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Economics for Managers
University of Management and Technology
1901 North Fort Myer Drive
Arlington, VA 22209 USA
Phone: (703) 516-0035
Fax: (703) 516-0985
Website: www.umtweb.edu
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Chapter 10, ECON125
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Chapter 10
Money in the U.S.
Economy
Mastrianna, F.V. Basic Economics (14th
ed.) © 2007 Thomson South-Western.
ISBN 9780324400700
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Copyright Warning
This presentation is the intellectual property of the textbook
publisher Thomson South-Western 2007. Students are hereby
advised that they may not copy or distribute this work to any
third party
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Learning Objectives
Upon successfully completing this module, the student should
be able to:
Briefly describe the evolution of currency
Define money and explain its functions and how it is measured
Understand the quantity theory of money and show how
changes in M and V affect P and Q
Describe the effects of changes in the money supply on total
income and output and the price level
Illustrate the multiple expansion of the money supply using a
given initial checkable deposit and reserve requirement
Explain how the Consumer Price Index is constructed and used
Distinguish between nominal wages and real wages and explain
how to convert nominal wages into real wages
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Nature of Money
Commodity money
Currency in which the commodity itself actually serves as
money
Gold, stones, shells
Representative money
Money that is redeemable for a commodity, such as gold or
silver
Fiat money
Money that is not redeemable for a commodity and is
accepted on faith
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Money
Anything generally accepted in exchange for other goods
and services
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Functions of Money
Standard of value
Measure of the value of all other goods and services
Medium of exchange
Used to purchase other goods and services
Avoids double coincidence of wants
In a barter economy, the need to find a match between what
each of two traders wants to obtain and what each wants to offer
in exchange
Store of value
Allows conversion of excess goods into money which can be
stored/retained
Standard of deferred payment
Allows for payment over an extended period of time
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Measuring the Money Supply
Money stock
Quantity of money in existence at any given time
Liquidity
The ease with which an asset can be converted into the
medium of exchange
Currency
Paper money and coins
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M1 Money Stock
Most liquid definition of money; includes currency, travelers
checks, and checkable deposits
Checkable deposits
Checking deposits at banks and other depository institutions
including demand deposits (checking accounts), NOW
accounts, ATS accounts, and share draft accounts
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M2 Money Stock
The total of M1 and savings deposits, small time
deposits, and money market funds
Savings deposits
Interest-bearing funds held in accounts that do not allow for
automatic transfer services
Time deposits
Funds that earn a fixed rate of interest and must be held for a
stipulated period of time
Money market funds
Deposits held in accounts that are invested in a broad range
of financial assets, such as government and corporate bonds
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M3 Money Stock
The total of M2, plus large negotiable certificates of
deposit and Eurodollars
Eurodollars
U.S. dollars deposited in foreign banks and consequently
outside the jurisdiction of the United States
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The Equation of Exchange
A relationship between the supply of money and the price
level
MV = PQ
where
M = total money supply
V = velocity of money
P = price level or average price per
transaction
Q = total transactions in the economy
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The Equation of Exchange
The left side of the equation (MV)
Represents the total amount spent on goods and services
The right hand side of the equation (PQ)
Represents the total amount received by sellers
The total amount of final purchases in the economy must
equal the amount of money in circulation multiplied by the
average number of times per year that each dollar
changes hands
Truism
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Transactions Approach
An analysis of the equation of exchange that assumes
any money received is spent directly or indirectly to buy
goods and services
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Quantity Theory of Money
A classical view of the nature of money
Money is passive
The price level (P) is exactly proportional to the money
supply (M)
Based upon two important assumptions:
The national economy is inherently stable and tends to
operate at full employment of all productive resources
The velocity of money is stable because people’s spending
habits tend to be constant over time
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Quantity Theory of Money
Based upon these two assumptions, quantity theorists
concluded that:
If total output (Q) and velocity (V) are relatively constant, any
increase in the money supply (M) should lead to a directly
proportionate increase in the price level (P)
Not all economists accept the validity of the quantity theory
of money because they question the basic assumptions of
full employment and stable velocity
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Money and the Circular Flow:
Relationships of Investment, Savings, the Government
Budget, and the Money Supply
Conditions Tending
Toward Stable Total
Output and Stable
Price Level
Conditions Tending
Toward Decrease in
Total Output and/or
Decline in Price Level
Conditions Tending
Toward Increase in
Total Output and/or
Increase in Price Level
Planned I = Planned S
Planned I < Planned S
Planned I > Planned S
Balanced government
budget
Surplus government
budget
Deficit government
budget
Exports = Imports
Net imports
Net exports
Stable money supply
Decrease in money
supply
Increase in money
supply
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Creation of Money
Bank deposits are made
Banks provide loans
Reserve requirements
Multiple expansion of the money supply
Contraction of the money supply
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Money Multiplier
The reciprocal of the reserve ratio
1
Money multiplier 
Required reserve ratio
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Expansion of the Money Supply
10% Reserve Requirement
Bank Deposit Reserve Loan
A
$1,000
$100
$900
B
900
90
810
C
810
81
729
D
729
73
656
E
656
66
590
F
590
59
531
G
531
53
478
H
478
48
430
I
430
43
387
J
387
39
348
etc.
