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MONEY AND INFLATION
What is money?
• Money is a generalized claim on all other
assets. It must be acceptable, scarce,
desirable, and divisible.
Three Properties of Money
• Medium of Exchange--A financial asset
(money) is used to trade (exchange) real
assets (goods and services).
• Store of Value--Money serves as a means
of storing purchasing power.
• Unit of Account--All prices are
denominated in terms of the monetary
unit, such as the dollar.
Types of Assets that Serve as Money
• Physical or Full-Bodied Money -- Assets with real
or intrinsic value that serve as money as long as
their value in exchange exceeds their value in use.
(Gold)
• Representative Money -- Assets with little or no
intrinsic value, such as currency and cheap metal
coins, that represent claims on assets with
intrinsic value.
• Fiat Money -- Money unbacked by any form of
Physical Money
Types of Assets that Serve as Money
• Legal Tender Laws – Laws passed to mandate the
acceptance of Fiat Money within an economy
• Seigniorage – Government revenue from the
manufacture of money calculated as the
difference between the face value and the cost of
the note or coin
• Deposit or Credit Money -- Assets without either
intrinsic value or representative value. Credit
money (deposit liabilities of banks) are backed by
financial assets, such as loans or securities.
Definition of the Money Supply
• Monetary Aggregates
– M1 – Currency, Travelers Checks and other
demand deposits
– M2 – M1 + Retail MMMF’s , savings, and
small time deposits
– M3 – M2 + Institutional MMMF’s, Large
time deposits, and Eurodollars
– MZM – Readily available M2 and M3
– L – The Total Stock of Money
Definition of the Money Supply
• The Transaction Approach--Any
definition of the money supply relating
money to current spending.
– Money (M1) is special--It is the medium of
exchange in the economy. Money is obtained
for the purpose of spending.
– All other assets must be converted to money
(M1) before "spending".
Definition of the Money Supply
(continued)
• The Store of Value Approach--Any definition of
the money supply associating money to its
ability to store or hold purchasing power
through time. Spending may occur now or
later.
– Money serves as a store of purchasing power.
– Monetarists believe that liquid, near-money
financial assets, such as M2, M3, serve as means to
"store" purchasing power.
– MZM is a definition of money that includes those
parts of M2 and M3 that can be obtained
immediately.
Recent Measures of Money and
the Money Supply
DEFINITION
BILLIONS
Currency and
travelers
checks
M1
MZM
M2
M3
L
$ 457.0
1,072.0
3,789.0
4,293.0
5,776.0
7,062.0
PERCENTAGE DEGREE OF
LIQUIDITY1
OF L
6.5
Highest
15.2
53.6
60.8
81.8
100.0
Source: Federal Reserve Bank of St. Louis monetary data for September 1998.
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Lowest
Money and Money Substitutes
• Credit Cards Versus Debit Cards
– Deposit balances, a part of the money
supply, are liabilities (credit balance) of
depository institutions.
– A check, paper or electronic order, transfers
(debits) deposits to new owners and their
designated bank.
Money and Money Substitutes
(continued)
– Debit cards, used in automatic teller
machines (ATM), point of sale terminals
where payment is made electronically, or in a
paper-based system when something is
purchased. A debit to a credit deposit
balance reduces the balance. Hence, the
name, debit card.
Money and Money Substitutes
(continued)
– Credit cards are preapproved lines of credit.
When used, the bank is making a loan (asset)
and paying someone (deposit). Later, the
credit card user pays off the loan with a
check (debit to their deposit account).
Credit card usage is not a money or deposit
transfer. It is a loan/deposit transaction,
increasing the money supply, until the credit
card bill is paid.
Money and Money Substitutes
(continued)
• Money Market Mutual Funds (MMMF)
and Stock and Bond Mutual Funds
– MMMF are investment companies that issue
$1 shares in return for money to invest in
liquid, short-term, high quality debt
securities.
– MMMF balances are a store of value and are
a part of the M2 money supply definition, not
the M1 definition of transaction balances.
Money and Money Substitutes
(concluded)
– Mutual funds, other than MMMF, also have
check-writing services, though the value of
the MF shares vary with the value of the
asset, stocks, bonds, commodities, etc.
Role of Money in an Economy
• To facilitate efficient (lowest cost)
exchange between economically
specialized persons.
• Barter is inefficient and does not
facilitate exchange. There are many
barter prices for an item in a barter
economy; only one price in a money
economy.
Transmission Mechanism for
Monetary Policy: Keynesian
View
What is Inflation
• Inflation is the proliferation of monetary
units (currency) leading to a general rise
in the price level
The value of money is evidenced
in its purchasing power.
• Sustained decreases in the ratio (exchange
value) between money (financial assets) and
goods and services (real assets) represent a
decline in the purchasing power of money.
• The value of money can be measured by the
change in price levels. Inflation is an increase
in the general price level over time. The value
of money can be measured by inflation.
Price Index--A measure of the price
levels at a particular point in time.
• A broadly determined market basket of goods
and services is assembled and priced for the
(base year) starting point.
• Using the base year as 100, subsequent prices
for the market basket are compared to the
"base" year.
• Changes in the price index measures the
inflation or deflation rate and thus the
changing value of money.
Widely Used Price Indices
• The Consumer Price Index (CPI) -- The price
of a broad consumer market basket of new,
final goods and services. Updated monthly.
• Producer Price Index (PPI) -- A set of prices for
a cross section of intermediate (not final) goods.
Updated monthly.
• Gross Domestic Product Deflator -- A set of
prices for all goods and services included in
GDP. Updated quarterly.
Annual Rate of Inflation (CPI)
for the Economy (1965-1998)
14.0
Percentage Change
12.0
10.0
8.0
6.0
4.0
2.0
0.0
1965
75
85
95
Using Price Indices--Comparing
nominal (current market prices) and
real (purchasing power) values.
• Nominal values are price-weighted measures of
goods and services. Nominal values increase
and decrease as prices rise and fall,
respectively. In the base year (period) of a
price index, the nominal value equals the real
value.
• Real values are nominal values adjusted
(deflated) for price level changes. With
increases in the price level (measured by the
price index), the real values decline.
Inflation Summary--Continued
increase in average price levels.
• With unanticipated inflation, wealth transfers
from savers to borrowers in financial markets.
• Persons with fixed incomes are able to buy less
in periods of inflation.
• Interest rates, the time price of money, increase
with inflation.
• Inflation is associated with periods of high
money supply growth relative to the growth of
the economy.