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Chapter 25
Money
© 2005 Thomson
Economic Principles
Barter exchange
The characteristics of money
Gold-backed and fiat money
Liquidity
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Economic Principles
The equation of exchange
The quantity theory of money
The classical view of money
The Keynesian view of money
Monetarism
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Introduction
Barter
• The exchange of one good for another,
without the use of money.
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Introduction
1. What is the key problem with
barter exchange?
• To function effectively, barter requires a
double coincidence of each party to the
exchange wanting precisely what the other
has to offer. A double coincidence of wants
is difficult to achieve.
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The Invention of Money
Money
• Any commonly accepted good that acts as
a medium of exchange, a measure of value,
and a store of value.
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The Invention of Money
Money must be durable,
portable, divisible, homogeneous,
and supplies must be stable.
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The Invention of Money
Which of the following is most
likely to serve as money:
a. Strawberries
b. Cows
c. Gold
d. Water
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The Invention of Money
Which of the following is most
likely to serve as money:
a. Strawberries
b. Cows
c. Gold
d. Water
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The Invention of Money
Which of the following is most
likely to serve as money:
• Strawberries are not durable, cows are
not easily divisible, and most of the time
the supply of water is too abundant and
difficult to control.
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The Invention of Money
Gold makes a good type of money
because:
a. Gold supplies are fairly stable.
b. Gold is homogeneous.
c. Gold is durable.
d. Gold is divisible.
e. Gold is portable.
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The Invention of Money
Fiat money
• Paper money that is not backed by or
convertible into any good.
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Fluffy Rabbits and Gresham’s Law
Suppose more valuable silver quarters
and less valuable copper-nickel quarters
freely circulate together in the economy.
What would happen over time?
• People would keep the more valuable silver
quarters, and eventually only the less
valuable copper-nickel quarters would
freely circulate.
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Fluffy Rabbits and Gresham’s Law
Suppose more valuable silver quarters
and less valuable copper-nickel quarters
freely circulate together in the economy.
What would happen over time?
• Sir Thomas Gresham, a 16th century
merchant to the English crown, observed
that bad money drives out good.
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Money in a Modern Economy
Currency
• Coins and paper money.
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Money in a Modern Economy
Liquidity
• The degree to which an asset can easily
be exchanged for money.
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Money in a Modern Economy
Liquidity is what distinguishes
money from any other asset form.
• Some assets are relatively liquid, and
can serve as money.
• Most assets are highly illiquid and thus
far removed from serving as money.
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Money in a Modern Economy
Money supply
• Typically, M1 money. The supply of
currency, demand deposits, and traveler’s
checks used in transactions.
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Money in a Modern Economy
M1 Money supply
• The supply of the most immediate form
of money. It includes currency, demand
deposits, and traveler’s checks.
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Money in a Modern Economy
M2 Money supply
• M1 money plus less-immediate forms of
money, such as savings accounts, money
market mutual fund accounts, money
market deposit accounts, repurchase
agreements, and small-denomination time
deposits.
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Money in a Modern Economy
M3 Money supply
• M2 money plus large-denomination time
deposits and large-denomination
repurchase agreements.
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Explaining the Impressive
Growth of M2 Money
What caused the impressive
growth of M2 money?
• Deregulation of the banking industry led to
a large increase in money market accounts
(mutual funds and deposit accounts), and
increased the liquidity of savings accounts.
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Money in a Modern Economy
The dividing line between money
and nonmoney assets is blurry.
Most any asset is potential money.
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Money in a Modern Economy
Are credit cards a form of money?
• No. They may be accepted as readily as
money by stores, but credit cards are loans
that must be repaid.
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EXHIBIT 1
U.S. MONEY SUPPLY: 2003 ($ BILLIONS)
Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, September 2003), p. A13, table 1.21.
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Exhibit 1: U.S. Money Supply:
2003 ($ billions)
1. True or false: The largest
component of M1 is demand
deposits.
• False. In 2003 currency was over $646
billion of the $1,272.2 billion supply of M1
money.
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Exhibit 1: U.S. Money Supply:
2003 ($ billions)
2. True or false: The largest
component of M2 is M1.
