12 MONEY CHAPTER.

12 MONEY CHAPTER

Objectives After studying this chapter, you will able to
Define money and describe its functions Explain the economic functions of banks and other depository institutions Describe some financial innovations that have changed the way we use money today Explain how banks create money Explain the effects of the quantity of money on the price level and real GDP, and explain the quantity theory of money

Money Makes the World Go Around
Money has taken many forms; what is money now? What do banks do, and can they create money? What happens if the amount of money grows rapidly?

What is Money? Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three other functions: Medium of exchange Unit of account Store of value The defining characteristic of money Adam Smith wrote, “Money is a commodity or token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange. That interpretation is wrong. Smith is defining money as the means of payment. Money is a commodity or token that everyone will accept as payment for the things they have to sell. When I was at the start of my career, I had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed). Anna made a remark that for me was one of those defining moments. She said money is the means of payment. Nothing else performs this function. It is unique to money. Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment—the means of settling a debt so that there is no remaining obligation between the parties to a transaction.

What is Money? Medium of Exchange
A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. Unit of Account A unit of account is an agreed measure for stating the prices of goods and services.

What is Money? Store of Value
As a store of value, money can be held for a time and later exchanged for goods and services. Money in the United States Today Money in the United States consists of: Currency Deposits at banks and other depository institutions Currency is the general term for bills and coins. Fiat money. To get across the idea of money, take a green piece of paper and cut it to the same size as a dollar bill. Then take the paper into class along with a dollar bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer? The contrast between money in economics and money in every day language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in every day language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why. A picky point. The textbook is careful to not use the term money supply in this chapter. Instead, it talks about the quantity of money. The money supply appears in the next chapter and is reserved for the relationship between the quantity of money and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention.

What is Money? The two main official measures of money in the United States are M1 and M2. M1 consists of currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses. M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits. Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you can poke fun at some of the suggestions. (Point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock.) By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.

What is Money? Figure 12.1 illustrates the composition of these two measures in 2001 and shows the relative magnitudes of the components of money.

What is Money? The items in M1 clearly meet the definition of money; the items in M2 do not do so quite so clearly but still are quite liquid. Liquidity is the property of being instantly convertible into a means of payment with little loss of value. Checkable deposits are money, but checks are not– checks are instructions to banks to transfer money. Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.

Depository Institutions
A depository institution is a firm that accepts deposits from households and firms and uses the deposits to make loans to other households and firms. The deposits of three types of depository institution make up the nation’s money: Commercial banks Thrift institutions Money market mutual funds Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text of course focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.

Commercial Banks A commercial bank is a private firm that is licensed to receive deposits and make loans. A commercial bank’s balance sheet summarizes its business and lists the bank’s assets, liabilities, and net worth. The objective of a commercial bank is to maximize the net worth of its stockholders.

To achieve its objective, a bank makes risky loans at an interest rate higher than that paid on deposits. But the banks must balance profit and prudence; loans generate profit, but depositors must be able to obtain their funds when they want them. So banks divide their funds into two parts: reserves and loans. Reserves are the cash in a bank’s vault and deposits at Federal Reserve Banks. Bank lending takes the form of liquid assets, investment securities, and loans.

Thrift Institutions The thrift institutions are: Savings and loan associations Savings banks Credit unions

A savings and loan association (S&L) is a depository institution that accepts checking and savings deposits and that makes personal, commercial, and home-purchase loans. A savings bank is a depository institution owned by its depositors that accepts savings deposits and makes mainly mortgage loans. A credit union is a depository institution owned by its depositors that accepts savings deposits and makes consumer loans.

Money Market Mutual Funds A money market fund is a fund operated by a financial institution that sells shares in the fund and uses the proceeds to buy liquid assets such as U.S. Treasury bills.

