TM 13-1 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money is any commodity or token that is generally acceptable as the means of payment

TM 13-1Copyright © 1998 Addison Wesley Longman, Inc.

What is Money?

• Money is any commodity or token that is generally acceptable as the means of payment.

• A means of payment is a method of settling a debt.


What Money Does?

• functions of Money

1) Medium of exchange

2) Unit of account

3) Store of value


Measures of Money?

• Official Measures of Money

1) M1 consists of currency and traveler’s checks plus checking deposits.

• Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government


Measures of Money?


2) M2 consists of M1 plus saving deposits and time deposits


Measures of Money?


3) M3 consists of M2 plus large-scale time deposits and term deposits


Two Measures of Money


Financial Intermediaries

• Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.



• Four Types of Financial Intermediaries

1) Commercial banks

2) Savings and loan associations

3) Savings banks and credit unions

4) Money market mutual funds



• Commercial Banks

• A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.



• Commercial Banks

• Their balance sheet is described by the following formula:

Liabilities + Net Worth = Assets



• Reserves and Loans

• Banks divide their funds into two parts:• Reserves are cash in a bank’s vault plus its deposits

at Federal Reserve banks

• Loans



• Three Types of Assets Held by Banks

1) Liquid assets are U.S. government Treasury bills and commercial bills

2) Investment securities are longer-term U.S. government bonds and other bonds

3) Loans are commitments of fixed amounts of money for agreed- upon periods of time


Financial Intermediaries (FI)

• The Economic Functions of FI

1) Creating Liquidity

2) Minimizing the cost of borrowing

3) Minimizing the cost of monitoring borrowers

4) Pooling Risk


How Banks Create Money

• Reserves: Actual and Required

• The reserve ratio is the fraction of a bank’s total deposits that are held in reserves.

• The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold.

• Excess reserves are actual reserves minus required reserves.



• Creating Deposits by Making loans in a One-Bank Economy

Let’s see an example of howbanks create money.


Reserves $100 Deposits $400

Loans $300

Total $400 Total $400

Creating Money at theOne-and-Only Bank

Balance sheet on January 1

Assets(millions of dollars)

Liabilities(millions of dollars)



Loans $300








Loans $303








• The Deposit Multiplier

reservesinChange

depositsinChangemultiplierDeposit



• Creating Deposits by Making Loans with Many Banks

Let’s see how the

banking system creates money


The Multiple Creationof Bank Deposits

The sequence The running tallyReserves Loans Deposits



The sequence The running tally

Deposit$100,000

Reserves Loans Deposits




Deposit$100,000


$25,000

$75,000 $25,000

$75,000 $100,000Loan

$75,000Reserve$25,000



The sequence

Deposit$100,000

Loan$75,000

Deposit$75,000

Reserve$25,000

The running tallyReserves Loans Deposits

$25,000

$75,000 $25,000

$75,000 $100,000




Deposit$100,000


$25,000

$75,000 $25,000

$75,000 $100,000Loan

$75,000

Deposit$75,000

Reserve$25,000

Loan$56,250

Reserve$18,750 $43,750 $131,250 $175,000



The sequence

Deposit$56,250

The running tallyReserves Loans Deposits




$43,750 $131,250 $175,000

Deposit$56,250

Loan$42,187

Reserve$14,063 $57,813 $173,437 $231,250




Deposit$56,250

Loan$42,187

Reserve$14,063

Deposit$42,187

$43,750 $131,250 $175,000

$57,813 $173,437 $231,250




$68,360 $205,077 $273,437

Loan$31,640

Reserve$10,547




$68,360 $205,077 $273,437

Loan$31,640

Reserve$10,547

andso on...

$100,000 $300,000 $400,000


The Fed controls the money supply by adjusting the reserves of the banking system.


The Fed controls the money supply by adjusting the reserves of the banking system. These reserves are controlled by three tools available to the Fed.


1) Required reserve ratios



2) Discount rate



2) Discount rate

3) Open market operations


• Required Reserve Ratios

• The Fed determines a required reserve ratio for each type of deposit.• In 1997, banks were required to keep 3 percent of

checking deposits up to $49 million and 10 percent of deposits in excess of $49 million.

• Other deposits had no reserve requirement.


• Discount Rate

• The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks.


• Open Market Operations

• Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market.


Money, Real GDP, andthe Price Level

• We are going to study the effect the money supply has on real GDP, the price level, and the inflation rate.



• The Short-Run Effects of a Change in the Quantity of Money

• Let’s study how a change in the quantity of money effects these factors by examining the aggregate supply-aggregate demand model.


Short-Run Effects ofChange in Quantity of Money

Real GDP (trillions of 1992 dollars)

Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

120

107

6.8 7.4




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

AD0

6.6 7.0 7.2 7.6

120

107

6.8 7.4

LAS

SAS

AD1




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

AD0

6.6 7.0 7.2 7.6

120

107

6.8 7.4

LAS

SAS

AD1




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

120

107

6.8 7.4

LAS

SAS

AD1


Long-Run Effects ofChange in Quantity of Money


Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

AD1

SAS1




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD1

SAS1

AD2




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD1

SAS1

AD2




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD1

SAS1

AD2

SAS2




Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD2

SAS2


Learning Objectives (cont.)

• Explain how banks create money

• Explain why the quantity of money is an important economic magnitude

• Explain the quantity theory of money



• The Quantity Theory of Money

• The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

• This theory is based upon the velocity of circulation and the equation of exchange.



• The Quantity Theory of Money

• The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.



• GDP equals the price level (P) times real GDP (Y), or:

GDP = PY



• Make the quantity of money M, and the velocity of circulation V is determined by:

V = PY/M


The Velocity of Circulation in the United States: 1930–1996



• The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or

MV=PY



• We can convert the equation of exchange into the quantity theory of money by making two assumptions:

1) The velocity of circulation is not influenced by the quantity of money.

2) Potential GDP is not influenced by the quantity of money.



• Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.



• This can be shown by using the equation of exchange to solve for the price level.

P = (V/Y)M



• In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

MYVP )/(



• Dividing this equation by an earlier one, P = (V/Y)M, gives us

MMPP //



• This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money.

• This gives us the quantity theory of money:

• In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.



• The AS-AD model predicts the same outcome as the quantity theory of money.

• It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.



• Historical Evidence on the Quantity Theory of Money

• The data are broadly consistent with the quantity theory of money, but the relationship is not precise.

• The relationship is stronger in the long run than in the short run.


Money Growth andInflation in the United States


Money Growth andInflation in the United States


Money Growth andInflation in the World Economy


Money Growth andInflation in the World Economy



• Correlation, Causation, and Other Influences

• The evidence shows that money growth and inflation are correlated.



• Correlation, Causation, and Other Influences

• This does not represent causation.• Does money growth cause inflation, or does

inflation cause money growth?

• Does some other factor cause inflation (deficit spending)?

Documents

TM 13-1 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money is any commodity or token that is generally acceptable as the means of payment