1. Money and money supply Chapter 31 in Economics ECONOMICS

2. Slide 14-2 Copyright © 2000 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

3. Slide 14-3 Copyright © 2000 Addison Wesley Longman, Inc. 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

4. Slide 14-4 Copyright © 2000 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

5. Slide 14-5 Copyright © 2000 Addison Wesley Longman, Inc. 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.

6. Slide 14-6 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Functions of Money 1) Medium of exchange 2) Unit of account 3) Means of payment 4) Store of value 5) World-wide money

7. Slide 14-7 Copyright © 2000 Addison Wesley Longman, Inc. 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.

8. Slide 14-8 Copyright © 2000 Addison Wesley Longman, Inc. 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.

9. Slide 14-9 Copyright © 2000 Addison Wesley Longman, Inc. The Unit of Account Functions of Money Simplifies Price Comparisons Movie$6.00 each2 six-packs of soda Soda$3.00 per six-pack2 ice-cream cones Ice cream$1.50 per cone3 packs of jelly beans Jelly beans$0.50 per pack2 cups of coffee Coffee$0.25 per cup1 local phone call Price inPrice in units Goodmoney unitsof another good

10. Slide 14-10 Copyright © 2000 Addison Wesley Longman, Inc. 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. Only REAL MONEY: Gold and Silver Gold: in (a) physical bullion-bar, coin and round (b) paper certificate

11. Slide 14-11 Copyright © 2000 Addison Wesley Longman, Inc. New York Gold Spot Price (24hrs) Nov 30, 2015 at 08:57 EST Gold Price Per Ounce$ 1,061.38 +1.28 Gold Price Per Gram$ 34.12+0.04 Gold Price Per Kilo$ 34,124.16+41.15

12. Slide 14-12 Copyright © 2000 Addison Wesley Longman, Inc. GOLD

13. Slide 14-13 Copyright © 2000 Addison Wesley Longman, Inc. New York Silver Spot Price (24hrs) Nov 30, 2015 at 09:16 EST Silver Price Per Ounce$ 14.19+0.02 Silver Price Per Gram$ 0.460 Silver Price Per Kilo$ 456.22+0.64

14. Slide 14-14 Copyright © 2000 Addison Wesley Longman, Inc. Silver Bullet 20mm 25 oz 427 USD

15. Slide 14-15 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Means of exchange: Based on credit relations: buying on credit or selling on credit

16. Slide 14-16 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? World-wide money Gold, silver, platinum, USD, Euro, Swiss Frank, British Pound, Swiss Franc and other “hard currencies”

17. Slide 14-17 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Money Today consists of: Currency Deposits at banks and other financial institutions

18. Slide 14-18 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Money Today (cont.) Currency is the bills and coins that we use. Deposits (current account) are also money because they can be converted into currency and are used to settle debts.

19. Slide 14-19 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Official Measures of Money (cont.) 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.

20. Slide 14-20 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Official Measures of Money (cont.) M2 consists of M1 plus saving deposits and time deposits.

21. Slide 14-21 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Official Measures of Money (cont.) M3 consists of M2 plus large-scale time deposits and term deposits

22. Slide 14-22 Copyright © 2000 Addison Wesley Longman, Inc. 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. Checking deposits are money because they can be transferred by writing a check. M1 is money

23. Slide 14-23 Copyright © 2000 Addison Wesley Longman, Inc. 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

24. Slide 14-24 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Other Points Regarding Money 1) Deposits are money but checks are not. 2) Credit cards are not money.

25. Slide 14-25 Copyright © 2000 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

26. Slide 14-26 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.

27. Slide 14-27 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks and credit unions 4) Money market mutual funds

28. Slide 14-28 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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.

29. Slide 14-29 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries Commercial Banks 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.

30. Slide 14-30 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries Commercial Banks Their balance sheet is described by the following formula: Liabilities + Net Worth = Assets

31. Slide 14-31 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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 borrow. Lending is risky. Banks must be prudent in how they use their deposits.

32. Slide 14-32 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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

33. Slide 14-33 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries Three Types of Assets Held by Banks 1) Liquid assets are government Treasury bills and commercial bills. 2) Investment securities are longer-term government bonds and other bonds. 3)Loans are commitments of fixed amounts of money for agreed- uponperiods of time.

34. Slide 14-34 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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.

35. Slide 14-35 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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.

36. Slide 14-36 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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.

37. Slide 14-37 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries 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 Treasury bills

38. Slide 14-38 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries The Economic Functions of Financial Intermediaries 1)Creating Liquidity 2) Minimizing the cost of borrowing

39. Slide 14-39 Copyright © 2000 Addison Wesley Longman, Inc. Financial Intermediaries The Economic Functions of Financial Intermediaries 3) Minimizing the cost of monitoring borrowers 4) Pooling Risk

40. Slide 14-40 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Financial Regulation Two types of regulation faced by financial intermediaries: Deposit insurance Balance sheet rules

41. Slide 14-41 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation 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

42. Slide 14-42 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation 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.