The Economic Functions of Depository Institutions Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans. This spread exists because depository institutions Create liquidity Minimize the cost of obtaining funds Minimize the cost of monitoring borrowers Pool risk

Financial Regulation, Deregulation, and Innovation
Depository institutions face two types of regulations: Deposit insurance Balance sheet rules This section can be easily motivated with a few ‘horror stories’—either of the 1930s, of the Savings and Loan scandals of the 1980s, of the former Soviet Union in the 1990s, or Argentina in Deposit insurance is a great example of an idea that created unintended consequences because of how it changed incentives for bankers; the Savings and Loan debacle illustrates the problem very well. A good discussion can arise out of asking students for suggestions as to how the negative consequences of current deposit insurance could be avoided while maintaining the benefits—bright students may see the possibilities in risk-adjusting premiums for banks or privatizing the insurance mechanisms. Students often think of innovation as inherently involving new concrete things—machines or products. Financial innovation is a great context in which to get across the idea that non-material innovations can be at least as important economically—perhaps the idea of limited liability being the archetype of a financial innovation with enormous economic impact.

Deposits at banks, S&Ls, savings banks, and credit unions are insured by the Federal Deposit Insurance Corporation (FDIC). This insurance guarantees deposits in amounts of up to $100,000 per depositor. This guarantee gives depository institutions the incentive to make risky loans because the depositors believe their funds to be perfectly safe; because of this incentive balance sheet regulations have been established.

There are four main balance sheet rules: Capital requirements Reserve requirements Deposit rules Lending rules

Deregulation in the 1980s The 1980s were marked by considerable financial deregulation, when federal legislation and rule changes lifted many of the restrictions on depository institutions, removing many of the distinctions between banks and others, and strengthening the control of the Federal Reserve over the system.

Deregulation in the 1990s In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed, which permits U.S. banks to establish branches in any state. It led to a wave of mergers.

Financial Innovation The 1980s and 1990s have been marked by financial innovation—the development of new financial products aimed at lowering the cost of making loans or at raising the return on lending. Financial innovation occurred for three reasons: The economic environment--high inflation Massive technological change Avoidance of regulation

Deregulation, Innovation, and Money The combination of deregulation and innovation has produced large changes in the composition of money, both M1 and M2.

How Banks Create Money Reserves: Actual and Required
The fraction of a bank’s total deposits held as reserves is the reserve ratio. The required reserve ratio is the fraction that banks are required, by regulation, to keep as reserves. Required reserves are the total amount of reserves that banks are required to keep. Excess reserves equal actual reserves minus required reserves.

How Banks Create Money Creating Deposits by Making Loans in a One-Bank Economy When a bank receives a deposit of currency, its reserves increase by the amount deposited, but its required reserves increase by only a fraction (determined by the required reserve ratio) of the amount deposited. The bank has excess reserves, which it loans. These loans can only end up as deposits in our one and only bank, where they boost deposits without changing total reserves, which creates money.

How Banks Create Money Figure 12.2 illustrates how one bank create money by making loans.

The deposit multiplier = 1/Required reserve ratio.
How Banks Create Money The Deposit Multiplier The deposit multiplier is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits. The deposit multiplier = 1/Required reserve ratio.

How Banks Create Money Creating Deposits by Making Loans with Many Banks With many banks, one bank lending out its excess reserves cannot expect its deposits to increase by the full amount loaned; some of the loaned reserves end up in other banks. But then the other banks have excess reserves, which they loan. Ultimately, the effect in the banking system is the same as if there was only one bank, so long as all loans are deposited in banks.

How Banks Create Money Figure 12.3 illustrates money creation with many banks. A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance. Mark Rush (our study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money”.) Label this piece of paper a “$100 bill.” In class hand one of the students the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Starke, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will clearly see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”

Money, Real GDP, and the Price Level
The Short-Run Effects of a Change in the Quantity of Money An increase in the quantity of money increases aggregate demand. The AD curve shifts rightward. Real GDP increases and the price level rises.

