The Role of Money in the Macroeconomy Introduction of the Concepts 1

Financial Markets/Institutions Bringing together of buyers and sellers of financial securities to establish prices Provides 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

Money Currency – bills and coins Includes demand deposits (checking accounts) issued by banks Plays a key role in influencing the behavior of the economy as a whole and the performance of financial institutions and markets

Monetary Economy Facilitates transactions within the economy Principal mechanism through which central banks attempt to influence aggregate economic activity Economic Growth Employment Inflation

Banking Place where savers can invest their funds to earn interest with a minimum of risk. Make loans to individuals and small businesses

Banks Banks 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

Monetary Policy The Fed directly influences the lending and deposit creation activities of banks

Flow of funds from lenders to borrowers

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 inflation Too little money will result in an inefficient economy

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 exchange it is the only financial asset that virtually every business, household, and unit of government will accept in payment of goods and services. Store of value reserve of future purchasing power. 3

Liquid Asset Something that can be turned into a generally acceptable medium of exchange, without loss of value Liquidity is a continuum from very liquid to illiquid Currency and checking accounts are most liquid assets

Monetary Base A “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.

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

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.

Monetary Aggregate A grouping of assets sufficiently liquid to be defined as a measure of money.

What is the money supply? currency+checking accounts M2 M1 + savings accounts + small CDs +MMDA +MMMF M3 M2 + large CDs 4

Who Determines Our Money Supply? Federal Reserve is responsible for execution of national monetary policy Created by Congress in 1913 Twelve district Federal Reserve Banks scattered throughout the country Board of Governors located in Washington, D.C.

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 preferences Fed implements monetary policy by altering the money supply and influencing bank behavior

Barter Direct exchange of goods/services for other goods/services Very inefficient and limited economy No medium of exchange or unit of account Requires double coincidence of wants—”I have something you want and you have something I want” Items must have approximate equal value Need to determine the “exchange rate” between different goods/services

Money Any commodity accepted as medium of exchange can be used as money Frees people from need to barter Makes exchange more efficient Permits specialization of labor—sell one’s labor to the market in exchange for money to purchase goods/services

Money Prices, expressed in money terms, permit comparison of values between different goods Must 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

How Large Should the Money Supply Be? Purchase goods/services economy can produce, at current prices Generate level of spending on Gross Domestic Product (GDP) that produces high employment and stable prices Monetary Policy is used as a countercyclical tool—vary the money supply to influence economic activity

Increases in the Money Supply Alters Public’s Liquidity and Influences Spending Direct Impact—excess liquidity is spent on goods/services Indirect Impact—purchase financial assets which lowers interest rates which stimulates business investment and consumer spending However, changes in liquidity may alter demand for money and not influence GDP—people hoard the additional money Public’s reaction to changes in liquidity is not consistent, so Fed cannot always judge impact of a change in money supply

Velocity When the Fed increases the money supply, recipients of this additional liquidity probably will spend some on GDP Over time there will be a multiple increase in spending

Velocity of Money The number of times the money supply turns over in a period of time to support spending on output The Fed has no control over the velocity of money since this is dependent on behavior of the public It 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

Velocity of Money Velocity 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

Money and Inflation Inflation—Persistent rise of prices Hyperinflation—Prices rising at a fast and furious pace Deflation—Falling prices, usually during severe recessions or depressions Inflation reduces the real purchasing power of the currency—can buy fewer goods/services with the same nominal amount of money

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 supply Increase in money supply is a necessary condition for persistent inflation, but it is probably not a sufficient condition

Examples Case 1—Economy in a recession. Expanding money supply may lead to more employment and higher output Case 2—Economy near full employment/output. Expanding money supply can lead to higher output/employment, but also higher prices Case 3—Economy producing at maximum. Expanding money supply will most likely lead to increasing inflation.

Money and Inflation To return to the 1940s, the smallest bill would be $10 and the smallest coin would be a dime. 10

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.

Who creates money? The Federal Reserve Depository Institutions The Public 5

Fractional Reserve System Required Reserves Excess Reserves 11

How a bank creates money Assets Claims Reserves Transactions Deposits Securities Savings Deposits Loans CDs Equity 12

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.

Money in the Digital Economy Electronic Payments Automated 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.