Money Money

Money

• Money: anything that functions as a means of payment (medium of exchange), unit of account, and store of value.

• GREATLY reduces transaction costs!

• Barter (trade) much less efficient for it demands a double coincidence of wants

Money

• Many items have played the role of money money– Salt, olive oil, silver, gold, cigarettes, etc

• ideal money is easy to transport, widely recognized, and can not be counterfeited

Functions of money

• Medium of exchange-means of payment

• Unit of account-standardized means of measuring prices

• Store of value-must retain value

Measuring Money

• Not as easy as it would appear

• What should we use as money?

• Just currency?

• Currency and other stored money?

• Multiple definitions

Money Aggregates

• M1--currency and checkable deposits

• checkable deposits = deposits subject to check withdrawal

• Considered as Money Supply (MS)

Money definitions continued

• M2 = M1 + other highly liquid assets such as money market deposit accounts (individual small time deposits)

• M3= M2 + less liquid assets (Large and longer time deposits, term repo’s, institutional MM funds)

Evolution of payments system

• Money to electronic payments

• lose float, but gain efficiency

• Easy section on ATMs, electronic fund transfers etc.

Money Supply, Money Demand, and Monetary Equilibrium

• The money supply is a policy variable that is controlled by the Central Bank. Through instruments such as open-market

operations, the CB directly controls the quantity of money supplied.

Money Supply, Money Demand, and Monetary Equilibrium

Money demand has several determinants, including interest rates and the average level of prices in the economy.

• People hold money because it is the medium of exchange. The amount of money people choose to hold

depends on the prices of goods and services.

Money Supply, Money Demand, and Monetary Equilibrium

Money Supply, Money Demand, and Monetary Equilibrium

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Quantity fixedby the CB

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Moneydemand

Money Supply, Money Demand, and the Equilibrium Price Level

Eq

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Eq

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rice level

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

MS1

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Moneydemand

The Effects of Monetary Injection

M1

MS

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The Quantity Theory of Money

• How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy

determines the value of money. The primary cause of inflation is the growth in

the quantity of money.

Velocity and the Quantity Equation

The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Velocity and the Quantity Equation

V = (P x Y)/M

Where: V = velocity

P = the price level

Y = the quantity of output

M = the quantity of money

Velocity and the Quantity Equation

• Rewriting the equation gives the quantity equation:

M x V = P x Y

Velocity and the Quantity Equation

The quantity equation relates the quantity of money (M) to the

nominal value of output (P x Y).

Velocity and the Quantity Equation

• The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

Nominal GDP

Indexes (1960 = 100)

1,500

1,000

500

01960 1965 1970 1975 1980 1985 1990 1995 2000

M2

Nominal GDP, the Quantity of Money, and the Velocity of Money

Velocity

The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money

• The velocity of money is relatively stable over time.

• When the CB changes the quantity of money, it causes proportionate changes in the nominal value of output (P x Y).

• Because money is neutral, money does not affect output.

Money and Prices During Four Hyperinflations

(b) Hungary

Money supply

19251924192319221921

Price level

100,000

10,000

1,000

100

Index (Jan. 1921 = 100)

(a) Austria

19251924192319221921

100,000

10,000

1,000

100

Index (Jan. 1921 = 100)

Price level

Money supply

Money and Prices During Four Hyperinflations

c) Germany

1

100 trillion

1 million

10 billion

1 trillion

100 million

10,000

100

19251924192319221921

Price level

Moneysupply

d) Poland

Money

supply

Price level

Index (Jan. 1921 = 100)

100

10 million

100,000

1 million

10,000

1,000

19251924192319221921

Index (Jan. 1921 = 100)

The Fisher Effect

• According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount.

• The real interest rate stays the same.

rateInflation + rateinterest Real

=rateinterest Nominal

Percent(per year)

0

6

10

15

1960 1965 1970 1975 1980 1985 1990 1995

The Nominal Interest Rate and the Inflation Rate

3

12

Inflation

Nominal interest rate

Summary

• The overall level of prices in an economy adjusts to bring money supply and money demand into balance.

