Download Notes on Market for Money

These notes are not a replacement for the text. They are to highlight the important issues
that I will tend to focus on more and text on more. Plus, cover those areas where I depart
from the test. The information here will help you to answer my worksheets.
What is money?
Money is financial asset (and thus acts as a store of value) that people use to purchase
goods and services (medium of exchange).
This class will use a very narrow notion of what fits the money definition. Specifically,
this class uses M1 as its money definition. This means only currency (and coin) and
checkable deposits in banks (which includes travelers checks) shall be considered money.
This means that deposits in savings accounts are NOT money (people generally don’t use
these deposits to buy goods and services).
If you have $100 in cash in your pocket, you have money.
If you have $100 deposited in a checking account, you have money.
If you have $100 deposited in a savings account (or other financial asset) you do NOT
have money. You have savings.
There are several ways to “get rid of” money. Two ways are useful to think about when
theorizing about money. Someone can get rid of money by:
1) Spending it
2) Saving it
Money Equilibrium:
The book uses graphs to describe a money equilibrium. I try to describe how
equilibriums occur without the use of graphs.
What is a money equilibrium?
Supply of Money = Demand for Money
What does this mean?
Supply of Money is quantity of money that has been created by the government
and private banks. It is how much money there is.
Demand for Money is how much money people want to hold. “Hold” is key. To
have money means not having other things. Demanding money means having money
instead of the alternatives which are the goods you could buy instead or interest earning
financial securities.
How does the economy reach a money equilibrium?
If there is not an equilibrium for money, then there’s two possibilities
Money Surplus: Money Supply > Money Demand
Money Shortage: Money Supply < Money Demand
What happens if there’s a Money Surplus?
This means there exists more money than people want to hold.
People have more than they want to keep.
So people will get rid of their excess of money.
How would do they do that? One way is that they spend their excess
money (Splurging).
If people are trying buy more goods than normal, this will make prices
rise.
And the value of money will fall.
Any time a money surplus occurs, the above happens.
What happens if there’s a Money Shortage?
This means people want to hold more money than exists.
People don’t have as much money as they want (and they’re willing to
give up goods and services or financial assets to acquire more money).
So people will try to acquire the money short-fall
How would do they do that? One way is by buying less (Hoarding)
If people are buying fewer goods than normal, this will make prices fall.
And the value of money will rise.
Any time a money shortage occurs, the above happens.
Money Supply
Money supply is created by two different organizations.
Fiat money, currency and coin, is created by the government
Bank money, checkable deposits, is created by private banks.
We can describe the money supply with the formula:
Money Supply = Monetary Base * Money Multiplier
The monetary base is what the government created. It is equal to currency
in the hands of the public plus bank deposits at the Federal Reserve
The money multiplier is how much money banks create.
The Fed can control the Monetary Base in two ways:
1) OMO, Open Market Operations. The Fed would expand the money
supply by purchasing things (government financial securities, to be
specific) in the Open Market (not directly from the government, that’s
illegal).
2) Discount Rate. The Fed would expand the money supply by lower the
“discount rate” which is the interest rate the Fed charges banks who
borrow from the Fed.
Banks create money through “multiplication.” This is where banks take deposits
and lend them out which creates more deposits than can be lent out which leads to
more loans, etc.
There are two main factors that affect the size of the money multiplier
1) Size of Reserves. The more reserves that the banking system holds,
the less money can be lent out and multiplied. The biggest factor
determining the size of reserves is the reserve requirement set by the
Fed
2) People’s preference for checking accounts (bank money) instead of
currency. If people prefer to hold more bank money instead of
currency (they deposit their cash into checking accounts), banks will
have more deposits to lend out and multiply.
The Federal Reserve Banking System
Is the Fed autonomous? Is the Fed separated from the rest of the government and
isolated from politics?
3 Reasons why the above questions would be answered “yes”
1) The Fed is run by a board whose members are appointed for long
terms (14 years) and cannot be re-appointed.
2) The Fed is self funded, not dependent on Congress for funding
3) The Fed cannot have direct financial dealings with government. Thus
the Fed conducts OMO, not private, secret operations.
