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a. What is money?

•According to the most issued by a financial institution which functions as


common definition of money, money is cash but is protected against loss or theft. M1=
anything that is routinely used to pay for currency:+ checking account deposits:+traveler’s
goods and services and to pay off debts-- checks. M2=savings accounts, money market
anything readily acceptable as a means of funds.M3 is a broad definition of money (in terms
payment. b.Barter and the double coincidence of its components) consisting of M2, plus various
of w ants—Importance of money•The alternative kinds of large deposit accounts with balances
to a money economy is a barter economy in exceeding $l00,000, including institutional money
which all exchanges are straight trades of goods market mutual funds and European accounts held
and services.The problem with a barter economy is by U.S. citizens. Why do we include checking
that bartered exchange requires a double accounts in our measure of money?Simply
coincidence of wants: the unlikely occurrence because they are spendable cash; so many
that two people each have a good the other wants. payments are made by checks, and checks are
Most people would have to spend time searching for readily accepted as means of payments.Dollar bills
others to trade with a huge waste of resources. are called Federal Reserve Notes (FRN) because
Money has three main properties or functions. they are issued by the Federal Reserve.Banking
It serves as (1) the medium of exchange, (2) the system, the “Fed”, which is the central bank for the
unit of account, and (3) a store of value.(1)The United States; FRN: a dollar bill of any
medium of exchange:The defining property of denomination that is the paper currency of the
money. Something serves as a medium of U.S.f.Money versus incomeMoney is a stock
exchange if people are routinely willing to accept it variable. It is determined at one point in time; it
in exchange for goods and services (including does not really have any time dimension.Income is
factors of production).(2) The unit of account:The a flow variable, such as the amount earned over a
unit of account is the standard that defines the period of time. It is determined with reference to
value of goods and services exchanged.(3) A store two points in time.g.Central Banks & Monetary
of value:A store of value is an asset that can be PolicyCentral bank: an institution that oversees
used to transport purchasing power from one period the banking system and regulates the money
to another. To serve these three supply.Monetary policy: the setting of the money
purposes,money should be: durable (gold is supply by policymakers in the central bank. Federal
durable, but ice-cream or fish are not); divisible (to Reserve (Fed): the central bank of the U.S.h.How
facilitate small purchases as well as large--wheat banks create and destroy moneyThe Fed
might work but tractors would not); limited in controls the money supply and regulates banks.
supply (so as to have high value per weight or Banks clearly play an important role in the money
volume measure; thus sand would not work well, supply because bank deposits are part of the
even though it is durable and divisible).d.The 2 money supply (recall that Ml includes checking
ki nds of moneyCommodity money: takes the account deposits, and M2 also includes savings
form of a commodity with intrinsic value.Intrinsic account deposits).Creating and destroying
value means the commodity would have value even FRNsThe Fed exchanges Treasury securities with a
if it weren’t being used as money.Fiat money: few large securities dealers in the secondary Open
money without intrinsic value, used as money Market. An exchange of its Treasury securities by
because of government decree.Fiat money is the Fed is called an Open Market Operation.The
worthless – except as money.Example:the U.S. Fed buys Treasury securities from the dealers to
dollar.e.How is the money supply measured? increase the amount of FRNoutstanding - Open
How money is measuredThe money supply (or market purchase.The Fed sells Treasury
money stock): the quantity of money available in securities to the dealers to decrease the amount of
the economy.According to the most common FRNoutstanding - Open Market sale.Creating
definition, the money supply consists of three and destroying checking account
items: (1) Currency: the paper bills and coins of balancesCommercial banks create new checking
various denominations circulating in the economy account balances when they make loans. Calling in
(in the hands of the (non-bank) public).(2) Demand loans or deciding not to write new loans as old
(checking) deposits: checking accounts with loans are repaid decreases the amount of checking
unlimited checking privileges (providing the account balances.Banks usually make loans up
account has sufficient funds); balances in bank to the point where they can no longer do so
accounts that depositors can access on demand by because of the reserve requirement
writing a check.(3) Traveler’s checks: check restriction. Legal reserves, reserve
requirement, reserve required ratio, required Legal reserves = Required reserves + Excess
reserves.The required reserves are the holdings
reserves, excess reservesBank’s "legal of cash and funds on deposit with the Fed by
reserves" is defined as the deposits kept at the depository institutions that are required by law to
central bank by depository institutions (banks) plus backstop the public’s deposits held by these same
institutions. Required reserves are equal to the
their cash on hand (currency and coin in the vaults product of each type of deposit subject to reserve
of depository institutions).Legal requirements times the reserve requirement
reserves=deposits at Fed + cash in vaults of percentages set by the Federal Reserve Board. (See
previous example).The excess reserves are the
depository institutions.In a fractional reserve difference between total legal reserves held by a
banking system, banks keep a fraction of deposits depository institution and its required
as reserves and use the rest to make loans.The Fed reserves.Excess reserves represent funds
which can be loaned out and therefore are the
establishes reserve requirements, regulations on sources of funds from which the nation’s
the minimum amount of reserves that banks must money supply grows. Excess reserves may also
be used to purchase securities, or for other
hold against deposits.The reserve requirement
purposes. Banks don't hold 100% reserves
(or required reserve ratio), denoted by RR, is the because it's more profitable to use the
percentage of its total deposits that a bank must reserves to make loans, which earn interest.
