chapter 13 money chapter 30 in economics. tm 13-2 copyright © 1998 addison wesley longman, inc....

CHAPTER 13Money

CHAPTER 13Money

Chapter 30 in EconomicsChapter 30 in EconomicsChapter 30 in EconomicsChapter 30 in Economics

TM 13-2Copyright © 1998 Addison Wesley Longman, Inc.

Learning Objectives

• Define money and describe its functions

• Explain the economic functions of banks and other financial institutions

• Describe the financial innovations of the 1980s and 1990s


Learning Objectives (cont.)

• Explain how banks create money

• Explain why the quantity of money is an important economic magnitude

• Explain the quantity theory of money


Learning Objectives





What is Money?

• Money is any commodity or token that is generally acceptable as the means of payment.

• A means of payment is a method of settling a debt.


What is Money?

• Other functions of Money

1) Medium of exchange

2) Unit of account

3) Store of value


What is Money?

• Medium of Exchange

• A medium of exchange is an object that is generally accepted in exchange for goods and services.• Without money, people would have to exchange

goods for goods, or barter.


What is Money?

• Unit of Account

• A unit of account is an agreed measure for stating the prices of goods and services.• This simplifies value comparisons and purchase

decision making if all prices are expressed using a uniform measure.


The Unit of Account Functions of Money Simplifies Price Comparisons

Movie $6.00 each 2 six-packs of soda

Soda $3.00 per six-pack 2 ice-cream cones

Ice cream $1.50 per cone 3 packs of jelly beans

Jelly beans $0.50 per pack 2 cups of coffee

Coffee $0.25 per cup 1 local phone call

Price in Price in unitsGood money units of another good


What is Money?

• Store of Value

• A store of value is any commodity or token that can be held and exchanged later for goods and services.


What is Money?

• Money in the United States Today

• Money in the U.S. consists of:• Currency

• Deposits at banks and other financial institutions


What is Money?

• Money in the United States Today

• Currency is the bills and coins that we use.

• Deposits are also money because they can be converted into currency and are used to settle debts.


What is Money?

• Official Measures of Money

1) M1 consists of currency and traveler’s checks plus checking deposits.

• Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government


What is Money?


2) M2 consists of M1 plus saving deposits and time deposits


What is Money?


3) M3 consists of M2 plus large-scale time deposits and term deposits


Two Measures of Money


What is Money?

• Are M1 and M2 Really Money?

• The test of whether an asset is money is whether it serves as a means of payment.• Currency does so

• Checking deposits are money because they can be transferred by writing a check.

• M1 is money


What is Money?

• Are M1 and M2 Really Money

• Some savings deposits are readily accessible and can be used as a means of payment.

• Other deposits are less liquid.• Liquidity is the property of being instantly

convertible into a means of payment with little loss in value.

• M2 is money


What is Money?

• Other Points Regarding Money

1) Deposits are money but checks are not.

2) Credit cards are not money.


Learning Objectives





Financial Intermediaries

• Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.



• Four Types of Financial Intermediaries

1) Commercial banks

2) Savings and loan associations

3) Savings banks and credit unions

4) Money market mutual funds



• Commercial Banks

• A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.




• Their balance sheet lists their assets, liabilities, and net worth.• The assets are what the bank owns

• The liabilities are what the bank owes

• These include deposits

• Net worth is the difference between assets and liabilities.




• Their balance sheet is described by the following formula:

Liabilities + Net Worth = Assets



• Profit and Prudence: A Balancing Act

• Banks attempt to maximize the net worth of their stockholders• They earn profit by lending at a higher interest rate

than they borrows

• Lending is risky

• Banks must be prudent in how they uses their deposits



• Reserves and Loans

• Banks divide their funds into two parts:• Reserves are cash in a bank’s vault plus its deposits

at Federal Reserve banks

• Loans



• Three Types of Assets Held by Banks

1) Liquid assets are U.S. government Treasury bills and commercial bills

2) Investment securities are longer-term U.S. government bonds and other bonds

3) Loans are commitments of fixed amounts of money for agreed- upon periods of time



• Savings and Loan Associations

• A savings and loan association is a financial intermediary that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans.



