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Principles of Economics
by Fred M Gottheil
PowerPoint Slides prepared by Ken Long
Chapter 25, Money
©1999 South-Western College Publishing
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What is Money?
Note that money is a manmade invention: before
money, people used
barter
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What is Barter?
The exchange of one good
for another, without the
use of money
©1999 South-Western College Publishing
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When can Barter work?
When people are basically
self sufficient and there is a
double coincidence of
wants
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What is a Double
Coincidence of wants?
A situation in which two
traders both have what
the other person wants
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Inefficiency of Barter
Time consuming due to
the need for the double
coincidence of wants
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What is Money?
Any commonly accepted
good that acts as a:
 medium of exchange
a measure of value (unit of
account)
a store of value
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What is commodity
money?
Actual products that
became acceptable as
money, thus had 2
purposes to it: to be used
as a product or as money
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What are the
Properties of Money?
It must be ...
•
•
•
•
•
•
durable
portable
divisible
identical
scarce
stable in
supply
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One commodity that meets
most of the requirements of
money was of course...
GOLD
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What is Fiat Money?
Paper money that is not
backed by or convertible
into any good
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What is an example of
Fiat Money?
Currency - coins
& paper money
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What is Legal Tender?
Anything that creditors
are required to accept
as payment for debts
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Does gold or silver
back up our money?
No, our money is not
backed up by anything
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Why does Fiat Money
have value?
Because it is useful
and relatively scarce,
and due to its
acceptability
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15
What does the term
Liquidity mean?
The degree to which an
asset can easily be
exchanged for money
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Which form of money
is most Liquid?
It depends on the
circumstances,
in our economy,
currency is
most liquid
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For a history of money:
http://www.ex.ac.uk/~RDavies/
arian/llyfr.html
©1999 South-Western College Publishing
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What is our
Money Supply?
Typically, M1 money
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What is M1 Money?
•
•
•
•
Currency (held outside of banks)
Demand Deposits
Traveler’s checks
Other checkable deposits
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What is M2 Money?
M1 plus less-immediate forms of
money, such as savings
accounts, money market mutual
funds, money market deposit
accounts, and smalldenomination time deposits
©1999 South-Western College Publishing
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What is M3 Money?
M2 plus large-denomination
time deposits and largedenomination repurchase
agreements
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• Large time deposits
M3
+
• Money market accounts
• Savings deposits
• Small time deposits
• Miscellaneous moneys
M2
+
• Checkable deposits
• Travelers checks
• Currency
MI
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What is Near Money?
Financial assets that can
be converted into money
such as savings bonds
and corporate bonds
©1999 South-Western College Publishing
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Are Credit Cards Money?
No! Because merchants
expect to be paid by the
credit card company
©1999 South-Western College Publishing
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For an insight of why
credit cards are not
money visit:
http://www.mastercard.com
http://www.visa.com
©1999 South-Western College Publishing
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Monetary Theory
• How does monetary
policy affect the
economy?
• Differing views on this
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Begin with the old
quantity theory of
money, based on the
equation of exchange
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How does the Money
Supply effect prices?
The Equation of Exchange
relates the economy’s price
level, the quantity of goods,
and the money supply
©1999 South-Western College Publishing
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What is the
Equation of Exchange?
Money Velocity
Prices
Quantity
MV = PQ
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Note that Q = real GDP,
PQ equals nominal GDP
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What is Velocity?
The average number of
times per year each
dollar is used to
transact an exchange
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Example, suppose PQ,
nominal GDP = 8 trillion
•If the money supply
equals 1 trillion, what is
velocity?
•Answer: 8
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What is the Classical
View of Money?
Classical economists
believe that the velocity
and quantity of output
are constant in short-run
equilibrium
©1999 South-Western College Publishing
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Conclusion of the old
quantity theory
If V and Q treated as
constants, then M affects
only P-price level is
proportional to the
money supply
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If V is constant, and if Q is not affected by M, then M
can only affect P--this is the conclusion of old
classical theory
Money Velocity
Prices
Quantity
MV = PQ
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What does the
Quantity Theory of Money
illustrate?
Money does not influence
how much we produce but
it does influence prices
©1999 South-Western College Publishing
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Monetarism, a modern
version of the classical
quantity theory
Monetarists, V not constant , but
stable or predictable
Q tends in the long run to move to
its full employment level
Monetarists tend to be critical of
allowing the money supply to be
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too volatile
Milton Friedman, best
known monetarist
Argues that bad monetary policy
worsened the great depression
Calls for a monetary rule on the part
of the Fed, constant growth in the
money supply regardless of what
is going on in the economy
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What is the Keynsian
View of Money?
They reject the idea that V
is constant and that Q
always reflects fullemployment GDP
©1999 South-Western College Publishing
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How do the Keynsians
view Velocity?
Even though they agree
that spending and saving
are basically stable,
velocity is also effected
by interest rates and
expectations
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What factors can lead to
a rise in velocity?
• Increased use of electronic
banking
• Use of credit cards
• Getting paid more frequently
• Higher rates of inflation
• Higher interest rates
42
Must look at the demand
for money
Why hold money instead
of other assets?
43
According to the Classical
Economist, why do people
demand money?
People demand money to
make transactions
©1999 South-Western College Publishing
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What is the Transactions
Demand for Money?
The quantity of money
demanded by households
and businesses to transact
their buying and selling
of goods and services
©1999 South-Western College Publishing
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According to the
Keynsians, why do
people demand money?
• Transactions motive
• Precautionary motive
• Speculative motive
©1999 South-Western College Publishing
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Speculative Motive
Individuals may choose to hold
bonds over money: Because the
market value of interest-bearing
bonds is inversely related to the
interest rate, investors may wish to
hold bonds when the interest rates
are high with the hope of selling
them when interest rates fall.
Due to speculative
motive, money demand
varies inversely with
interest rates
48
Money demand curve
i1
i2
D
M1 M2
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Now put in a money
supply curve, have
equilibrium
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Money supply and demand
S1
i1
D
M1
551
1
According to the
Keynsians, how does
money affect GDP?
An increase in the money
supply increases GDP and
not necessarily prices,
especially in a recession
©1999 South-Western College Publishing
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The Keynesian
Transmission
Mechanism
Increased money supply reduces
interest rates, raising planned
investment, and thus a
multiplier expansion of GDP
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Increase in money from S1 to S2
S1
S2
i1
i2
D
M1 M2
©1999 South-Western College Publishing
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An increase in Investments
i1
i2
I
I1 I2
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Aggregate Supply Curve
AS
P
AD6
AD5
AD4
AD3
AD1 AD2
©1999 South-Western College Publishing
GDP
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http://www.frbatlanta.org/
http://woodrow.mpls.frb.fed.us/ec
oned/curric/money.html
http://www.treas.gov/
http://www.usmint.gov
©1999 South-Western College Publishing
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• What is Barter?
• What is Money?
• What are the Properties of Money?
• What is Fiat Money?
• Why does Fiat Money have value?
• What does the term Liquidity
mean?
• What is M1 Money?
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• What is Barter?
• What is Money?
•
•
•
•
•
•
•
What are the Properties of Money?
What is Fiat Money?
Why does Fiat Money have value?
What does the term Liquidity mean?
What is M1 Money?
What is the Classical View of Money?
What is the Keynsian View of Money?
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END
©1999 South-Western College Publishing
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