CHAPTER 14 Money CHAPTER 14 Money Chapter 31 in Economics Michael Parkin ECONOMICS 5e

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 of the 1980s and 1990s

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

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

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.

Slide 14-6 Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Other functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value

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.

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.

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

Slide 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.

Slide Copyright © 2000 Addison Wesley Longman, Inc. What is Money? Money in the United States Today Money in the United States consists of: Currency Deposits at banks and other financial institutions

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

Slide 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.

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

Slide 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

Slide Copyright © 2000 Addison Wesley Longman, Inc. Two Measures of Money

Slide 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

Slide 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

Slide 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.

Slide 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

Slide 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.

Slide 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

Slide 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.

Slide 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.

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

Slide 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.

Slide 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

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

Slide 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.

Slide 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.

Slide 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.

Slide 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 U.S. Treasury bills

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

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

Slide 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

Slide 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

Slide 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.

Slide 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.

Slide 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.

Slide 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.

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

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Deregulation in the 1980s Other actions affecting financial intermediaries include: The passage of the Garn-St. Germain Depository Institutions Act in The abolition of Regulation Q in 1985.

Slide 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

Slide 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.

Slide 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

Slide 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

Slide 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

Slide 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.

Slide 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.

Slide 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

Slide 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

Slide 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

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

Slide 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.

Slide 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

Slide 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

Slide 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

Slide Copyright © 2000 Addison Wesley Longman, Inc. How Banks Create Money The Deposit Multiplier in the United States The actual deposit multiplier in the U.S. works the same as the one presented. However, it does differ in some aspects.

Slide Copyright © 2000 Addison Wesley Longman, Inc. How Banks Create Money The deposit multiplier in the United States differs from our model economy’s for three main reasons: 1)The actual required reserve ratio is smaller than the 25 percent used here. 2) Banks sometimes choose to hold excess reserves.

Slide Copyright © 2000 Addison Wesley Longman, Inc. How Banks Create Money The deposit multiplier in the United States differs from our model economy’s for three main reasons: 3)Not all loans made by banks return to them in the form of reserves.

Slide 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

Slide Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level We are going to study the effect the money supply has on real GDP, the price level, and the inflation rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The Short-Run Effects of a Change in the Quantity of Money Let’s study how a change in the quantity of money effects these factors by examining the aggregate supply-aggregate demand model.

Slide Copyright © 2000 Addison Wesley Longman, Inc. AD 1 SAS AD 0 Short-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. SAS 2 AD 2 SAS 1 AD 1 Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS 113 0

Slide 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

Slide 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.

Slide 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.

Slide 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

Slide 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

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

Slide 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

Slide 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.

Slide 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.

Slide 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

Slide 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:

Slide 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

Slide 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.

Slide 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.

Slide 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.

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

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

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

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

Slide 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.

Slide 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)?

Slide Copyright © 2000 Addison Wesley Longman, Inc. The End