Presentation on theme: "The Role of Money in the Macroeconomy"— Presentation transcript:
1 The Role of Money in the Macroeconomy Introduction of the Concepts1
2 Financial Markets/Institutions Bringing together of buyers and sellers of financial securities to establish pricesProvides a mechanism for those with excess funds (savers) to lend to those who need funds (borrowers)Includes banks, savings and loans, credit unions, investment banks and brokers, mutual funds, stock and bond markets
3 Money Currency – bills and coins Includes demand deposits (checking accounts) issued by banksPlays a key role in influencing the behavior of the economy as a whole and the performance of financial institutions and markets
4 Monetary Economy Facilitates transactions within the economy Principal mechanism through which central banks attempt to influence aggregate economic activityEconomic GrowthEmploymentInflation
5 BankingPlace where savers can invest their funds to earn interest with a minimum of risk.Make loans to individuals and small businesses
6 BanksBanks serve as the principal caretaker of the economy’s money supply, and along with other financial intermediaries, provide important source of funds.Banks are intimately involved in how the Federal Reserve influences overall economic activity
7 Monetary PolicyThe Fed directly influences the lending and deposit creation activities of banks
9 What is the proper amount of money for the economy? Sir William Petty (1623–87) wrote in 1651“To which I say that there is a certain measure and proportion of money requisite to drive the trade of a nation, more or less than which would prejudice the same”Too much money will lead to inflationToo little money will result in an inefficient economy
10 Functions of Money Standard of value Medium of exchange Store of value or unit of account for all the goods and services we might wish to trade.Medium of exchangeit is the only financial asset that virtually every business, household, and unit of government will accept in payment of goods and services.Store of valuereserve of future purchasing power.3
11 Liquid AssetSomething that can be turned into a generally acceptable medium of exchange, without loss of valueLiquidity is a continuum from very liquid to illiquidCurrency and checking accounts are most liquid assets
12 Monetary BaseA “base” amount of money that serves as the foundation for a nation’s monetary system.Under a gold standard, the amount of gold bullion.In a fiat money system, the sum of currency in circulation plus reserves of banks and other depository institutions.
13 The Monetary Base Currency: Reserves: Coins and paper money.Reserves:Cash held by depository institutions in their vaults or on deposit with the Federal Reserve System.Monetary Base = Currency + Reserves
14 The Use Of Coins Seigniorage: Debasement: The difference between the market value of money and the cost of its production, which is gained by the government that produces and issues the money.Debasement:A reduction in the amount of precious metal in a coin that the government issues as money.
15 Monetary AggregateA grouping of assets sufficiently liquid to be defined as a measure of money.
16 What is the money supply? currency+checking accountsM2M1 + savings accounts + small CDs +MMDA +MMMFM3M2 + large CDs4
17 Who Determines Our Money Supply? Federal Reserve is responsible for execution of national monetary policyCreated by Congress in 1913Twelve district Federal Reserve Banks scattered throughout the countryBoard of Governors located in Washington, D.C.
18 Who Determines Our Money Supply? Fed influences the total money supply, but not the fraction of money between currency and demand deposits which is determined by public preferencesFed implements monetary policy by altering the money supply and influencing bank behavior
19 Barter Direct exchange of goods/services for other goods/services Very inefficient and limited economyNo medium of exchange or unit of accountRequires double coincidence of wants—”I have something you want and you have something I want”Items must have approximate equal valueNeed to determine the “exchange rate” between different goods/services
20 MoneyAny commodity accepted as medium of exchange can be used as moneyFrees people from need to barterMakes exchange more efficientPermits specialization of labor—sell one’s labor to the market in exchange for money to purchase goods/services
21 MoneyPrices, expressed in money terms, permit comparison of values between different goodsMust retain its value—the value of money varies inversely with the price level (inflation)If money breaks down as a store of value (hyperinflation), economy resorts to barter
22 How Large Should the Money Supply Be? Purchase goods/services economy can produce, at current pricesGenerate level of spending on Gross Domestic Product (GDP) that produces high employment and stable pricesMonetary Policy is used as a countercyclical tool—vary the money supply to influence economic activity
23 Increases in the Money Supply Alters Public’s Liquidity and Influences Spending Direct Impact—excess liquidity is spent on goods/servicesIndirect Impact—purchase financial assets which lowers interest rates which stimulates business investment and consumer spendingHowever, changes in liquidity may alter demand for money and not influence GDP—people hoard the additional moneyPublic’s reaction to changes in liquidity is not consistent, so Fed cannot always judge impact of a change in money supply
24 VelocityWhen the Fed increases the money supply, recipients of this additional liquidity probably will spend some on GDPOver time there will be a multiple increase in spending
25 Velocity of MoneyThe number of times the money supply turns over in a period of time to support spending on outputThe Fed has no control over the velocity of money since this is dependent on behavior of the publicIt is possible the public will choose to hold onto the additional liquidity (hoarding of money)Ultimately, the Fed needs to be concerned whether the additional spending which results from increased money supply will result in higher production or higher prices
26 Velocity of MoneyVelocity is the way in which the quantity of money is related to economic activity.The speed with which money is spent.Velocity = changes in spending/quantity of money = ΔGDP/ΔM.If Velocity = 5, then if M increases by $10 billion, GDP will rise by $50 billion.9
27 Money and Inflation Inflation—Persistent rise of prices Hyperinflation—Prices rising at a fast and furious paceDeflation—Falling prices, usually during severe recessions or depressionsInflation reduces the real purchasing power of the currency—can buy fewer goods/services with the same nominal amount of money
28 Money, The Economy, and Inflation Economists generally agree that, in the long-run, inflation is a monetary phenomenon—can occur only with a persistent increase in money supplyIncrease in money supply is a necessary condition for persistent inflation, but it is probably not a sufficient condition
29 Examples Case 1—Economy in a recession. Expanding money supply may lead to more employment and higher outputCase 2—Economy near full employment/output.Expanding money supply can lead to higher output/employment, but also higher pricesCase 3—Economy producing at maximum.Expanding money supply will most likely lead to increasing inflation.
30 Money and InflationTo return to the 1940s, the smallest bill would be $10 and the smallest coin would be a dime.10
31 Hyperinflation Example Hyperinflation occurred in Germany after World War I, with inflation rates sometimes exceeding 1000 percent per month. By the end of hyperinflation in 1923, the price level had risen to more than 30 billion times what it had been just two years before. The quantity of money needed to purchase even the most basic items became excessive. Near the end of the hyperinflation, a wheelbarrow of cash would be required to pay for a loaf of bread. Money was losing its value so rapidly that workers were paid and given time off several times during the day to spend their wages before the money became worthless. No one wanted to hold on to money, and so the use of money to carry out transactions declined and barter became more and more dominant.
32 Who creates money? The Federal Reserve Depository Institutions The Public5
33 Fractional Reserve System Required ReservesExcess Reserves11
34 How a bank creates money Assets ClaimsReserves Transactions DepositsSecurities Savings DepositsLoans CDsEquity12
35 Money and Banking in the Digital Age Cybertechnologies:Technologies that connect savers, investors, traders, producers, and governments via computer linkages.Electronic money (e-money):Money that people can transfer directly via electronic impulses.Wire transfers:Payments made via telephone lines or through fiber-optic cables.
36 Money in the Digital Economy Electronic PaymentsAutomated clearinghouses:Institutions that process payments electronically on behalf of senders and receivers of those payments.Point-of-sale (POS) transfer:Electronic transfer of funds from a buyer’s account to the firm from which a good or service is purchased at the time the sale is made.Automated bill payment:Direct payment of bills by depository institutions on behalf of their customers.
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