Because legal reserve assets earn little or no
keep as legal reserves at the central bank (Fed).
income, most depository institutions keep
Reserve requirements are regulations on the their excess reserves close to zero. When
minimum amount of reserves that banks must hold excess reserves are zero, then (actual) legal
reserves = required reserves, and banks are
against deposits.
said to be fully loaned up--they have loaned out
the maximum amount authorized by law.The
Banks may hold more than this minimum amount if
money (deposit expansion) multiplier:the
they choose.The reserve ratio, R, is the fraction of
amount of money (deposits) the banking system
deposits that banks hold as reserves, or total
generates with each dollar of reserves.
reserves as a percentage of total deposits. (Actual)
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Also, an increase in bank reserves leads to a of central banking in the pursuit of
greater than one-for-one increase in deposits monetary policy:i.Full employment of
(and loans), hence, the money supply. The resources ii.Reasonable price stabilityiii.
money multiplier is the relationship between Sustainable economic growthiv. Stable balance
the final change in the money supply and the of payments positionk. How the Fed
change in reserves that caused this controls the money supply—The tools of
change.The money (deposit expansion) monetary policyThe Fed controls the money
multiplier=multiple by which money supply supply by controlling the amount of reserves in
(deposits)can increase for every dollar increase the banking system.If the Fed wants to
in reserves.Under four assumptions:(l) No increase the money supply, it creates more
one wants to hold FRNs or “pocket money”;(2) reserves, thereby freeing banks to create
Banks are “fully loaned-up”; (3) No thrifts or additional deposits by making new loans.If it
saving accounts;(4) No leakages to the foreign wants to reduce the money supply, it reduces
banking system.Three important properties reserves. Three tools that the Fed uses to
of money multiplier:(l) No the same as affect reserves:(l) Open Market Operations
spending multiplier;(2) It is symmetric;(3) (OMO: OMP or OMS)—The most important tool
Inversely related to the reserve requirement.i. today. (2) The reserve requirement (RR)(3) The
The Federal Reserve System—Its role and discount rate(DR)Open-Market Operations
functionsThe Federal Reserve System is the (OMOs)The purchase and sale of U.S.
