Download Aim: What is Money? - The Bronx High School of Science

Aim: What is Money?
Money
• a concept – an idea we have of
something that allows us to
recognize specific examples of it
Characteristics of Money
• durable
• portable
• divisible
• scarce
• acceptable
(uniformity/recognizable)
Functions of Money
• medium of exchange
• store of value
• standard of measure
Medium of Exchange, Store of Value or
Standard of Measure ?
• Ben bought 2 tickets for the movie.
• Alex likes to keep a $20 bill stashed
away in his wallet for emergencies.
• Kyle was trying to decide whether to buy
three candy bares for $.50 each or one
chocolate sundae for $1.65.
• The manager of Apex Stores gave Maria
her paycheck.
Our Money
• fiat money/token money
• intrinsically worthless
Why would anyone accept
worthless scraps of paper as
money instead of something that
has value such as gold, cigarettes
or cattle?
The Supply of Money in the Economy
• M1 - transaction money: demand
deposits, travelers checks, currency
held outside of banks, other checkable
deposits
• M2 – broad money, M1 + savings
accounts, money market accounts,
other near money
• M3 – beyond M1 and M2
What about credit cards?
Aim: How does the U.S control
Money?
The Federal Reserve System was
set up to bring order to the
chaotic finances of the United
States
• control inflation
• control the flow of money
• control the flow of credit
Structural Elements of the Fed
• 7 member Board of Governors
appointed by the President confirmed
by the Senate
• provides financial services to
depository institutions – the bankers’
bank – uniform currency, check
collection, wire transfers, hold
reserves, creditor of last resort
• Supervision of financial community
• FRB serves as the government’s bank
– checking, government borrowing
• self-financed
• monetary watchdog
• Federal Open Market Committee
(FOMC) sets monetary policy
Significant History
•
•
•
•
•
“Not Worth a Continental”
McCullough v. Maryland
Jackson v. Bank
1863 National Banking Act
1907 JP Morgan saves the banking
system
• 1913 Federal Reserve Act
Aim: How does the Fed control
the money supply?
• The basic purpose of monetary
policy is to manipulate the money
supply
• control the amount of money
available for loans
Instruments/tools the Fed uses to
control the flow of money and credit
• Reserve requirements
• Discount Rate
• Open Market Operations (buy and sell
government securities
Expansionary Monetary Policy
(bolster a recessionary economy)
• ↓ reserve requirement
• ↓ discount rate
• buy govt securities
Contractionary Monetary Policy
(slow/dampen an inflationary economy
• ↑ reserve requirement
• ↑ discount rate
• sell govt securities
Monetary Policy works indirectly
• no guarantee that people will
respond the way the Fed wants
• Fed needs to be sure that it is
choosing the right action at the
right time
Monetarist
• Money supply should grow with
GDP
Aim: How does the banking
system create money?
Banks cannot print money, so how do
they create it?
The banking system creates money
through the money supply multiplier
a.k.a. the deposit expansion multiplier
Bank
A
Cash
20%
Deposits Reserve
Potential for
New loans
$1,000.00 $ 200.00
$ 800.00
B
800.00
160.00
640.00
C
640.00
128.00
512.00
D
512.00
102.40
409.60
2,048.00
409.60
1,638.40
All
others
TOTAL $5,000.00 $1,000.00
$4,000.00
Money Multiplier
1/ Reserve Requirement
i.e.
1/.20 = 5
Leaks in the System
• In the real world, the multiplier is a bit less
than its potential
• Any currency that remains outside the
banking system reduces the size of the
multiplier
• Money is drained in 2 ways
– People put money in a cookie jar or under
their mattress
– Banks do not stick strictly to their legal
reserve requirements
Aim: How is money just
another commodity that reacts to supply
and demand?
Demand for Money
• Interest rates (r) and the national
income (Y) help determine how much
money households and firms wish to
hold
r = opportunity cost of holding money
↑output → ↑ in the # of transactions → ↑ Md
↑ p → shift in the D curve for M to the right
The real rate of interest is crucial in making
investment decisions. Business firms want to
know the true cost of borrowing for
investment. If inflation is positive, which it
generally is, then the real interest rate is lower
than the nominal interest rate. If we have
deflation, and the inflation rate is negative, then
the real interest rate will be larger.
The supply of money is vertical no matter
what the interest rate is on the vertical
axis, since the Federal Reserve controls
the supply of money through its monetary
policy tools
The Money Market
Tight Money Policy
When the Federal Reserve adopts a tight
money policy, the supply of money
moves to the left, and the interest rate
rises. This discourages investment and
interest-sensitive consumption, which
decreases the aggregate demand. Price
levels fall, while real output decreases.
The Money Market
M↓ → r↑→ I↓ → AE↓ → Y↓
Easy Money Policy
When the Federal Reserve adopts an easy
money policy, the supply of money
moves to the right, and the interest rate
falls. This stimulates investment and
interest-sensitive consumption, which
increases the aggregate demand. Price
levels rise, while real output increases.
The Money Market
M↑ → r↓ → I↑ → AE↑ → Y↑
Price-level changes will affect the
demand curve in the money market
diagram. At higher price levels, more
money is needed for transactions, so
people will choose to hold a greater
quantity of money. A higher price level
means that the demand curve moves to
the right, increasing the nominal interest
rate if the supply of money is constant.
Nominal rates are determined in the money
market. Money demanded and money supplied
determines the equilibrium interest rate. The
demand curve will slope downward. The
vertical axis (interest rate) is the opportunity
cost of holding money. An increase in the
interest rate raises the cost of holding money
and reduces the quantity of money demanded.
A decrease in the interest rate reduces the cost
of holding money and increases the quantity of
money demanded.
Loanable Funds Market -- Real Interest Rates
Real interest rates are determined in the loanable
funds market. The loanable funds theory of interest
explains the interest rate in terms of the demand and
supply of funds available for lending. Equilibrium
occurs where the supply (savings) intersects the
demand (investment, consumption). Movement to
equilibrium is the process of determining the real
interest rate in the economy. The supply of loanable
funds is all income that people have chosen to save
and lend out rather than use for their own
consumption. The demand for loanable funds comes
from households and firms that wish to borrow to
make investments.
Loanable Funds Market
Loanable Funds Market
Loanable Funds Market
Aim: How does the Classical model of
monetary policy “work”?
Quantity theory of money
• the theory that price level varies in
response to changes in the quantity of
money
• centers around the equation of exchange
MV=PQ
M = quantity of money
V = Velocity
P = Price Level
Q = quantity of real goods sold (real GDP)
Classical assumptions
• Velocity of money is the number of
times per year, on average, a dollar
goes around to generate a dollar’s
worth of income – velocity is the
amount of income per year generated
by a dollar in the economy
• Classical economists assume velocity
remains constant
• If velocity remains constant, the quantity
theory can be used to predict how much
nominal GDP will grow if we know how
much the money supply grows
• Classical economists assume that Q (real
GDP) is independent of the money supply
– Q is autonomous, meaning real output
is determine by forces outside the
quantity theory – real output is not
influenced by changes in the money
supply
• Some economists believe that the real
quantity of money demanded is
proportional to real aggregate spending
– if this is true, then the effect of
changes in interest rates on real money
demanded is reflected in the changes
in the velocity of money
• Velocity of money is thought to be
stable through the 1980s.
Monetarist
• Money supply should grow with
GDP