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CChapter 25hapter 25

MoneyMoney

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Gottheil - Principles of Economics, 4e

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

b. Cows

c. Gold

d. Water

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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.

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

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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

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

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

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

Suppose 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 nonmoney 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: 2003 ($ BILLIONS)

Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, September 2003), p. A13, table 1.21.

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Exhibit 1: U.S. Money Exhibit 1: U.S. Money Supply: 2003 ($ Supply: 2003 ($

billions)billions)1. True or false: The largest component of M1 is demand deposits. • False. In 2003 currency was over $646 billion of the $1,272.2 billion supply of M1 money.

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billions)billions)2. True or false: The largest component of M2 is M1. • False. In 2003 M1 was $1,272.2 billion, but savings deposits and money market accounts made up $2,227.3 of the $6,046.4 billion supply of M2 money.

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billions)billions)3. True or false: The largest component of M3 is made up of Eurodollars. • False. In 2003 the largest component of M3 was M2. Eurodollars were only a minor part of M3.

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EXHIBIT 2

GROWTH OF THE MONEY SUPPLY:1970–2003

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

1970-20031970-20031. True or false: M1 grew more slowly than M2 and M3 between 1970 and 2003. • 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:

1970-20031970-20031. 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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Know Your Know Your Currencies?Currencies?

1. Which of the following counties does not use the dollar as its currency?

a. Hong Kong.

b. Ireland.

c. Zimbabwe.

d. Australia.

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1. Which of the following counties does not use the dollar as its currency?

a. Hong Kong.

b. Ireland.

c. Zimbabwe.

d. Australia.

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2. Each of the European Union countries—with the exception of the United Kingdom—switched in 1999 from their national currencies to a common one. The name of this common currency is thea. EU.

b. Dollar.

c. Euro.

d. Common.

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2. Each of the European Union countries—with the exception of the United Kingdom—switched in 1999 from their national currencies to a common one. The name of this common currency is thea. EU.

b. Dollar.

c. Euro.

d. Common.

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3. The British currency is the

a. dollar.

b. pound.

c. gold.

d. sterling silver.

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3. The British currency is the

a. dollar.

b. pound.

c. gold.

d. sterling silver.

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4. What picture is on the face of the British currency?a. Buckingham Palace.

b. Queen Elizabeth II.

c. Queen Victoria.

d. Union Jack.

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4. What picture is on the face of the British currency?a. Buckingham Palace.

b. Queen Elizabeth II.

c. Queen Victoria.

d. Union Jack.

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5. In 1977, the Israelis switched their currency from the pound to the currency that was used in biblical Israel. That currency is thea. lira.

b. shekel.

c. dinar.

d. kroner.

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5. In 1977, the Israelis switched their currency from the pound to the currency that was used in biblical Israel. That currency is thea. lira.

b. shekel.

c. dinar.

d. kroner.

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6. Russia was once part of the U.S.S.R.—the Union of Soviet Socialist Republics—and the currency of the U.S.S.R. then was the ruble. Today, Russia’s currency is the

a. czar.

b. pound.

c. franc.

d. ruble.

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6. Russia was once part of the U.S.S.R.—the Union of Soviet Socialist Republics—and the currency of the U.S.S.R. then was the ruble. Today, Russia’s currency is the

a. czar.

b. pound.

c. franc.

d. ruble.

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7. Which country’s currency is not the peso?a. Brazil.

b. Mexico.

c. Argentina.

d. Philippines.

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7. Which country’s currency is not the peso?a. Brazil.

b. Mexico.

c. Argentina.

d. Philippines.

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8. China and Japan’s currencies are, respectively, thea. yak and the yang.

b. yuan and the yen.

c. han and the edo.

d. edo and the han.

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8. China and Japan’s currencies are, respectively, thea. yak and the yang.

b. yuan and the yen.

c. han and the edo.

d. edo and the han.

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9. India’s currency is the

a. ruble.

b. riyal.

c. rand.

d. rupee.

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9. India’s currency is the

a. ruble.

b. riyal.

c. rand.

d. rupee.

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10. The approximate life of a United States coin isa. 5 years.

b. 10 years.

c. 25 years.

d. 50 years.

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10. The approximate life of a United States coin isa. 5 years.

b. 10 years.

c. 25 years.

d. 50 years.

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The Quantity Theory of The Quantity Theory of MoneyMoney

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 Affects Exhibit 5: Money Affects Real GDPReal 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.

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