C hapter 25 Money © 2002 South-Western. 2 Economic Principles Barter Exchange The Characteristics of Money Gold-Backed and Fiat Money Liquidity

CChapter 25hapter 25

Money

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Barter Exchange

• The Characteristics of Money

• Gold-Backed and Fiat Money

• Liquidity

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Economic PrinciplesEconomic Principles

• The Equation of Exchange

• The Quantity Theory of Money

• The Classical View of Money

• The Keynesian View of Money

• Monetarism

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IntroductionIntroduction

Barter

The exchange of one good for another, without the use of money.

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IntroductionIntroduction

1. What is the key problem with barter exchange?

• To function effectively, barter requires a double coincidence of each party to the exchange wanting precisely what the other has to offer. A double coincidence of wants is difficult to achieve.

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The Invention of The Invention of MoneyMoney

Money

Any commonly accepted good that acts as a medium of exchange, a measure of value, and a store of value.

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Money must be durable, portable, divisible, homogeneous, and supplies must be stable.

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Which of the following is most likely to serve as money:

a. Strawberries.

b. Cows.

c. Gold.

d. Water.

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c. Gold.

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Strawberries are not durable, cows are not easily divisible, and most of the time the supply of water is too abundant and difficult to control.

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Gold makes a good type of money because:

a. Gold supplies are fairly stable.

b. Gold is homogeneous.

c. Gold is durable.

d. Gold is divisible.

e. Gold is portable.

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Fiat money

Paper money that is not backed by or convertible into any good.

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Fluffy Rabbits and Fluffy Rabbits and Gresham’s LawGresham’s Law

Suppose that more valuable silver quarters and less valuable copper-nickel quarters freely circulate together in the economy. What would happen over time?

• People would keep the more valuable silver quarters, and eventually only the less valuable copper-nickel quarters would freely circulate.

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Fluffy Rabbits and Fluffy Rabbits and Gresham’s LawGresham’s Law

Suppose that more valuable silver quarters and less valuable copper-nickel quarters freely circulate together in the economy. What would happen over time?

• Sir Thomas Gresham, a 16th century merchant to the English crown, observed that bad money drives out good.

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Money in a Modern Money in a Modern EconomyEconomy

Currency

Coins and paper money.

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Liquidity

The degree to which an asset can easily be exchanged for money.

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Liquidity is what distinguishes money from any other asset form.

• Some assets are relatively liquid, and can serve as money.

• Most assets are highly illiquid and thus far removed from serving as money.

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Money supply

Typically, M1 money. The supply of currency, demand deposits, and traveler’s checks used in transactions.

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M1 Money supply

The supply of the most immediate form of money. It includes currency, demand deposits, and traveler’s checks.

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M2 Money supply

M1 money plus less-immediate forms of money, such as savings accounts, money market mutual fund accounts, money market deposit accounts, repurchase agreements, and small-denomination time deposits.

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M3 Money supply

M2 money plus large-denomination time deposits and large-denomination repurchase agreements.

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Explaining the Explaining the Impressive Growth of Impressive Growth of

M2 MoneyM2 MoneyWhat caused the impressive growth of M2 money?

• Deregulation of the banking industry led to a large increase in money market accounts (mutual funds and deposit accounts), and increased the liquidity of savings accounts.

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The dividing line between money and non-money assets is blurry. Most any asset is potential money.

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Are credit cards a form of money?

• No. They may be accepted as readily as money by stores, but credit cards are loans that must be repaid.

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EXHIBIT 1 U.S. MONEY SUPPLY: 2000 ($ BILLIONS)

Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, December 2000), p. A13, table 1.21.

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Exhibit 1: U.S. Money Exhibit 1: U.S. Money Supply: 2000 Supply: 2000 ($Billions)($Billions)

1. True or false: The largest component of M1 is demand deposits.

• False. In 2000 currency was over $523 billion of the $1,095 billion supply of M1 money.

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2. True or false: The largest component of M2 is M1.

• False. In 2000 M1 was $1,094.9 billion, but savings deposits and money market accounts made up $1,839.4 of the $4,860.9 billion supply of M2 money.

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3. True or false: The largest component of M3 is made up of Eurodollars.

• False. In 2000 the largest component of M3 was M2. Eurodollars were only a minor part of M3.

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EXHIBIT 2GROWTH OF THE MONEY SUPPLY: 1970–2000

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Exhibit 2: Growth of Exhibit 2: Growth of the Money Supply: the Money Supply:

1970-20001970-20001. True or false: M1 grew more slowly than M2 and M3 between 1970 and 2000.

• True. Deregulation of the banking industry increased elements of M2, which in turn increased M3.

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Exhibit 2: Growth of Exhibit 2: Growth of the Money Supply: the Money Supply:

1970-20001970-20001. True or false: By 1992, M2 became larger than M3.

• False. That cannot occur because M3 includes M2 plus other types of money.

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Money Challenge Money Challenge QuizQuiz

1. What is the largest denomination of currency printed today?

a. $10,000.

b. $1,000.

c. $500.

d. $100.

