C hapter 25 Money © 2002 South-Western. 2 Economic Principles Barter Exchange The Characteristics...

CChapter 25hapter 25

Economic PrinciplesEconomic Principles

• Barter Exchange

• The Characteristics of Money

• Gold-Backed and Fiat Money

• Liquidity

Economic PrinciplesEconomic Principles

• The Equation of Exchange

• The Quantity Theory of Money

• The Classical View of Money

• The Keynesian View of Money

• Monetarism

IntroductionIntroduction

Barter

The exchange of one good for another, without the use of money.

IntroductionIntroduction

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.

The Invention of The Invention of MoneyMoney

Any commonly accepted good that acts as a medium of exchange, a measure of value, and a store of value.

Money must be durable, portable, divisible, homogeneous, and supplies must be stable.

Which of the following is most likely to serve as money:

a. Strawberries.

b. Cows.

c. Gold.

d. Water.

c. Gold.

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.

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.

Fiat money

Paper money that is not backed by or convertible into any good.

Fluffy Rabbits and Fluffy Rabbits and Gresham’s LawGresham’s Law

Suppose that 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.

Fluffy Rabbits and Fluffy Rabbits and Gresham’s LawGresham’s Law

Suppose that 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.

Money in a Modern Money in a Modern EconomyEconomy

Currency

Coins and paper money.

Liquidity

The degree to which an asset can easily be exchanged for money.

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.

Money supply

Typically, M1 money. The supply of currency, demand deposits, and traveler’s checks used in transactions.

M1 Money supply

The supply of the most immediate form of money. It includes currency, demand deposits, and traveler’s checks.

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.

M3 Money supply

M2 money plus large-denomination time deposits and large-denomination repurchase agreements.

Explaining the Explaining the Impressive Growth of Impressive Growth of

M2 MoneyM2 MoneyWhat 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.

The dividing line between money and non-money assets is blurry. Most any asset is potential money.

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.

EXHIBIT 1 U.S. MONEY SUPPLY: 2000 ($ BILLIONS)

Source: Federal Reserve Bulletin (Washington, D.C.: Federal Reserve, December 2000), p. A13, table 1.21.

Exhibit 1: U.S. Money Exhibit 1: U.S. Money Supply: 2000 Supply: 2000 ($Billions)($Billions)

1. True or false: The largest component of M1 is demand deposits.

• False. In 2000 currency was over $523 billion of the $1,095 billion supply of M1 money.

2. True or false: The largest component of M2 is M1.

• False. In 2000 M1 was $1,094.9 billion, but savings deposits and money market accounts made up $1,839.4 of the $4,860.9 billion supply of M2 money.

3. True or false: The largest component of M3 is made up of Eurodollars.

• False. In 2000 the largest component of M3 was M2. Eurodollars were only a minor part of M3.

EXHIBIT 2GROWTH OF THE MONEY SUPPLY: 1970–2000

Exhibit 2: Growth of Exhibit 2: Growth of the Money Supply: the Money Supply:

1970-20001970-20001. True or false: M1 grew more slowly than M2 and M3 between 1970 and 2000.

• True. Deregulation of the banking industry increased elements of M2, which in turn increased M3.

Exhibit 2: Growth of Exhibit 2: Growth of the Money Supply: the Money Supply:

1970-20001970-20001. True or false: By 1992, M2 became larger than M3.

• False. That cannot occur because M3 includes M2 plus other types of money.

Money Challenge Money Challenge QuizQuiz

1. What is the largest denomination of currency printed today?

a. $10,000.

b. $1,000.

c. $500.

d. $100.

1. What is the largest denomination of currency printed today?

d. $100.

2. What agency actually prints currency?

a. The Federal Reserve System.

b. The Bureau of Engraving and Printing.

c. The Internal Revenue System.

d. The U.S. Mint.

2. What agency actually prints currency?

b. The Bureau of Engraving and Printing.

3. All of the U.S. coins currently minted portray…

a. past U.S. presidents.

b. national parks.

c. national monuments.

d. various universities founded before 1900.

3. All of the U.S. coins currently minted portray…

a. past U.S. presidents.

4. The average life of a $1 bill is…

a. 3-6 months.

b. 6-9 months.

c. 12-18 months.

d. 3 years.

c. 12-18 months.

a. 3-4 years.

b. 5-6 years.

c. 7-8 years.

d. 8-9 years.

6. Some features of U.S. currency that deter counterfeiters include…

a. tiny red and blue fibers in the paper.

b. a polyester strip embedded vertically in the paper.

c. special inks.

d. all of the above.

6. Some features of U.S. currency that deter counterfeiters include…

d. all of the above.

7. The former U.S. President or statesman featured on the $5 bill is…

a. George Washington.

b. Andrew Jackson.

c. Ulysses S. Grant.

d. Abraham Lincoln.

a. George Washington.

b. Andrew Jackson.

d. Abraham Lincoln.

9. The emblem or monument printed on the back of the $50 bill is…

a. the Great Seal of the United States.

b. the White House.

c. the U.S. Capitol.

d. independence Hall.

9. The emblem or monument printed on the back of the $50 bill is…

c. the U.S. Capitol.

10. Currency printed after 1929 is…

a. 6.14’’ by 2.61’’.

b. 6.00’’ by 3.00’’.

c. 5.25’’ by 3.36’’.

d. 5.00’’ by 3.00’’.

10. Currency printed after 1929 is…

a. 6.14’’ by 2.61’’.

The Quantity Theory The Quantity Theory of Moneyof Money

Velocity of money

The average number of times per year each dollar is used to transact an exchange.

Equation of exchange

MV = PQ. The quantity of money times its velocity equals the quantity of goods and services produced times their prices.

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.

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.

Quantity theory of money

P = MV/Q. The equation specifying the direct relationship between the money supply and prices.

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 full-employment GDP, then the direct relationship between M and P remains intact.

EXHIBIT 3 HISTORICAL RECORD OF MONEY VELOCITY

Exhibit 3: Historical Exhibit 3: Historical Record of Money Record of Money

VelocityVelocityHow 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.

Keynesians reject the monetarist’s idea that V is either stable or predictable, and that Q always reflects full-employment GDP. In this case, changes in M will affect more than just P—they may also change Q.

The Demand for The Demand for MoneyMoney

Transactions demand for money

The quantity of money demanded by households and businesses to transact their buying and selling of goods and services.

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.

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.

EXHIBIT 4 THE SPECULATIVE DEMAND FOR MONEY

Exhibit 4: The Exhibit 4: The Speculative Demand Speculative Demand

for Moneyfor MoneyAccording 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.

Exhibit 4: The Exhibit 4: The Speculative Demand Speculative Demand

for Moneyfor MoneyAccording 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.

EXHIBIT 5A MONEY AFFECTS REAL GDP

EXHIBIT 5B MONEY AFFECTS REAL GDP

EXHIBIT 5C MONEY AFFECTS REAL GDP

Exhibit 5: Money Exhibit 5: Money Affects Real GDPAffects 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.

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.

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.

C hapter 25 Money © 2002 South-Western. 2 Economic Principles Barter Exchange The Characteristics...

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