We just understood the equilibrium and transmission mechanisms of the goods market. Now we will analyze the money market…
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Presentation on theme: "We just understood the equilibrium and transmission mechanisms of the goods market. Now we will analyze the money market…"— Presentation transcript:
1 We just understood the equilibrium and transmission mechanisms of the goods market. Now we will analyze the money market…
2 Overview of money - What is money? Money supply - Types of money Roles of money (medium of exchange, unit of account, store of value).- Types of moneyCommodity money, fiduciary money, fiat money.- Measuring money M1 and M2- Should each country has one “official” own money?Money supply- Institutions involved in money creation- Private banks- Central Bank Open market operations, required reserve ratio, discount rate- Supply curve of money
3 Overview of money What is money? -- Medium of exchange (quintessential function):What sellers generally accept and buyers generally use to pay for goods and services.A monetary economy is welfare improving compared with barter economy because it avoids mutual coincidence of wants.- Unit of account:A standard unit that provides a consistent way of quoting pricesExample:
4 A standard unit that provides a consistent way of quoting prices - Unit of account:A standard unit that provides a consistent way of quoting pricesExamples:a) 2 goods: Lunches (L) and cloth (C)→ 1 relative price: L in terms of unit of Cb) 3 goods: Lunches (L), cloth (C) and wood (W)→ 3 relative prices: L in terms of unit of CL in terms of unit of WC in terms of unit of Wc) n goods: → relative prices(e.g. n=1000 → relative prices)In a monetary economy you just need n prices in terms of money!
5 - Liquidity of money: - Store of value: An asset that can be used to transport purchasing power from one time period to another.- Liquidity of money:The property of money that makes it a good medium of exchange as well as a store of value.
6 Types of money - Fiduciary money: - Commodity money: Items used as money that also have intrinsic value in some other use.- Fiduciary money:Paper money that is backed by precious metals or other commodities.- Fiat money: Paper money that is intrinsically worthless.
9 Measuring money - Remember… - What is money and what is not? Liquidity Money is an asset that is issued to: i) buy things (medium of exchange) ii) to hold wealth (store of value) iii) to quote prices (unit of account)- What is money and what is not?Coins and currency money Checking account Traveler’s checks Savings accounts Certificate of depositLiquidity
10 - Different measures of money based on liquidity M1 = currency held outside banks + checking accounts traveler’s checks + other checkable depositsM2 = M1 + savings accounts + money market accounts small certificate of deposits
11 Should each country has one “official” own money? - As a general rule, each country has one “official” own moneyUS$, Argentinean Peso, Chinese Yuan- Some countries share a common currencyEuro, East Caribbean dollar, Colonies françaises d'Afrique ("French colonies of Africa")- Some countries have not own or shared currency Ecuador (since 2000), Panama - Some countries have more than one “currency” Argentina has more than 15 currencies!
12 Money supply Institutions involved in money creation - Central Bank (e.g. the Federal Reserve in the US):Monetary institution that has the legal authority to issue bills and coins.Among other functions it regulates the banking system and is the lender of last resort.- Private banks (e.g. Bank of America):Act as a link between those who have money to lend and those who want to borrow money.Central bank and Private banksEquilibrium in money marketEquilibrium interest rate
13 Private banks - Balance sheet of a typical private bank - Brief review of accounting- Balance sheet of a typical private bank- The creation of money- The money multiplier
14 Central Bank- The Central Bank can determine the supply of notes (bills and coins).- Let us examine the balance sheet of the Central Bank (Fed 2005, millions of US$).Assets LiabilitiesGold $11, Federal reserve notes $729,601 Loans to banks ,330 Deposits: US treasure Bank reserves ,130 securities 724, US treasury , Other liabilities and net worth 60,366TOTAL $820,910 TOTAL $820,910
15 - How does the Central Bank controls the money supply? If Central Bank wants to ↑Ms creates more reserves there by freeing banks to create additional deposits by making more loans.If it wants to decrease the money supply, it reduces reserves.The Central Bank has available 3 tools:1) Engaging in open market operations2) Changing the required reserve ratio3) Changing the discount rate
16 1) Engaging in open market operations The purchase and sale by the Central Bank of government securities (bonds) in the open market.Example: Central Bank sells gov. securities ↓Ms∆Ms = money multiplier ∆reserves = 5 * (-5) = -25
17 2) Changing the required reserve ratio Increases (decreases) in the required reserve ratio allows banks to have less (more) deposits with the existing volume of reserves, therefore decreasing (increasing) the supply of money.Example: Central Bank reduce reserve ratio from 20% to 12.5% ↑Ms∆Ms = ∆money multiplier reserves = (8 - 5) * 100 = 300
18 3) Changing the discount rate (interest rate that banks pay to the Central Bank to borrow from it) discount rate ↑cost of borrowing ↓loans to banks ↓reserves ↓MsExample: Central Bank ↓discount rate ↑Ms∆Ms = money multiplier ∆reserves money multiplier ∆loans = 5 * 20 = 100