Why the Fed is not completely independent:
The Fed could be altered by an act of Congress. To protect such a change,
the President could threaten a veto. Thus, the Fed will usually have a
good relationship with the president to gain some protection. Plus, the
president appoints the board members (confirmed by Senate).
Money Demand
The equation of exchange can describe money demand:
Money Demand = P * Y / V
As prices or income (production of goods and services) increases, money demand
increases.
If goods are more expensive, you’ll need more money
If there are more goods to buy, you’ll need more money
As Velocity increases, money demand decreases
What determines Velocity?
1) The nominal interest rate. With a higher nominal interest rate, money
is more costly to hold (it’s better to have interest bearing financial
assets – it’s better to have savings). People will attempt to hold less
money by making velocity increase.
2) Cost of banking. If it is more expensive to acquire money from banks,
people will want to conduct banking transactions (the acquisition of
money) less often which means they will withdraw more money each
time they transact.
Inflation:
Using the above model of the market for money, you can find all factors that would cause
an in increase in prices.
What would cause an increase in prices?
1) A money surplus
What would cause a money surplus?
2) An increase in money supply or
3) A decrease in money demand
What would cause an increase in money supply?
4) Increase in the monetary base (the Fed expanding the money
supply by doing OMO purchases or lowering the discount rate).
5) Increase in the money multiplier
What would cause the money multiplier to increase?
6) Decrease in bank reserves (The Fed could have reduced
the reserve requirement)
7) Increase in people’s preference for bank money over
currency (people deposit more of their currency into
checking accounts)
What would cause a decrease in money demand?
8) Decrease in real income
9) Increase in velocity
What would cause an increase in velocity?
10) An increase in the nominal interest rate (real interest
rate or inflation rate increases)
11) A decrease in the cost of banking (if banking
transaction are lower cost, people will move money around
faster)
Thus the answer to the question, “what could make prices rise” has many parts.
Ignoring some of the finer reasons, we could generalize to say that inflation is caused by:
Increases in the Money Supply
Increases in Velocity
Decreases in real income.
An equation can be created to reflect these three factors of inflation:
Inflation = Money Supply Growth + Velocity Growth – Real Income Growth
The reason for the minus sign in front of Real Income Growth is because it takes a
decrease in real income to raise prices. Or, putting it another way, real income
growth causes prices to go down, or inflation to be lower.
More to say about that equation: Of the three general factors that contribute to inflation,
Money Supply Growth is almost always the largest. Money supply growth almost always
explains any significant changes in the inflation rate when looking at different countries
or looking at one country’s history.
Also, Money Supply growth is almost entirely under the control of government. Thus,
inflation is almost always something the government chooses to have.
Does it matter what the inflation rate is? Is inflation good for an economy? Is inflation
bad for an economy?
The theory of Neutrality of Money (also related to the idea of the “Classical
Dichotomy)
The theory of neutrality of money is that changing the money supply has
no real effect on the economy. “Real effect” means a change in a real
measure of the economy such as real income, real interest rates, and
unemployment. Changing the money supply can change nominal values
in the economy (things stated in money terms, dollars in the US) but not
real values.
The argument for neutrality of money is that if the money supply increases
and prices go up, will this have any impact on real qualities of the
economy? Though things cost more, people are paid more nominal
income. So their purchasing power remains the same. The increase in
money supply did nothing real.
In this way, the rate of inflation in the long run has no real effect on the
economy.
However, inflation can be disruptive to an economy. Some examples are:
 Winner and Loser
o There may be some people who benefit from inflation at the
expense of someone else. The net benefit to the economy is
zero, so in the macro aggregate, inflation still has no effects.
o The most consistent winner from inflation is government. As
the government injects money into the economy, it devalues
old money and transfers that value to the new money the
government just injected. Money injections which cause
inflation devalues your money, thus you lose but government
wins. In this way, government caused inflation is a form of
taxation
o When inflation is unexpectedly high, borrowers who borrowed
at a fixed interest rate win. The lender loses.
o People who have a fixed income (some retirees with fixed
pensions) lose from inflation. The people paying the pension
win.
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