• Savings Banks and Credit Unions

• A savings bank (mutual savings bank) is a financial intermediary owned by its depositors that accepts deposits and makes mostly home-purchase loans.



• Savings Banks and Credit Unions

• A credit union is a financial intermediary owned by its depositors that accepts savings deposits and makes mostly consumer loans.• The key difference between savings banks and

credit unions is that credit unions are owned by a social or economic group such as a firm’s employees.



• Money Market Mutual Funds

• A money market mutual fund is a financial institution that obtains funds by selling shares and uses these funds to buy highly liquid assets such as U.S. Treasury bills



• The Economic Functions of Financial Intermediaries

1) Creating Liquidity

2) Minimizing the cost of borrowing



• The Economic Functions of Financial Intermediaries

3) Minimizing the cost of monitoring borrowers

4) Pooling Risk


Financial Regulation, Deregulation, and Innovation

• Financial Regulation

• Two types of regulation faced by financial intermediaries:• Deposit insurance

• Balance sheet rules



• Deposit Insurance

• The deposits of most financial intermediaries are insured by the Federal Deposit Insurance Corporation.• Receives its income from compulsory premiums

paid by financial intermediaries

• Protects depositors



• The balance sheet regulations faced by financial intermediaries include:

1) Capital requirements• The minimum amount of an owner’s own financial

resources that must be put into an intermediary




2) Reserve requirements• Rules setting out the minimum percentages of

deposits that must be held in currency or other safe, liquid assets




3) Deposit rules• Restrictions on the different types of deposits that

an intermediary can accept




4) Lending rules• Restrictions on the proportions of different types of

loans that an intermediary may make



• Deregulation in the 1980s

• The Depository Institutions’ Deregulation and Monetary Control Act (DIDMCA), passed in 1980, removed many of the distinctions between commercial banks and other financial intermediaries.



• Deregulation in the 1980s

• Other actions affecting financial intermediaries include:• The passage of the Garn-St. Germain Depository

Institutions Act in 1982

• The abolition of Regulation Q in 1985


Learning Objectives






• Financial Innovation

• Financial innovation is the development of new ways of borrowing and lending.• Primary aim is to increase the profit from financial

intermediation



• The three main influences on financial innovation are:

1) Economic environment

2) Technology

3) Regulation



• Financial Innovations

• Variable interest rate mortgages

• Widespread credit card usage

• Rise in the importance of the Eurodollar

• Paying interest on checkable deposits


How Banks Create Money

• Reserves: Actual and Required

• The reserve ratio is the fraction of a bank’s total deposits that are held in reserves.

• The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold.

• Excess reserves are actual reserves minus required reserves.



• Creating Deposits by Making loans in a One-Bank Economy

Let’s see an example of howbanks create money.


Reserves $100 Deposits $400

Loans $300

Total $400 Total $400

Creating Money at theOne-and-Only Bank

Balance sheet on January 1

Assets(millions of dollars)

Liabilities(millions of dollars)



Loans $300








Loans $303








• The Deposit Multiplier

reservesinChange

depositsinChangemultiplierDeposit



• Creating Deposits by Making Loans with Many Banks

Let’s see how the

banking system creates money


The Multiple Creationof Bank Deposits

The sequence The running tallyReserves Loans Deposits



The sequence The running tally

Deposit$100,000

Reserves Loans Deposits




Deposit$100,000


$25,000

$75,000 $25,000

$75,000 $100,000Loan

$75,000Reserve$25,000



The sequence

Deposit$100,000

Loan$75,000

Deposit$75,000

Reserve$25,000

The running tallyReserves Loans Deposits

$25,000

$75,000 $25,000

$75,000 $100,000




Deposit$100,000


$25,000

$75,000 $25,000

$75,000 $100,000Loan

$75,000

Deposit$75,000

Reserve$25,000

Loan$56,250

Reserve$18,750 $43,750 $131,250 $175,000



The sequence

Deposit$56,250

The running tallyReserves Loans Deposits




$43,750 $131,250 $175,000

Deposit$56,250

Loan$42,187

Reserve$14,063 $57,813 $173,437 $231,250




Deposit$56,250

Loan$42,187

Reserve$14,063

Deposit$42,187

$43,750 $131,250 $175,000

$57,813 $173,437 $231,250




$68,360 $205,077 $273,437

Loan$31,640

Reserve$10,547




$68,360 $205,077 $273,437

Loan$31,640

Reserve$10,547

andso on...

