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© 2007 Thomson South-Western © 2009 UMT

Economics for ManagersEconomics for Managers

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Version 090825


Chapter 10Chapter 10 Money in the U.S. Money in the U.S.

EconomyEconomyMastrianna, F.V. Basic Economics (14th ed.) © 2007 Thomson South-Western.

ISBN 9780324400700



Visit UMT online at www.umtweb.eduVersion 090825


Copyright WarningCopyright 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





Learning ObjectivesLearning Objectives

Upon successfully completing this module, the student should be able to:

Briefly describe the evolution of currencyDefine money and explain its functions and how it is measuredUnderstand the quantity theory of money and show how changes in M and V affect P and QDescribe the effects of changes in the money supply on total income and output and the price levelIllustrate the multiple expansion of the money supply using a given initial checkable deposit and reserve requirementExplain how the Consumer Price Index is constructed and usedDistinguish between nominal wages and real wages and explain how to convert nominal wages into real wages





Nature of MoneyNature of Money

Commodity moneyCurrency in which the commodity itself actually serves as money

Gold, stones, shells

Representative moneyMoney that is redeemable for a commodity, such as gold or silver

Fiat moneyMoney that is not redeemable for a commodity and is accepted on faith





MoneyMoney

Anything generally accepted in exchange for other goods and services





Functions of MoneyFunctions of Money

Standard of valueMeasure of the value of all other goods and services

Medium of exchangeUsed to purchase other goods and servicesAvoids 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 valueAllows conversion of excess goods into money which can be stored/retained

Standard of deferred paymentAllows for payment over an extended period of time





Measuring the Money SupplyMeasuring the Money Supply

Money stockQuantity of money in existence at any given time

LiquidityThe ease with which an asset can be converted into the medium of exchange

CurrencyPaper money and coins





M1 Money StockM1 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






The total of M1 and savings deposits, small time deposits, and money market funds

Savings depositsInterest-bearing funds held in accounts that do not allow for automatic transfer services

Time depositsFunds that earn a fixed rate of interest and must be held for a stipulated period of time

Money market fundsDeposits held in accounts that are invested in a broad range of financial assets, such as government and corporate bonds






The total of M2, plus large negotiable certificates of deposit and Eurodollars

EurodollarsU.S. dollars deposited in foreign banks and consequently outside the jurisdiction of the United States





The Equation of ExchangeThe Equation of Exchange

A relationship between the supply of money and the price level

MV = PQwhere

M = total money supplyV = velocity of moneyP = price level or average price per

transactionQ = total transactions in the economy





The Equation of ExchangeThe 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 handsTruism





Transactions ApproachTransactions Approach

An analysis of the equation of exchange that assumes any money received is spent directly or indirectly to buy

goods and services





Quantity Theory of MoneyQuantity Theory of Money

A classical view of the nature of moneyMoney is passiveThe 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 resourcesThe velocity of money is stable because people’s spending habits tend to be constant over time





Quantity Theory of MoneyQuantity 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





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 supplyDecrease in money

supplyIncrease in money

supply

Money and the Circular Flow: Money and the Circular Flow: Relationships of Investment, Savings, the Government Relationships of Investment, Savings, the Government

Budget, and the Money SupplyBudget, and the Money Supply





Creation of MoneyCreation of Money

Bank deposits are madeBanks provide loansReserve requirementsMultiple expansion of the money supplyContraction of the money supply





Money MultiplierMoney Multiplier

The reciprocal of the reserve ratio

ratio reserve Required1 multiplierMoney





Expansion of the Money SupplyExpansion of the Money Supply

10% Reserve Requirement 20% Reserve RequirementBank Deposit Reserve Loan Bank Deposit Reserve LoanA $1,000 $100 $900 A $1,000 $200 $800 B 900 90 810 B 800 160 640 C 810 81 729 C 640 128 512 D 729 73 656 D 512 102 410 E 656 66 590 E 410 82 328 F 590 59 531 F 328 66 262 G 531 53 478 G 262 52 210 H 478 48 430 H 210 42 168 I 430 43 387 I 168 34 134 J 387 39 348 J 134 27 107etc. etc. etc. etc. etc. etc. etc. etc. $10,000 $1,000 $9,000 $5,000 $1,000 $4,000





Price IndexPrice 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

100%period base inbasket market of Price

yeargiven a inbasket market of Price





ExampleExample

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





Consumer Price Index (CPI)Consumer Price Index (CPI)

An index that compares the price of a group of basic goods and services as purchased by urban residentsWeighted according to the percentage of total spending that is applied to each of several categories, including food, rent, apparel, transportation, and medical careComponents 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%)





Limitations of the CPILimitations of the CPI

Measures relative change in the cost of living Does not measure the actual cost of living

Not a completely pure price indexQuality improvements problemUpward bias of between 1 and 2 percentage points annually





COLA ClausesCOLA Clauses

Cost-of-living adjustment clausesCollective bargaining agreementsSocial Security paymentsFederal income tax

Can be inflationary, because they increase wages or salaries without necessarily increasing productivity





CPIs of Other CountriesCPIs of Other Countries

Maintained in developed nationsVary from one country to anotherUse caution when comparingBureau of Labor Statistics:

Foreign CPI conversions





Other Price IndexesOther Price Indexes

Producer Price Index, PPIA measure of the average prices received by producers and wholesalers

GDP Implicit Price DeflatorA broadest measure of price changes than either the CPI or the PPITakes into account the prices of all final goods and services produced by the economyAn index of the price level of aggregate output





The Value of MoneyThe 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) × 100For 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





Real IncomeReal Income

The constant dollar value of goods and services producedThe purchasing power of money income





Effects of Changes in Price LevelEffects of Changes in Price Level

Inflation is:an advantage to those whose incomes increase faster than the price levela disadvantage to those whose incomes decrease faster than the price levela disadvantage to those whose incomes remain stable when price level increasesan advantage to debtorsa disadvantage to creditors


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