• False. In 2003 M1 was $1,272.2 billion,
but savings deposits and money market
accounts made up $2,227.3 of the $6,046.4
billion supply of M2 money.
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Exhibit 1: U.S. Money Supply:
2003 ($ billions)
3. True or false: The largest
component of M3 is made up of
Eurodollars.
• False. In 2003 the largest component of
M3 was M2. Eurodollars were only a
minor part of M3.
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EXHIBIT 2
GROWTH OF
THE MONEY
SUPPLY:
1970–2003
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© 2005 Thomson
Exhibit 2: Growth of the
Money Supply: 1970-2003
1. True or false: M1 grew more
slowly than M2 and M3 between
1970 and 2003.
• True. Deregulation of the banking
industry increased elements of M2, which
in turn increased M3.
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Exhibit 2: Growth of the
Money Supply: 1970-2003
1. True or false: By 1992, M2
became larger than M3.
• False. That cannot occur because M3
includes M2 plus other types of money.
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Know Your Currencies?
1. Which of the following counties does
not use the dollar as its currency?
a. Hong Kong.
b. Ireland.
c. Zimbabwe.
d. Australia.
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Know Your Currencies?
1. Which of the following counties does
not use the dollar as its currency?
a. Hong Kong.
b. Ireland.
c. Zimbabwe.
d. Australia.
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Know Your Currencies?
2. Each of the European Union countries—
with the exception of the United Kingdom—
switched in 1999 from their national
currencies to a common one. The name of
this common currency is the
a. EU.
b. Dollar.
c. Euro.
d. Common.
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Know Your Currencies?
2. Each of the European Union countries—
with the exception of the United Kingdom—
switched in 1999 from their national
currencies to a common one. The name of
this common currency is the
a. EU.
b. Dollar.
c. Euro.
d. Common.
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Know Your Currencies?
3. The British currency is the
a. dollar.
b. pound.
c. gold.
d. sterling silver.
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Know Your Currencies?
3. The British currency is the
a. dollar.
b. pound.
c. gold.
d. sterling silver.
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Know Your Currencies?
4. What picture is on the face of
the British currency?
a. Buckingham Palace.
b. Queen Elizabeth II.
c. Queen Victoria.
d. Union Jack.
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Know Your Currencies?
4. What picture is on the face of
the British currency?
a. Buckingham Palace.
b. Queen Elizabeth II.
c. Queen Victoria.
d. Union Jack.
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Know Your Currencies?
5. In 1977, the Israelis switched their currency
from the pound to the currency that was used
in biblical Israel. That currency is the
a. lira.
b. shekel.
c. dinar.
d. kroner.
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Know Your Currencies?
5. In 1977, the Israelis switched their currency
from the pound to the currency that was used
in biblical Israel. That currency is the
a. lira.
b. shekel.
c. dinar.
d. kroner.
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Know Your Currencies?
6. Russia was once part of the U.S.S.R.—the
Union of Soviet Socialist Republics—and the
currency of the U.S.S.R. then was the ruble.
Today, Russia’s currency is the
a. czar.
b. pound.
c. franc.
d. ruble.
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Know Your Currencies?
6. Russia was once part of the U.S.S.R.—the
Union of Soviet Socialist Republics—and the
currency of the U.S.S.R. then was the ruble.
Today, Russia’s currency is the
a. czar.
b. pound.
c. franc.
d. ruble.
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Know Your Currencies?
7. Which country’s currency is
not the peso?
a. Brazil.
b. Mexico.
c. Argentina.
d. Philippines.
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Know Your Currencies?
7. Which country’s currency is
not the peso?
a. Brazil.
b. Mexico.
c. Argentina.
d. Philippines.
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Know Your Currencies?
8. China and Japan’s currencies
are, respectively, the
a. yak and the yang.
b. yuan and the yen.
c. han and the edo.
d. edo and the han.
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Know Your Currencies?
8. China and Japan’s currencies
are, respectively, the
a. yak and the yang.
b. yuan and the yen.
c. han and the edo.
d. edo and the han.
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Know Your Currencies?
