Download Know Your Currencies?

Chapter 25
MONEY
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
1
Economic Principles
Barter exchange
The characteristics of money
Gold-backed and fiat money
Liquidity
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Gottheil — Principles of Economics, 7e
2
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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Gottheil — Principles of Economics, 7e
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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
Why would a government lose
money “making” money—coins like
the penny and nickel?
• Metal prices have tripled since 2003.
• Because copper, zinc, and nickel are
commodities, we have no control over their
prices.
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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: 2008 ($ BILLIONS)
Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, September 2008), p. A13, table 1.21.
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Exhibit 1: U.S. Money Supply: 2008
1. True or false: The largest component
of M1 is demand deposits.
• False. In 2008 currency was over $760 billion
of the $1,374.8 billion supply of M1 money.
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Exhibit 1: U.S. Money Supply: 2006
2. True or false: The largest component
of M2 is M1.
• False. In 2006 M1 was $1,376.9 billion, but
savings deposits and money market
accounts made up $3,657.4 of the $6,761.2
billion supply of M2 money.
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EXHIBIT 2
GROWTH OF
THE MONEY
SUPPLY:
1970–2008
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Exhibit 2: Growth of the Money
Supply: 1970–2008
M1 money increased from $214 billion
in 1970 to $1,374.8 billion in 2008, or
by an annual rate of 5.4 percent.
The M2 money components (M2, M1)
increased by 9.4 percent.
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Exhibit 2: Growth of the Money
Supply: 1970–2008
1. True or false: M1 grew more slowly
than M2 between 1970 and 2008.
• True. Deregulation of the banking industry
increased elements of M2.
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Exhibit 2: Growth of the Money
Supply: 1970–2008
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. Euro
b. Pound
c. Gold
d. Sterling silver
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Know Your Currencies?
3. The British currency is the
a. Euro
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. Princess Diana
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. Princess Diana
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. Putin
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. Putin
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 yang
b. Yuan and yen
c. Han and edo
d. Yin and yan
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Know Your Currencies?
8. China and Japan’s currencies are,
respectively, the
a. Yak and yang
b. Yuan and yen
c. Han and edo
d. Yin and yan
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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
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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.
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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 fullemployment 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
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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 full-employment
level of real GDP. Thus only prices change,
not real GDP.
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The Liquidity Trap
The Liquidity trap occurs when the
interest rate (reflecting expected
returns on the bond market) is so low
that all additions to the money supply
are held in cash.
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EXHIBIT 6 THE LIQUIDITY TRAP
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Exhibit 6: The Liquidity Trap
When interest rate falls to X in Exhibit
6, the bond option is entirely ignored
and the additional money is held only
in cash.
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Exhibit 6: The Liquidity Trap
The interest rate X, in Exhibit 6, is
called a liquidity trap rate because at
that rate money becomes trapped in
the sense that any addition to the
money supply has no influence on the
level of investment and real GDP.
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