1. Copyright  2000 by Harcourt, Inc. 1-1 CHAPTER 1 MONEY AND INFLATION Copyright ©2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

2. Copyright  2000 by Harcourt, Inc. 1-2 What is money? l Money is a generalized claim on all other assets. It must be acceptable, scarce, desirable, and divisible.

3. Copyright  2000 by Harcourt, Inc. 1-3 Three Properties of Money l Medium of Exchange--A financial asset (money) is used to trade (exchange) real assets (goods and services). l Store of Value--Money serves as a means of storing purchasing power. l Unit of Account--All prices are denominated in terms of the monetary unit, such as the dollar.

4. Copyright  2000 by Harcourt, Inc. 1-4 Types of Assets that Serve as Money l Physical or Full-Bodied Money -- Assets with real or intrinsic value that serve as money as long as their value in exchange exceeds their value in use. l Representative Money -- Assets with little or no intrinsic value, such as currency and cheap metal coins, that represent claims on assets with intrinsic value. l Deposit or Credit Money -- Assets without either intrinsic value or representative value. Credit money (deposit liabilities of banks) are backed by financial assets, such as loans or securities.

5. Copyright  2000 by Harcourt, Inc. 1-5 Definition of the Money Supply l The Transaction Approach--Any definition of the money supply relating money to current spending. –Money (M 1 ) is special--It is the medium of exchange in the economy. Money is obtained for the purpose of spending. –All other assets must be converted to money (M 1 ) before "spending".

6. Copyright  2000 by Harcourt, Inc. 1-6 Definition of the Money Supply (continued) l The Store of Value Approach--Any definition of the money supply associating money to its ability to store or hold purchasing power through time. Spending may occur now or later. –Money serves as a store of purchasing power. –Monetarists believe that liquid, near-money financial assets, such as M 2, M 3, serve as means to "store" purchasing power. –MZM is a definition of money that includes those parts of M 2 and M 3 that can be obtained immediately.

7. Copyright  2000 by Harcourt, Inc. 1-7 Current Definitions of Money and the Money Supply Source: Federal Reserve Bank of St. Louis monetary data for September 1998.

8. Copyright  2000 by Harcourt, Inc. 1-8 Liquidity of an Asset --The ease or cost of converting an asset to money. l Transaction Costs--Costs involved in converting an asset to money (brokerage fees). l Price Risk--Potential loss of value involved in the conversion (sale) of an asset to money. l The liquidity of an asset is inversely related to transaction costs and to the price risk of an asset. The higher the transaction costs and the greater the price variation of an asset, the less the liquidity of an asset.

9. Copyright  2000 by Harcourt, Inc. 1-9 Money and Money Substitutes l Credit Cards Versus Debit Cards –Deposit balances, a part of the money supply, are liabilities (credit balance) of depository institutions. –A check, paper or electronic order, transfers (debits) deposits to new owners and their designated bank.

10. Copyright  2000 by Harcourt, Inc. 1- 10 Money and Money Substitutes (continued) –Debit cards, used in automatic teller machines (ATM), point of sale terminals where payment is made electronically, or in a paper-based system when something is purchased. A debit to a credit deposit balance reduces the balance. Hence, the name, debit card.

11. Copyright  2000 by Harcourt, Inc. 1-11 Money and Money Substitutes (continued) –Credit cards are preapproved lines of credit. When used, the bank is making a loan (asset) and paying someone (deposit). Later, the credit card user pays off the loan with a check (debit to their deposit account). Credit card usage is not a money or deposit transfer. It is a loan/deposit transaction, increasing the money supply, until the credit card bill is paid.

12. Copyright  2000 by Harcourt, Inc. 1- 12 Money and Money Substitutes (continued) l Money Market Mutual Funds (MMMF) and Stock and Bond Mutual Funds –MMMF are investment companies that issue $1 shares in return for money to invest in liquid, short- term, high quality debt securities. –MMMF balances are a store of value and are a part of the M 2 money supply definition, not the M 1 definition of transaction balances.

13. Copyright  2000 by Harcourt, Inc. 1- 13 Money and Money Substitutes (concluded) –Mutual funds, other than MMMF, also have check- writing services, though the value of the MF shares vary with the value of the asset, stocks, bonds, commodities, etc.

14. Copyright  2000 by Harcourt, Inc. 1- 14 Role of Money in an Economy l To facilitate efficient (lowest cost) exchange between economically specialized persons. l Barter is inefficient and does not facilitate exchange. There are many barter prices for an item in a barter economy; only one price in a money economy.

15. Copyright  2000 by Harcourt, Inc. 1- 15 Transmission Mechanism for Monetary Policy: Keynesian View

16. Copyright  2000 by Harcourt, Inc. 1- 16 The value of money is evidenced in its purchasing power. l Sustained decreases in the ratio (exchange value) between money (financial assets) and goods and services (real assets) represent a decline in the purchasing power of money. l The value of money can be measured by the change in price levels. Inflation is an increase in the general price level over time. The value of money can be measured by inflation.

17. Copyright  2000 by Harcourt, Inc. 1- 17 Price Index --A measure of the price levels at a particular point in time. l A broadly determined market basket of goods and services is assembled and priced for the (base year) starting point. l Using the base year as 100, subsequent prices for the market basket are compared to the "base" year. l Changes in the price index measures the inflation or deflation rate and thus the changing value of money.

18. Copyright  2000 by Harcourt, Inc. 1- 18 Widely Used Price Indices l The Consumer Price Index (CPI) -- The price of a broad consumer market basket of new, final goods and services. Updated monthly. l Producer Price Index (PPI) -- A set of prices for a cross section of intermediate (not final) goods. Updated monthly. l Gross Domestic Product Deflator -- A set of prices for all goods and services included in GDP. Updated quarterly.

19. Copyright  2000 by Harcourt, Inc. 1- 19 Annual Rate of Inflation (CPI) for the Economy (1965-1998) Source: Economic Report of the President, 1991 and Federal Reserve Bank of St. Louis FRED data base after 1990.

20. Copyright  2000 by Harcourt, Inc. 1- 20 Using Price Indices --Comparing nominal (current market prices) and real (purchasing power) values. l Nominal values are price-weighted measures of goods and services. Nominal values increase and decrease as prices rise and fall, respectively. In the base year (period) of a price index, the nominal value equals the real value. l Real values are nominal values adjusted (deflated) for price level changes. With increases in the price level (measured by the price index), the real values decline.

21. Copyright  2000 by Harcourt, Inc. 1- 21 Using Price Indices (concluded) l Nominal prices may be deflated to a common base year to determine the real value with: –D 1 = dollars in Period 1 (Place 1) purchasing-power units. –D 2 = dollars in Period 2 (Place 2) purchasing-power units. –PI 1 = price index for Period 1 (Place 1). –PI 2 = price index for Period 2 (Place 2).

22. Copyright  2000 by Harcourt, Inc. 1- 22 Inflation Summary --Continued increase in average price levels. l With unanticipated inflation, wealth transfers from savers to borrowers in financial markets. l Persons with fixed incomes are able to buy less in periods of inflation. l Interest rates, the time price of money, increase with inflation. l Inflation is associated with periods of high money supply growth relative to the growth of the economy.