Definitions of Money

8/2/2019 Definitions of Money

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Chapter 10: An Intertemporal

Model with Money

Definitions of Money

Money Supply (money creation)

The Demand for Financial Assets

(Portfolio decisions)

Money Demand

Money Market Equilibrium

Inflation


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3 Roles of Money

Medium of exchange: Money accepted for

goods because it can be used to buy other

goods (Double coincidence of wants) Store of Value: trade current goods for

future goods

Unit of Account: All contracts

denominated in terms of money Types of Money

Commodity Money: Money that is

valuable on its own

Ex: gold, silver, cigarettes Problems:1) Quality difficult to verify

2) Costly to produce

3) Divert resource from other uses

Useful when laws are difficult toenforce

Private Bank Notes: Banks issue notes with

promise to redeem for gold

Mid 1800s in US, problem: bank solvency


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Gold Standard: Govt. issues paper currencybacked by gold.

Each note redeemable for a specified

quantity of gold Like a commodity money system withoutcost of carrying gold

Fiat Money

Pieces of paper that are essentially worthless

but are accepted in exchange for goods Value of money supported by beliefs

We believe others will accept the currency sowe do as well

Monetary Aggregates M0 (monetary base) = currency, bank

reserves at the Fed

M1 = currency + travelers checks, demanddeposits, (checking), assets widely used for

transactions M2 = M1 + savings deposits, small-

denomination time deposits, money marketmutual funds, additional assets that can beeasily converted to assets used in

transactions


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M3 = M2 + large denomination timedeposits, other assets that are less liquid(the non-M2 part of M3 is typically

associated with large institutions) Money Supply

Controlled by the Central Bank, stock ofmoney available to economy

The money supply is total means of

payments (currency plus other deposits) The money supply is related to the

monetary base by the money multiplier:Money Supply is a multiple of themonetary base

The U.S. has a fractional banking system.Banks may loan out more than they have inreserve. Such a system is subject to bankpanics if the system is no longer trustedand the public simultaneously withdraws

its money. (FDIC) The money supply is determined by the

monetary base and reserve requirements

Monetary base: currency and bankreserves. Directly controlled by the Fed


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Reserve Requirements: Banks loan out

more money than they have in reserve.

The minimum amount of reserves held

for each dollar is dictated by theFederal Reserve. Banks may choose to

hold greater reserves.

The balance sheet of the Federal Reserve

and commercial banks

Changes in the money supply

Open Market Purchases

Changes in Reserve Requirements

Changes in the discount rate

Open Market Purchases is the most

common method

Open market operations (the purchase or

sale of government bonds by the central

bank). Open market purchases/sales altersthe quantity of reserves the bank has

available to loan out

Open Market purchase


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How would an increase in reserve

requirements affect the money supply?

Portfolio Choice Decisions

How much of ones wealth should be

allocated to different types of assets.

(money (cash), CDs, bonds, stocks, real

estate)

Portfolio choice depends on risk, return,

and liquidity of the assets

Rate of Return: (payoff / investment)1

All else equal, hold asset with higher

return (in general stock return > bond

return > return on holding money)

real estate?


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Risk: rate of return is uncertain.

How much will I get for investing a $1000in the stock market this year?

Individual stocks may be risky, a portfolioof stocks may be less risky(diversification). Limits to diversificationmacroeconomic risk.

We assume people are risk-averse. That is

everything else equal, hold assets with lesrisk

Liquidity: measure of how long it takes to selan asset for its market value. Money is themost liquid asset (instantaneously

exchanged). Real Estate is illiquid. All else equal, we prefer assets that are

more liquid since we have uncertaintyabout future needs, (or potentialinvestment opportunities).

In choosing an asset portfolio we balanceexpected return, risk and liquidity

The demand for money depends on its return, theexpected return of alternative assets, the risk ofholding money, the risk of other assets, the need

for liquidity (expected nominal expenditure)


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The Money Demand Function

The price level. The higher the price level the

greater quantity of money needed to purchase

goods. Money demand is proportional to theprice level

Real Income. If we make more money we

want to buy more goods, to do so we need

more cash.

Interest Rates. If interest rates are high the

opportunity cost of holding cash is high so w

try and conserve our money balances. Note

We will refer to interest rates as the rate of

return on alternative assets to money andassume that the net nominal return to holding

money is 0.

We distinguish between real money demand

and nominal money demand. Nominal Money Demand.

MD = P L(Y, R )

L is increasing in Y and decreasing in R


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Real Money Demand.

MD / P = L(Y, R )

L is increasing in Y and decreasing in R

Other factors affecting money demand

1) change in the cost of using alternatives to

currency in transactions. (cost of check

clearing falls)

2) change in cost of converting other assets intocurrency (converting savings into cash

cheaper if more ATMs)

3) Change in Government regulation. After

1980 allowed interest on checking accounts(M1 money demand increased since

opportunity cost of holding M1 fell)

4) Change in inflation risk. Money is risky since

real return varies with inflation. inflation

risk demand for currency. Not much of problem in US currently.

5) Change in riskiness of alternative assets.

risk of alt asset in demand for money (

stock market volatility

demand formoney)


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Money Market Equilibrium

Money Demand equals Money Supply

Output (income) and interest rates are

determined in other markets, money marketequilibrium only determines the prices level.

The central bank sets the money supply and

hence the MS curve is a vertical line. Money

demand slopes upward since it is proportionato the price level.

The effect of an increase in MS on the P.

The effect of an increase in income on P.

The Relationship between real shocks and theprice level

In 1974 the US (like many countries)

faced an oil price shock (modeled as a

TFP shock). In 1974 nominal interest rate

rose, output fell, employment fell, realwages fell and the price level rose (high

inflation). Can the model we have

developed so far in this class explain these

events as the result of the oil shock?


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Inflation

Inflation is the percentage change in the price

level. If income, interest rates and everything

else that effects money demand (except theprice level) is held constant than the inflation

rate is equal to the rate of growth of money.

Cost of inflation

menu costs High inflation is generally associated with

high volatility in inflation and hence

macroeconomic risk is higher

If inflation is unanticipated then there is a

transfer of wealth from holders of nomina

assets to holder of real assets (real estate,

firm owners hold real assets). People at

lower income levels generally hold more

nominal assets and hence are hit thehardest (inflation is a regressive tax)

If inflation is unanticipated than those

with long term contracts get lower real

wages.

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Definitions of Money