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1. What is the largest denomination of currency printed today?

d. $100.

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2. What agency actually prints currency?

a. The Federal Reserve System.

b. The Bureau of Engraving and Printing.

c. The Internal Revenue System.

d. The U.S. Mint.

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2. What agency actually prints currency?

b. The Bureau of Engraving and Printing.

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3. All of the U.S. coins currently minted portray…

a. past U.S. presidents.

b. national parks.

c. national monuments.

d. various universities founded before 1900.

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3. All of the U.S. coins currently minted portray…

a. past U.S. presidents.

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4. The average life of a $1 bill is…

a. 3-6 months.

b. 6-9 months.

c. 12-18 months.

d. 3 years.

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c. 12-18 months.

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a. 3-4 years.

b. 5-6 years.

c. 7-8 years.

d. 8-9 years.

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d. 8-9 years.

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6. Some features of U.S. currency that deter counterfeiters include…

a. tiny red and blue fibers in the paper.

b. a polyester strip embedded vertically in the paper.

c. special inks.

d. all of the above.

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6. Some features of U.S. currency that deter counterfeiters include…

d. all of the above.

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7. The former U.S. President or statesman featured on the $5 bill is…

a. George Washington.

b. Andrew Jackson.

c. Ulysses S. Grant.

d. Abraham Lincoln.

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d. Abraham Lincoln.

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a. George Washington.

b. Andrew Jackson.


d. Abraham Lincoln.

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9. The emblem or monument printed on the back of the $50 bill is…

a. the Great Seal of the United States.

b. the White House.

c. the U.S. Capitol.

d. independence Hall.

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9. The emblem or monument printed on the back of the $50 bill is…

c. the U.S. Capitol.

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10. Currency printed after 1929 is…

a. 6.14’’ by 2.61’’.

b. 6.00’’ by 3.00’’.

c. 5.25’’ by 3.36’’.

d. 5.00’’ by 3.00’’.

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10. Currency printed after 1929 is…

a. 6.14’’ by 2.61’’.

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The Quantity Theory The Quantity Theory of Moneyof Money

Velocity of money

The average number of times per year each dollar is used to transact an exchange.

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Equation of exchange

MV = PQ. The quantity of money times its velocity equals the quantity of goods and services produced times their prices.

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The classical view:

• Real GDP (Q in the equation of exchange) depends on the amount of resources in the economy, which are fixed.

• Prices are flexible.

• Velocity is fixed.

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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.

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Quantity theory of money

P = MV/Q. The equation specifying the direct relationship between the money supply and prices.

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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.

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EXHIBIT 3 HISTORICAL RECORD OF MONEY VELOCITY

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Exhibit 3: Historical Exhibit 3: Historical Record of Money Record of Money

VelocityVelocityHow might the use of credit cards have explained the change in M1 velocity from the 1950s to the 1980s?

• Increased use of credit cards during this period allowed people to buy more goods and services with less cash and lower demand deposit balances relative to nominal GDP.

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Keynesians reject the monetarist’s idea that V is either stable or predictable, and that Q always reflects full-employment GDP. In this case, changes in M will affect more than just P—they may also change Q.

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The Demand for The Demand for MoneyMoney

Transactions demand for money

The quantity of money demanded by households and businesses to transact their buying and selling of goods and services.

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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.

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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.

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EXHIBIT 4 THE SPECULATIVE DEMAND FOR MONEY

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Exhibit 4: The Exhibit 4: The Speculative Demand Speculative Demand

for Moneyfor MoneyAccording to the speculative motive, why does the quantity of money demanded increase as interest rates decrease?

• People shift out of interest-paying accounts into holding money because the opportunity cost of holding money has fallen.

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Exhibit 4: The Exhibit 4: The Speculative Demand Speculative Demand

for Moneyfor MoneyAccording to the speculative motive, why does the quantity of money demanded increase as interest rates decrease?

• This reduces the cost of speculatively having money immediately available to take advantage of unforeseen good purchasing opportunities that may suddenly arise.

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EXHIBIT 5A MONEY AFFECTS REAL GDP

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EXHIBIT 5B MONEY AFFECTS REAL GDP

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EXHIBIT 5C MONEY AFFECTS REAL GDP

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Exhibit 5: Money Exhibit 5: Money Affects Real GDPAffects Real GDP

According to the Keynesian view, how does a change in the money supply affect real GDP?

• An increase in the money supply reduces interest rates.

• Lower interest rates increase investment spending.

• Increased investment spending increases aggregate demand.

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What is the shape of the aggregate supply curve when a change in the money supply affects real GDP but not the price level?

• The segment of the aggregate supply curve over which aggregate demand shifts is horizontal.

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How do classical economists and monetarists see the shape of the aggregate supply curve?

• 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.

Documents

C hapter 25 Money © 2002 South-Western. 2 Economic Principles Barter Exchange The Characteristics of Money Gold-Backed and Fiat Money Liquidity