43. Slide 14-43 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 2)Reserve requirements Rules setting out the minimum percentages of deposits that must be held in currency or other safe, liquid assets.

44. Slide 14-44 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 3) Deposit rules Restrictions on the different types of deposits that an intermediary can accept.

45. Slide 14-45 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 4) Lending rules Restrictions on the proportions of different types of loans that an intermediary may make.

46. Slide 14-46 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Deregulation in the 1980s (USA, UK) The Depository Institutions’ Deregulation and Monetary Control Act (DIDMCA), passed in 1980, removed many of the distinctions between commercial banks and other financial intermediaries.

47. Slide 14-47 Copyright © 2000 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

48. Slide 14-48 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Financial Innovation Financial innovation is the development of new ways of borrowing and lending. Primary aim is to increase the profit from financial intermediation.

49. Slide 14-49 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation The three main influences on financial innovation are: 1) Economic environment 2) Technology 3) Regulation

50. Slide 14-50 Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Financial Innovations Variable interest rate mortgages Widespread credit card usage Rise in the importance of the Eurodollar Paying interest on checkable deposits

51. Slide 14-51 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Explain how banks create money Explain why the quantity of money is an important economic magnitude Explain the quantity theory of money

52. Slide 14-52 Copyright © 2000 Addison Wesley Longman, Inc. 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.

53. Slide 14-53 Copyright © 2000 Addison Wesley Longman, Inc. How Banks Create Money Creating Deposits by Making loans in a One-Bank Economy Let’s see an example of how banks create money.

54. Slide 14-54 Copyright © 2000 Addison Wesley Longman, Inc. Creating Money at the One-and-Only Bank Balance sheet on January 1 Assets (millions of dollars) Liabilities (millions of dollars) Reserves$100Deposits$400 Loans$300 Total$400Total$400

55. Slide 14-55 Copyright © 2000 Addison Wesley Longman, Inc. Creating Money at the One-and-Only Bank Balance sheet on January 2 Assets (millions of dollars) Liabilities (millions of dollars) Reserves$101Deposits$401 Loans$300 Total$401Total$401

56. Slide 14-56 Copyright © 2000 Addison Wesley Longman, Inc. Creating Money at the One-and-Only Bank Balance sheet on January 3 Assets (millions of dollars) Liabilities (millions of dollars) Reserves$101Deposits$404 Loans$303 Total$404Total$404

57. Slide 14-57 Copyright © 2000 Addison Wesley Longman, Inc. How Banks Create Money The Deposit Multiplier

58. Slide 14-58 Copyright © 2000 Addison Wesley Longman, Inc. How Banks Create Money Creating Deposits by Making Loans with Many Banks Let’s see how the banking system creates money.

59. Slide 14-59 Copyright © 2000 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally Deposit $100,000 ReservesLoansDeposits $25,000$75,000$100,000 Loan $75,000 Deposit $75,000 Reserve $25,000 Loan $56,250 Reserve $18,750 $43,750$131,250$175,000

60. Slide 14-60 Copyright © 2000 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits 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

61. Slide 14-61 Copyright © 2000 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits $68,360$205,077$273,437 Loan $31,640 Reserve $10,547 and so on... $100,000$300,000$400,000

62. Slide 14-62 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Explain how banks create money Explain why the quantity of money is an important economic magnitude Explain the quantity theory of money

63. Slide 14-63 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

64. Slide 14-64 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

65. Slide 14-65 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level GDP equals the price level (P) times real GDP (Y), or: GDP = PY

66. Slide 14-66 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Make the quantity of money M, and the velocity of circulation V is determined by: V = PY/M

67. Slide 14-67 Copyright © 2000 Addison Wesley Longman, Inc. The Velocity of Circulation in the United States: 1930–1999

68. Slide 14-68 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or MV=PY

69. Slide 14-69 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

70. Slide 14-70 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

71. Slide 14-71 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level This can be shown by using the equation of exchange to solve for the price level. P = (V/Y)M

72. Slide 14-72 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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:

73. Slide 14-73 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Dividing this equation by an earlier one, P = (V/Y)M, gives us

74. Slide 14-74 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

75. Slide 14-75 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

76. Slide 14-76 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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.

77. Slide 14-77 Copyright © 2000 Addison Wesley Longman, Inc. Money Growth and Inflation in the United States

78. Slide 14-78 Copyright © 2000 Addison Wesley Longman, Inc. Money Growth and Inflation in the United States

79. Slide 14-79 Copyright © 2000 Addison Wesley Longman, Inc. Money Growth and Inflation in the World Economy

80. Slide 14-80 Copyright © 2000 Addison Wesley Longman, Inc. Money Growth and Inflation in the World Economy

81. Slide 14-81 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

82. Slide 14-82 Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level 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)?