central bank of the United States. The Federal government bonds by the Fed.•To increase
Reserve Bank originally was to provide an money supply, Fed buys govt bonds, paying
elastic currency and perform the fairly with new dollars.which are deposited in banks,
automatic tasks required to maintain the price increasing reserves.which banks use to make
of gold and keep the U.S. on the gold standard. loans, causing the money supply to
(1) Bankers’ bank; Holds reserves against expand.•To reduce money supply, Fed sells
deposits for the depository institutions(2) The govt bonds, taking dollars out of circulation,
clearing and collection of checks and other and the process works in reverse. •OMOs are
means of payment; Maintaining and improving easy to conduct, and are the Fed’s monetary
the nation’s payments mechanism (3) Issuing policy tool of choice.Reserve Requirements
currency and coin and providing other (RR): affect how much money banks can
services(4) Lender of last resort for financial create by making loans.•To increase money
institutions in need of reserves to prevent runs supply, Fed reduces RR. Banks make more
on banks(5) Stabilizing the money and capital loans from each dollar of reserves, which
markets (financial markets)(6) Supervising of increases money multiplier and money
the depository institutions to ensure that they supply.Discount Rate (DR): the interest rate
engage in sound banking practices; Maintaining on loans the Fed makes to bank.• Why
a sound banking and financial system(7) might banks run low on reserves?•On any
Serving as the federal government’s fiscal given day, it might turn out that depositors
agent(8) Carrying out monetary policy; Control make higher-than-expected withdrawals, or the
of the nation’s money supply(9) Providing bank makes more loans than expected.•The
information to the public.The ultimate goals Fed uses discount lending to provide extra
liquidity when financial institutions are ind d Transactions and prices are denominated in
trouble, e.g. after the Oct. l987 stock market nominal terms. The dollar value of a given
crash.Monetary Policy and the Fed Funds number of transactions will increase if the
RateThe federal funds rate adjusts to overall price level rises (or if inflation occurs),
balance the supply of and demand for thus requiring the use of more money to carry
federal funds.The Federal Reserve can use out those transactions. The idea is that if the
OMOs to target the fed funds rate.Whenever overall price level rises, people need more
the rate starts to fall below the Fed’s target, money to have a constant purchasing
the Fed sells government bonds in the open power.The quantity of money demanded for
market in order to pull reserves out of the transaction purposes is also inversely
banking system, which raises the rate as shown related to the level of interest rates on
in this diagram.If the rate rises above the Fed’s financial assets. The interest rates available
target, the Fed buys government bonds in the on other financial assets define the
open market, injecting reserves into the opportunity cost of holding money. When
banking system, and pushing the rate deciding how much money to hold for
down.For the Fed, OMOs are quick, easy, transaction purposes, households and
and effective, so the Fed can keep the fed businesses have to compare the interest rates
funds rate very close to the target.Does available on other assets with the time and
the Fed completely control the money the expense of converting these other assets
supply?--Problems Controlling the Money to money whenever they want to buy
SupplyThe Fed cannot completely control the something. The higher the interest rates, the
growth of the money supply.The Fed has more less money held for transaction purposes and
ability to control the monetary base (legal the more people want to hold financial assets
reserves plus coin and currency in circulation), with the higher rates of return; the lower the
but has less ability to control the money interest rates, the more money held for
multiplier.n.Bank Runs and the Money transaction purposes and the less people want
SupplyA run on banks: When people to hold financial assets with the lower rates of
suspect their banks are in trouble, they may return.M T = L(Y (+), P (+), r (-)).(2) The
“run” to the bank to withdraw their funds, precautionary demand for money:The
holding more currency and less deposits.o.The precautionary motive says that
supply curve for moneyIn real world, the households and businesses may keep some
supply of money id determined by Federal money on hand to cover temporary and
Reserve, the banking system, and unexpected expenses or losses of income,
consumers.Although the Fed does not such as a medical emergency, a temporary
completely control the money supply, , we will spell of unemployment, or an unexpected
assume that it does for simplicity.If the supply increase in the price of heating oil. Money
of money is entirely determined by the Fed, held for these purposes is quite small. These
then the money supply curve is vertical situations happen only infrequently, and
(perfectly inelastic) with respect to interest households and firms can find many safe,
rate.If the Fed’s money supply behavior is highly liquid short-term assets to hold as a
not influenced by the interest rate, the precautionary reserve that yield higher rates
money supply curve is a vertical line. of return than does money. Money market
Through open market operations (or any other mutual funds, U.S. Treasury bills, and
tool), the Fed can have the money supply be passbook savings accounts are three such
whatever value it wants.The Demand for assets. To the extent that a precautionary
money:The demand for money is the amount demand for money exists, however, the
of money that individual wish to hold at a given demand is likely to be highly sensitive
time. Money demand reflects how much wealth and inversely related to interest rates on
people want to hold in liquid form.A other highly liquid assets.MP =L(r (-)).(3)
household’s “money demand” reflects its
The speculative demand for moneyKeynes
preference for liquidity.What determines the
proposed a speculative motive for holding
demand for money? Three motives for holding
money based on expectations of future
money: (1) The transaction motive; (2) the
interest rates. People have a notion about
precautionary motive; (3) The speculative
what the "normal" or average rate of interest
motive.As we will see, ultimately, the
is on various financial assets. When interest
variables that influence money demand:Y,
rates rise above the "normal" range, people
r, and P.(1) The transaction demand for
see this as a temporary situation because
moneyThe transaction demand for money they expect interest rates to return to the
is the motive for holding money that derives "normal" levels. Therefore, they reduce
from money’s role as a medium of their money holdings in exchange for the
exchange. Households and businesses have other assets in order to take advantage
a transaction demand for money because of the opportunity. Conversely, when interest
money is the medium of exchange for buying rates fall below the "normal" range, people
goods and services.The quantity of money also see this as a temporary situation. They
demanded for transaction purposes is directly hold more money because they do not want
related to real national income. An to lock themselves into other financial assets
increase in national income means more when interest rates are unusually low.