etc.
etc.
etc.
$10,000 $1,000
$9,000
20% Reserve Requirement
Bank Deposit Reserve Loan
A
$1,000
$200
$800
B
800
160
640
C
640
128
512
D
512
102
410
E
410
82
328
F
328
66
262
G
262
52
210
H
210
42
168
I
168
34
134
J
134
27
107
etc.
etc.
etc.
etc.
$5,000 $1,000 $4,000
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Price Index
A measuring system for comparing the average price of a group of
goods and services in one period of time with the average price of
the same group of goods and services in another period
Price of market basket in a given year 100%
Price of market basket in base period
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Example
Based upon the information in Table 10-4, the price index
in 1989, with 1983 as the base year, would be computed
as:
PI = ($1,000/807) × 100% = 124  the price of this market
basket of goods and services has increased by 24%
between 1983 and 1989
Table 10-4 also illustrates the impact of changing the
base period used in computing the price index
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Consumer Price Index (CPI)
An index that compares the price of a group of basic
goods and services as purchased by urban residents
Weighted according to the percentage of total spending
that is applied to each of several categories, including
food, rent, apparel, transportation, and medical care
Components of the CPI
Food and beverages (16.4%), housing (40.5%), apparel
(4.2%), transportation (16.7%), medical care (6.0%),
recreation (5.9%), education and communication (5.4%),
and other goods and services (4.9%)
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Limitations of the CPI
Measures relative change in the cost of living
Does not measure the actual cost of living
Not a completely pure price index
Quality improvements problem
Upward bias of between 1 and 2 percentage points
annually
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COLA Clauses
Cost-of-living adjustment clauses
Collective bargaining agreements
Social Security payments
Federal income tax
Can be inflationary, because they increase wages or
salaries without necessarily increasing productivity
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CPIs of Other Countries
Maintained in developed nations
Vary from one country to another
Use caution when comparing
Bureau of Labor Statistics:
Foreign CPI conversions
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Other Price Indexes
Producer Price Index, PPI
A measure of the average prices received by producers
and wholesalers
GDP Implicit Price Deflator
A broadest measure of price changes than either the CPI
or the PPI
Takes into account the prices of all final goods and
services produced by the economy
An index of the price level of aggregate output
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The Value of Money
Price indexes are useful for determining the value of
money
Based on the goods and services that a given amount of
money can buy
Value of dollar = ($1.00/PI) × 100
For example, the PI for 2005 was computed as 192, thus
the dollar was valued at $0.52 ($1.00/192) × 100
A 2005 dollar would purchase only 52 cents worth of
goods as measured in 1982–1984 dollars
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Real Income
The constant dollar value of goods and services
produced
The purchasing power of money income
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Effects of Changes in Price Level
Inflation is:
an advantage to those whose incomes increase faster
than the price level
a disadvantage to those whose incomes decrease faster
than the price level
a disadvantage to those whose incomes remain stable
when price level increases
an advantage to debtors
a disadvantage to creditors
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