• When the central bank increases the supply of money, it causes the price level to rise.

• Persistent growth in the quantity of money supplied leads to continuing inflation.

Dissent on Keynes, Then and Now

Is the market the source of macroeconomic instability?

Roger W. Garrison 2009

Friedrich A. Hayek took issue with the structure of Keynes’s analytical framework:1. Can we actually ignore the effects of changes in the interest rate in our accounting for the saving behavior of income-earners and the investment decisions of entrepreneurs? 2. In there an identifiable market process that can translate decisions to save into decisions to produce for the future.3. How is economic stability affected by the overriding of market interest rates with interest rates imposed by policy makers?

Stock Market Crash

Unemployment

Bread Lines in New York

Prices were either too high or zero.

Food Lines in Paris

Oklahoma Dust Bowl

Make-shift Housing

Migrants Going West

Migrant Family in California

Despondency

Dorothea Lange's "Migrant Mother," destitute in a pea picker's camp, because of the failure of the early pea crop. These people had just sold their tent in order to buy food. Most of the 2,500 people in this camp were destitute. By the end of the decade there were still 4 million migrants on the road.

The phenomenon of bust and depression was observed and argued about long before the Great Depression and long before Keynes wrote his General Theory.

A fully satisfying explanation requires that we consider the phenomenon of boom, bust, and depression.But sorting out the differences between Milton Friedman and Maynard Keynes can be achieved with the narrower focus, i.e., bust and depression.

This focus suggests two questions in need of an answer:

1. What caused the bust? What was the triggering mechanism? What change in market conditions required adjustments of some kind on an economywide scale?

2. Why did it take so long for markets to adjust to the changed market conditions? If prices, wages, and interest rates needed to adjust, why didn’t they adjust?

2. Why did it take so long for markets to adjust to the changed market conditions? If prices, wages, and interest rates needed to adjust, why didn’t they adjust?

The adjustment of prices and wages did actually get underway. Prices started falling; wages started falling.People and their political leaders associated low prices and wages with bad times and high prices and wages with good times.

CCCCivil Conservation Corp

Make-Work Projects

New Deal-era promo for the NRA (National Recovery Administration).Producer: Metro-Goldwyn-MayerFeaturing: Jimmy Durante

Click the “Blue Eagle” for the 2 min. 49 sec. video.

1. And just what was that general decline in demand all about?

Was it really something inherent in market economies. Was it the unpredictable behavior of the investment community---as John Maynard Keynes claimed?Or was it some extra-market happening. Maybe some action of policymakers?Didn’t we have a similar decline in demand in the early 1920s---near the end of Warren G. Harding’s presidency?

Printing Money and Spending it.

The Equation of ExchangeAnd the Quantity Theory of Money

Pepe Smith earns a lot of money.Bill Gates has a lot of money.It’s better to buy a house when money is cheap.I need to cash a check to get some money.Money facilitates the exchange of goods and services.

Pepe Smith earns a lot of money.Bill Gates has a lot of money.It’s better to buy a house when money is cheap.I need to cash a check to get some money.Money facilitates the exchange of goods and services.

CURRENCYCREDIT MONEYINCOME WEALTH

MV = PQ M is the money supply (outside the banking system).

V is money’s velocity of circulation. P is the price level. Q is the economy’s output. PQ is total expenditures (E).

MV = PQThis is the “Equation of Exchange.”No economist, dead or living, has ever denied that MV actually does equal PQ.

V = PQ/M

Y=MV=PQ=EE is total expenditures (PQ)Y is total income = nominal GDPQ is real income = real GDP = Y/P

Case, Fair, and Oster use Y for real income.Friedman used a lower-case y for real income.Hence: Q = CFO’s Y = Friedman’s y.

Keynes believed that the velocity of money was subject to dramatic and unpredictable change.He believed that people “hoard” money, more so some times than others. (increased hoarding means a decrease in velocity.)In extreme episodes, people may be overcome by the “fetish of liquidity,” the fetish often accompanying the waning of animal spirits.

Milton Friedman (1912 - 2006)

• MV = PQ• Inflation is always

and everywhere a monetary phenomenon!!!