spending in the nation's factor and product Instead, they are content to sacrifice some
markets, and more spending causes interest now and wait until the interest rates
households and firms to hold more money to return to "normal".Speculative motive can be
facilitate the spending.The quantity of money viewed as one reason for holding bonds
demanded for transaction purposes is also instead of money because the market value of
directly related to the overall price level. interest bearing bonds is inversely related to
the interest rate. Investors may wish to hold d money is defined as the rate at which money
bonds when interest rates are high with the changes hands; also, The number of transactions
hope of selling them when interest rates in which the average dollar is used.The equation
fall.MS=L(r (-)).(4) The total demand for shows that an increase in the quantity of money
moneyThe total demand for money is the sum in an economy must by reflected in one of the
other three variables: (l) the price level must rise,
of all three demands for money:
(2) the quantity of output must rise, or (3) the
b.The equilibrium interest rateBring money velocity of money must fall.We can use the
supply and money demand together-The Theory quantity equation to explain equilibrium
of LiquidityPreference (Keynes). 3. MONEY price level and inflation rate, and the
GROWTH AND INFLATION: VELOCITY, THE quantity theory of money.(l) The velocity of
QUANTITY THEORY OF MONEY, AND THE
money is relatively stable over time.The
QUANTITY E QUATIONa.The Quantity Theory
Quantity Theory in 5 Steps:Start with quantity
of MoneyThe explanation of how the price level equation: M x V = P x Y.(l) V is stable.(2) So,
is determined and why it might change over time a change in M causes nominal GDP (P x Y) to
is called the quantity theory of money.This theory change by the same percentage. (3) A change in
asserts that the quantity of money available M does not affect Y: money is neutral, Y is
determines the price level and, hence, the value determined by technology & resources.(4) So, P
of money.This theory also asserts that the growth changes by same percentage as P x Y and M.
rate in the quantity of money available (5) Rapid money supply growth causes rapid
determines the inflation rate.As economist Milton inflation.
Friedman once put it, "inflation is always and
everywhere a monetary phenomenon."b. Real
vs. Nominal VariablesNominal variables are
measured in monetary units. Examples: nominal
GDP, nominal interest rate (rate of return
measured in $), nominal wage ($ per hour
worked).Real variables are measured in
physical units. Examples: real GDP, real interest
rate (measured in output) real wage (measured in
output).Relative prices are measured in
physical units, so they are real
variables.Real vs. Nominal WageAn important
relative price is the real wage:–W = nominal wage
= price of labor, e.g., $l5/hour.–P = price level =
price of goods and services, e.g., $5/unit of
output.Real wage is the price of labor relative to
the price of output:W/P.c. The Classical
Dichotomy:The theoretical separation of nominal
and real variables Hume and the classical
economists suggested that monetary
developments affect nominal variables but not
real variables.If central bank doubles the money
supply, Hume & classical thinkers contend•all
nominal variables – including prices – will
double.•all real variables – including relative
prices – will remain unchanged.d. The
Neutrality of Money:the proposition that
changes in the money supply do not affect real
variables, but nominal variables.Doubling money
supply causes all nominal prices to double; what
happens to relative prices?The relative price is
unchanged.This result is important because
relative prices, not nominal prices,
determine the economy’s allocation of
resources.Similarly, the real wage W/P remains
unchanged, so• quantity of labor supplied
does not change•quantity of labor demanded
does not change•total employment of labor does
not change.The same applies to employment of
capital and other resources.•Since employment
of all resources is unchanged, total output is also
unchanged by the money supply.Most
economists believe the classical dichotomy
and neutrality of money describe the
economy in the long run.Later, we will see
that monetary changes can have important
short-run effects on real variables.e.The
quantity equation:M +V = P+Y relates the
quantity of money (M), the velocity of money (V),
and the dollar (nominal) value of economy's
output of goods and services (P+Y = nominal
GDP). P is the price level (GDP deflator), and Y is
the quantity of output (real GDP).The velocity of