$100,000 $300,000 $400,000



• The Deposit Multiplier in the United States

• The actual deposit multiplier in the U.S. works the same as the one presented.

• However, it does differ in some aspects.



• The deposit multiplier in the United States differs from our model economy’s for three main reasons:

1) The actual required reserve ratio is smaller than the 25 percent used here.

2) Banks sometimes choose to hold excess reserves.



• The deposit multiplier in the United States differs from our model economy’s for three main reasons:

3) Not all loans made by banks return to them in the form of reserves.


Money, Real GDP, andthe Price Level

• We are going to study the effect the money supply has on real GDP, the price level, and the inflation rate.



• The Short-Run Effects of a Change in the Quantity of Money

• Let’s study how a change in the quantity of money effects these factors by examining the aggregate supply-aggregate demand model.


Short-Run Effects ofChange in Quantity of Money

Real GDP (trillions of 1992 dollars)

Pri

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(GD

P d

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100

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100

110

130

140

6.6 7.0 7.2 7.6

120

107

6.8 7.4




Pri

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(GD

P d

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100

110

130

140

AD0

6.6 7.0 7.2 7.6

120

107

6.8 7.4

LAS

SAS

AD1




Pri

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P d

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)

100

110

130

140

6.6 7.0 7.2 7.6

120

107

6.8 7.4

LAS

SAS

AD1


Long-Run Effects ofChange in Quantity of Money


Pri

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(GD

P d

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199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4




Pri

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vel

(GD

P d

efla

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199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

AD1

SAS1




Pri

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vel

(GD

P d

efla

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199

2 =

100

)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD1

SAS1

AD2




Pri

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(GD

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)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD1

SAS1

AD2

SAS2




Pri

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(GD

P d

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)

100

110

130

140

6.6 7.0 7.2 7.6

121

6.8 7.4

LAS

113

AD2

SAS2



• The Quantity Theory of Money

• The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

• This theory is based upon the velocity of circulation and the equation of exchange.



• The Quantity Theory of Money

• The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.



• GDP equals the price level (P) times real GDP (Y), or:

GDP = PY



• Make the quantity of money M, and the velocity of circulation V is determined by:

V = PY/M


The Velocity of Circulation in the United States: 1930–1996



• The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or

MV=PY



• We can convert the equation of exchange into the quantity theory of money by making two assumptions:

1) The velocity of circulation is not influenced by the quantity of money.

2) Potential GDP is not influenced by the quantity of money.



• Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.



• This can be shown by using the equation of exchange to solve for the price level.

P = (V/Y)M



• In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

MYVP )/(



• Dividing this equation by an earlier one, P = (V/Y)M, gives us

MMPP //



• This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money.

• This gives us the quantity theory of money:

• In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.



• The AS-AD model predicts the same outcome as the quantity theory of money.

• It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.



• Historical Evidence on the Quantity Theory of Money

• The data are broadly consistent with the quantity theory of money, but the relationship is not precise.

• The relationship is stronger in the long run than in the short run.


Money Growth andInflation in the United States


Money Growth andInflation in the World Economy



• Correlation, Causation, and Other Influences

• The evidence shows that money growth and inflation are correlated.



• Correlation, Causation, and Other Influences

• This does not represent causation.• Does money growth cause inflation, or does

inflation cause money growth?

• Does some other factor cause inflation (deficit spending)?

chapter 13 money chapter 30 in economics. tm 13-2 copyright © 1998 addison wesley longman, inc....

Documents

quantity of money

money1 deposits

sochecking deposits

means of payment

economic functions of

largescale time deposits

official measures of

moneysome savings deposits