9. India’s currency is the
a. ruble.
b. riyal.
c. rand.
d. rupee.
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Know Your Currencies?
9. India’s currency is the
a. ruble.
b. riyal.
c. rand.
d. rupee.
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Know Your Currencies?
10. The approximate life of a United
States coin is
a. 5 years.
b. 10 years.
c. 25 years.
d. 50 years.
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Know Your Currencies?
10. The approximate life of a United
States coin is
a. 5 years.
b. 10 years.
c. 25 years.
d. 50 years.
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The Quantity Theory of Money
Velocity of money
• The average number of times per year
each dollar is used to transact an exchange.
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The Quantity Theory of Money
Equation of exchange
• MV = PQ. The quantity of money times its
velocity equals the quantity of goods and
services produced times their prices.
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The Quantity Theory of Money
The classical view:
• Real GDP (Q in the equation of exchange)
depends on the amount of resources in the
economy, which are fixed.
• Prices are flexible.
• Velocity is fixed.
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The Quantity Theory of Money
The classical view:
• Since Q and V are fixed, while P is
flexible, the classical view holds that there
is a direct relationship between M and P.
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The Quantity Theory of Money
Quantity theory of money
• P = MV/Q. The equation specifying the
direct relationship between the money
supply and prices.
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The Quantity Theory of Money
Monetarists attempted to rescue the
classical view from evidence showing
that M1 velocity is not constant. They
argue that if velocity is stable and
predictable, and if Q is at fullemployment GDP, then the direct
relationship between M and P
remains intact.
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EXHIBIT 3
HISTORICAL RECORD OF MONEY VELOCITY
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Exhibit 3: Historical Record of
Money Velocity
How might the use of credit cards
have explained the change in M1
velocity from the 1950s to the 1980s?
• Increased use of credit cards during this
period allowed people to buy more goods
and services with less cash and lower
demand deposit balances relative to
nominal GDP.Gottheil - Principles of Economics, 4e
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The Quantity Theory of Money
Keynesians reject the monetarist’s
idea that V is either stable or
predictable, and that Q always
reflects full-employment GDP. In
this case, changes in M will affect
more than just P—they may also
change Q.
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The Demand for Money
Transactions demand for money
• The quantity of money demanded by
households and businesses to transact their
buying and selling of goods and services.
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The Demand for Money
The classical view is that the
transactions demand for money is
the only motive for demanding
money. If P or Q rises, the
transactions demand for money
will also rise.
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The Demand for Money
The Keynesian view is that in
addition to the transactions
demand for money, there is also a
precautionary motive and a
speculative motive for demanding
money.
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EXHIBIT 4
THE SPECULATIVE DEMAND FOR MONEY
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Exhibit 4: The Speculative
Demand for Money
According to the speculative motive,
why does the quantity of money
demanded increase as interest rates
decrease?
• People shift out of interest-paying accounts
into holding money because the opportunity
cost of holding money has fallen.
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Exhibit 4: The Speculative
Demand for Money
According to the speculative motive, why
does the quantity of money demanded
increase as interest rates decrease?
• This reduces the cost of speculatively having
money immediately available to take
advantage of unforeseen good purchasing
opportunities that may suddenly arise.
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EXHIBIT 5A MONEY AFFECTS REAL GDP
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EXHIBIT 5B MONEY AFFECTS REAL GDP
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EXHIBIT 5C MONEY AFFECTS REAL GDP
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Exhibit 5: Money Affects Real GDP
According to the Keynesian view, how
does a change in the money supply
affect real GDP?
• An increase in the money supply reduces
interest rates.
• Lower interest rates increase investment
spending.
• Increased investment spending increases
aggregate demand.
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The Demand for Money
What is the shape of the aggregate
supply curve when a change in the
money supply affects real GDP but
not the price level?
• The segment of the aggregate supply
curve over which aggregate demand shifts
is horizontal.
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The Demand for Money
How do classical economists and
monetarists see the shape of the
aggregate supply curve?
• The segment of the aggregate supply
curve over which aggregate demand shifts
is vertical, and occurs at the fullemployment level of real GDP. Thus only
prices change, not real GDP.
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