient

Permits specialization of labor—sell one’s Permits specialization of labor—sell one’s labor to the market in exchange for money labor to the market in exchange for money to purchase goods/servicesto purchase goods/services

MoneyMoney

Prices, expressed in money terms, permit Prices, expressed in money terms, permit comparison of values between different comparison of values between different goodsgoods

Must retain its value—the value of money Must retain its value—the value of money varies inversely with the price level varies inversely with the price level (inflation)(inflation)

If money breaks down as a store of value If money breaks down as a store of value (hyperinflation), economy resorts to barter(hyperinflation), economy resorts to barter

How Large Should the Money How Large Should the Money Supply Be?Supply Be?

Purchase goods/services economy can Purchase goods/services economy can produce, at current pricesproduce, at current prices

Generate level of spending on Gross Generate level of spending on Gross Domestic Product (GDP) that produces Domestic Product (GDP) that produces high employment and stable priceshigh employment and stable prices

Monetary Policy is used as a Monetary Policy is used as a countercyclical tool—vary the money countercyclical tool—vary the money supply to influence economic activitysupply to influence economic activity

Increases in the Money Supply Alters Public’s Increases in the Money Supply Alters Public’s Liquidity and Influences SpendingLiquidity and Influences Spending

Direct ImpactDirect Impact—excess liquidity is spent on —excess liquidity is spent on goods/servicesgoods/servicesIndirect ImpactIndirect Impact—purchase financial assets —purchase financial assets which lowers interest rates which stimulates which lowers interest rates which stimulates business investment and consumer spendingbusiness investment and consumer spendingHowever, changes in liquidity may alter demand However, changes in liquidity may alter demand for money and not influence GDP—people hoard for money and not influence GDP—people hoard the additional moneythe additional moneyPublic’s reaction to changes in liquidity is not Public’s reaction to changes in liquidity is not consistent, so Fed cannot always judge impact consistent, so Fed cannot always judge impact of a change in money supplyof a change in money supply

VelocityVelocity

When the Fed increases the money When the Fed increases the money supply, recipients of this additional liquidity supply, recipients of this additional liquidity probablyprobably will spend some on GDP will spend some on GDP

Over time there will be a multiple increase Over time there will be a multiple increase in spendingin spending

Velocity of MoneyVelocity of Money

The number of times the money supply turns The number of times the money supply turns over in a period of time to support spending on over in a period of time to support spending on outputoutputThe Fed has The Fed has nono control over the velocity of control over the velocity of money since this is dependent on behavior of money since this is dependent on behavior of the publicthe public– It is possible the public will choose to hold onto the It is possible the public will choose to hold onto the

additional liquidity (hoarding of money)additional liquidity (hoarding of money)

Ultimately, the Fed needs to be concerned Ultimately, the Fed needs to be concerned whether the additional spending which results whether the additional spending which results from increased money supply will result in higher from increased money supply will result in higher production or higher pricesproduction or higher prices

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

Money and InflationMoney and Inflation

InflationInflation—Persistent rise of prices—Persistent rise of pricesHyperinflationHyperinflation—Prices rising at a fast and —Prices rising at a fast and furious pacefurious paceDeflationDeflation—Falling prices, usually during —Falling prices, usually during severe recessions or depressionssevere recessions or depressionsInflation reduces the Inflation reduces the real purchasing real purchasing powerpower of the currency—can buy fewer of the currency—can buy fewer goods/services with the same nominal goods/services with the same nominal amount of moneyamount of money

Money, The Economy, and Money, The Economy, and InflationInflation

Economists generally agree that, in the Economists generally agree that, in the long-run, inflation is a monetary long-run, inflation is a monetary phenomenon—can occur only with a phenomenon—can occur only with a persistent increase in money supplypersistent increase in money supply

Increase in money supply is aIncrease in money supply is a necessary necessary condition for persistent inflation, but it is condition for persistent inflation, but it is probably not a probably not a sufficientsufficient condition condition

ExamplesExamples

Case 1Case 1—Economy in a recession. —Economy in a recession. – Expanding money supply may lead to more Expanding money supply may lead to more

employment and higher outputemployment and higher output

Case 2Case 2—Economy near full employment/output.—Economy near full employment/output.– Expanding money supply can lead to higher Expanding money supply can lead to higher

output/employment, output/employment, butbut also higher prices also higher prices

Case 3Case 3—Economy producing at maximum.—Economy producing at maximum.– Expanding money supply will most likely lead to Expanding money supply will most likely lead to

increasing inflation.increasing inflation.

Money and InflationMoney and Inflation

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

Hyperinflation ExampleHyperinflation Example

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

Who creates money?Who creates money?

The Federal ReserveThe Federal Reserve

Depository InstitutionsDepository Institutions

The PublicThe Public

Fractional Reserve SystemFractional Reserve System

Required Reserves Required Reserves

Excess Reserves Excess Reserves

How a bank creates moneyHow a bank creates money

AssetsAssets ClaimsClaimsReservesReserves Transactions DepositsTransactions Deposits

SecuritiesSecurities Savings DepositsSavings Deposits

LoansLoans CDsCDs

EquityEquity

Money and Banking in the Money and Banking in the Digital AgeDigital Age

Cybertechnologies:Cybertechnologies:– Technologies that connect savers, investors, traders, Technologies that connect savers, investors, traders,

producers, and governments via computer linkages.producers, and governments via computer linkages.

Electronic money (e-money):Electronic money (e-money):– Money that people can transfer directly via electronic Money that people can transfer directly via electronic

impulses.impulses.

Wire transfers:Wire transfers:– Payments made via telephone lines or through fiber-Payments made via telephone lines or through fiber-

optic cables.optic cables.

Money in the Digital EconomyMoney in the Digital Economy

Electronic PaymentsElectronic Payments– Automated clearinghouses:Automated clearinghouses:

Institutions that process payments electronically on behalf of Institutions that process payments electronically on behalf of senders and receivers of those payments.senders and receivers of those payments.

– Point-of-sale (POS) transfer:Point-of-sale (POS) transfer:Electronic transfer of funds from a buyer’s account to the firm Electronic transfer of funds from a buyer’s account to the firm from which a good or service is purchased at the time the sale from which a good or service is purchased at the time the sale is made.is made.

– Automated bill payment: Automated bill payment: Direct payment of bills by depository institutions on behalf of Direct payment of bills by depository institutions on behalf of their customers.their customers.