Figure 12.4 illustrates the effects of an increase in the quantity of money starting from below potential GDP. This section of the chapter has a lot of analytic content, and includes a number of things that can easily confuse students. Been here before. The section begins with another look at the AS-AD model and shows how a change in the quantity of money influences real GDP and the price level in the short run and the long run.

The Long-Run Effects of a Change in the Quantity of Money In the long run, real GDP equals potential GDP. An increase in the quantity of money at full employment increases real GDP and raises the price level. The money wage rate rises, which decreases short-run aggregate supply and decreases real GDP but raises the price level. In the long run, an increase in the quantity of money leaves real GDP unchanged but raises the price level.

Figure 12.5 illustrates the effects of an increase in the quantity of money starting from potential GDP.

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. The quantity theory of money is based on the velocity of circulation and the equation of exchange. The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP. Velocity of circulation. Emphasize that velocity is defined by the equation V = PY/M, and is not the average number of times a given piece of paper changes hands in a year. Nor is V the transactions velocity because most transactions are not payments for goods and services. (Transactions are twice PY because they also include payments for the services of factors of production, which equals PY, plus all the purely financial transactions such as buying and selling stocks, bonds, foreign currency, and real estates.) The quantity theory of money. Given that V is defined as PY/M, the equation of exchange, MV = PY is an identity. The quantity theory is not the equation of exchange but the propositions that (1) V is independent of M and (2) Y equals potential GDP, which is independent of M. Given these assumptions, the inflation rate equals the growth rate of the quantity of money. The quantity theory of hyperinflation. A possible exercise is to ask students whether we would expect the correlation between money growth and inflation to remain strong in a hyperinflation. Most will see that in a hyperinflation, velocity will increase. Emphasize that the level of velocity is greater in hyperinflation but if the inflation rate remains constant (and high) velocity also is constant (and high), so the quantity theory still holds. It does not hold in the move from low inflation to high inflation. The inflation rate overshoots the growth rate of the quantity of money.

Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M V = PY/M. Figure 12.6 on the next slide graphs the velocity of circulation for M1 and M2 for 1961–2001.

The equation of exchange states that MV = PY The quantity theory assumes that velocity and potential GDP are not affected by the quantity of money. So P = (V/Y)M Because (V/Y) does not change when M changes, a change in M brings a proportionate change in P.

That is, the change in P, P, is related to the change in M, M, by the equation: P = (V/Y)M Divide this equation by P = (V/Y)M and the term (V/Y) cancels to give P/P = M/M P/P is the inflation rate and = M/M is the growth rate of the quantity of money.

The Quantity Theory and the AS-AD Model The quantity theory of money can be interpreted in terms of the AS-AD model. In the long run, real GDP equals potential GDP and according to the AS-AD model, an increase in the quantity of money brings an equal percentage rise in the price level. The AS-AD model also makes clear why the quantity theory is a long-run theory. In the short run, an increase in the quantity of money brings an increase in real GDP and a smaller than proportionate increase in the price level.

Historical Evidence on the Quantity Theory of Money Historical evidence shows that U.S. money growth and inflation are correlated, more so in the long run than the short run, which is broadly consistent with the quantity theory.

Figure 12.7 graphs money growth and inflation in the United States from 1931 to 2001. Part (a) shows year-to-year changes.

Part (b) shows decade average changes.

International Evidence on the Quantity Theory of Money International evidence shows a marked tendency for high money growth rates to be associated with high inflation rates. Figure 12.8 shows the evidence.

Correlation, Causation, and Other Influences Correlation is not causation; money growth and inflation could be correlated because money growth causes inflation, or because inflation causes money growth, or because a third factor causes both. But the combination of historical, international, and other independent evidence gives us confidence that in the long run, money growth causes inflation. In the short run, the quantity theory is not correct; we need the AS-AD model.

12 MONEY CHAPTER THE END

12 MONEY CHAPTER.

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