MONEY DEFINED

• Money is anything that can be used as ALL of the following:

1. A medium of exchange2. A store of value3. A unit of account / Standard of Value

Our money is fiat… technically known as an inconvertible fiat standard

WHERE DOES $ COME FROM?

• The Federal Reserve System is the sole supplier of US currency.• The FED has a monopoly over the money supply• This is important!

ANY CHANGE IN MONEY SUPPLY IS A RESAULT OF FED POLICY NOT CONGRESS… Well sort of…

MONEY SUPPLYThere are a few measures of the Money Supply… Here are the two most important

• M1 – Liquid• Coin, currency and Demand Deposits (checking and

some savings accounts)

• M2 – Highly liquid but not cash• M1 + Time Deposits, Money Market Mutual Funds,

overnight Eurodollars

M1 to M2 the measure of money becomes larger and less liquid

M2 to M1 the measure of money becomes smaller but more liquid

TIME VALUE OF MONEY

• Simply, the understanding that because of inflation and opportunity cost, money today is worth more than money tomorrow.• This is why interest exists for borrowing and lending $

• Simple Interest• Is the rate of interest based only on the amount

borrowed (principle)• This ignores the interest charge on the interest over

time

• Compound interest• Interest calculated on the principle and also

accumulated interest of previous periods of a loan• The rate depends on the frequency of compounding

(ex. monthly or annually)

CALCULATING TIME VALUE OF MONEY… (INTEREST)

• Let v = future value of $

p = present value of $

r = real interest rate (nominal rate – inflation rate) expressed as a decimal

n = years

k = number of times interest is credited per year

• The Simple Interest Formula v = ( 1 + r )n * p

• The Compound Interest Formula v = ( 1 + r/k )nk * p

PRACTICE

• Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest savings is 1%. Calculate the future value of $1 after 1 year.

• Step 1: Calculate the real interest rater = i - Ir = 1% – 3% = -2% or -.02

• Step 2: Use the simple interest formula to calculate the future value of $1

v = ( 1 + r )n * p

v = ( 1 + (-.02))1 * $1

v = (.98) * $1

v = $0.98

PRACTICE 2

• Assume that inflation is still expected to be 3% but that the nominal interest rate on simple interest savings is 4%. Calculate the future value of $1 after 1 year.

• Step 1: Calculate the real interest rater = i - Ir = 4% - 3% = 1% or .01

• Step 2: Use the simple interest formula to calculate the future value of $1

v = ( 1 + r )n * p

v = ( 1 + .01)1 * $1

v = $1.01

PRACTICE 3 LAST ONE

• Assume that annual inflation is expected to be 2.5% and that the annual nominal interest rate on a 10 year certificate of deposit is 5% compounded monthly. Calculate the future value of $1,000 after 10 years.

• Step 1: Calculate the real interest rater = i - Ir = 5% - 2.5% = 2.5% or .025

• Step 2: Use the compound interest formula to calculate the future value of $1,000

v = ( 1 + r/k )nk * p

v = ( 1 + .025/12)10*12 * $1,000

v = ( 1 + 0.002083)120 * $1,000

v = $1,283.69

QUANTITY THEORY OF MONEY

• Theory states:• Nominal GDP = The Money Supply * The Velocity of

MoneyOr…

• MS * V = PL * GDPr (this is Nominal GDP)

• MS = money supply (M1 or M2)• V = money’s velocity

ILLUSTRATED…

• MV=PQ• M1=$2

trillion• V of M1 = 7• PQ = $14

trillion

GDPR

PL

AD

SRASLRAS

QF

P