Money

Outline
1. What is Money
2. Money Supply
3. Money and Price
4. Monetarism
5. Inflation
6. Money and Interest
What is Money
Definition
Money: Any good that is widely accepted for purposes of exchange
and the repayment of debt

Barter: Exchanging goods and services for other goods and services
without the use of money
Functions of Money
Medium of Exchange: Anything that is generally acceptable in
exchange for goods and services; a function of money

Unit of Account: A common measure in which relative values are

expressed; a function of money

Store of Value: The ability of an item to hold value over time; a

function of money
From Barter to Money (1/2)

Double Coincidence of Wants: In a barter economy, a requirement must

be met before a trade can be made. The term specifies that a trader must
find another trader who at the same time is willing to trade what the first
trader wants and wants what the first trader has
• At one time, there was trade but no money; instead, people bartered
• Money evolved in a natural, market-oriented way
• Making exchanges takes longer (on average) in a barter economy than in
a money economy because the transaction costs are higher; the time and
effort required are greater
From Barter to Money (2/2)

• In a barter economy, some goods are more readily accepted than

others in an exchange; when traders noticed the difference in
marketability, their behavior tends to reinforce the effect
• The more people accept good G because they know they can easily
trade it for most other things, the greater its relative acceptability
becomes
• This is how money evolved; when good G’s acceptance evolves to
the point that it is widely accepted for purposes of exchange, good
G is money
Money, Leisure, and Output
Exchanges take less time in a money economy than in a barter economy
because a double coincidence of wants is unnecessary; everyone is willing
to trade for money
• Frees up some transaction time, which people can use in other ways
• A money economy is likely to be richer in both goods and leisure time
• A person’s standard of living depends, to a degree, on the number and
quality of goods the person consumes and on the amount of leisure he or
she consumes
• We would expect the average person’s standard of living to be higher in
a money economy than in a barter economy
Money Supply
Definition: M1 and M2
M1: Currency held outside banks, plus checkable deposits, plus traveler’s checks
• Currency: Coins and paper money
• Central Bank (BSP) Notes: Paper money issued by the central bank
• Checkable Deposits: Deposits on which checks can be written

Money Is More Than Currency

People often equate money and currency, but money is more; it consists of
those items which define M1
Definition: M1 and M2
M2: M1 + savings deposits (including money market deposit accounts) + small-
denomination time deposits + money market mutual funds (retail)
• Savings Deposit: An interest-earning account at a commercial bank or thrift
institution. Normally, checks cannot be written on savings deposits, and the
funds in a savings deposit can be withdrawn at any time without a penalty
payment
• Time Deposit: An interest-earning deposit with a specified maturity date. Time
deposits are subject to penalties for early withdrawal - that is, withdrawal
before the maturity date. Small denomination time deposits are deposits of less
than $100,000
Definition: M1 and M2
• Money Market Deposit Account (MMDA): An interest-earning account at a bank or
thrift institution, for which a minimum balance is usually required and most of which
offer limited check-writing privileges
• Money Market Mutual Fund (MMMF): An interest-earning account at a mutual fund
company, for which a minimum balance is usually required and most of which offer
limited check-writing privileges. Only retail MMMF’s are part of M2

Where Do Credit Cards Fit In?

• A credit card is an instrument or document that makes it easier for the holder to
obtain a loan; by using a credit card, the shopper spends someone else’s money,
which she must repay
Money and Price
Background
Changes in money supply, can affect price level. This is based on the
Equation of Exchange and the Simple Quantity Theory of Money.

Equation of Exchange: An identity stating that the money supply

(M) times velocity (V) must be equal to the price level (P) times
Real GDP (Q): MV = PQ

Velocity: The average number of times a dollar is spent to buy final

goods and services in a year
From EE to the Simple Quantity Theory
Simple Quantity Theory of Money: Assumes that velocity (V) and
Real GDP (Q) are constant and predicts that changes in the money
supply (M) lead to strictly proportional changes in the price level (P)

Classical economists made the following assumptions:

1. Changes in velocity are so small that, for all practical purposes,
velocity can be assumed to be constant (especially over short
periods)
2. Real GDP, or Q, is fixed in the short run
From EE to the Simple Quantity Theory
SQTM in AD-AS
• An increase in the money supply will increase aggregate demand
and shift the AD curve to the right
• A decrease in the money supply will decrease aggregate demand
and shift the AD curve to the left
• An increase in velocity will increase aggregate demand and shift the
AD curve to the right
• A decrease in velocity will decrease aggregate demand and shift the
AD curve to the left
From EE to the Simple Quantity Theory
What if V and Q are not constant?
If we drop the assumptions that velocity (V) and Real GDP (Q) are
constant, we have a more general theory of the factors that cause
changes in the price level

In this theory, changes in the price level depend on three variables:

1. Money supply
2. Velocity
3. Real GDP
What if V and Q are not constant?
If the equation of exchange holds, then

𝑀𝑉
𝑃=
𝑄

Inflationary tendencies? A rise in M, V, or a fall in Q

Deflationary tendencies? A fall in either M, V, or a rise in Q

Monetarism
Four Monetarist Positions
1. Velocity Changes in a Predictable Way
• a function of certain variables—interest rate, expected inflation rate,
frequency of paychecks, and more
2. Aggregate Demand Depends on the Money Supply and on
Velocity
• M and V can change AD
3. The SRAS Curve is Upward Sloping
• Real GDP may change in the short run
4. The Economy is Self-Regulating (Prices and Wages are Flexible)
Monetarism in AD-AS
• Changes in the money supply will change aggregate demand
• A decrease in the money supply with velocity held constant, will
shift the AD curve to the left from AD1 to AD2; Real GDP will be
reduced to Q1 and price reduced to P2; unemployment will rise
• An increase in velocity causes the AD curve to shift right from AD1
to AD2; Real GDP and price rise; unemployment falls
• A decrease in velocity causes the AD curve to shift to the left from
AD1 to AD2; Real GDP and price fall; unemployment rises
Four Monetarist Positions
Four Monetarist Positions
Monetarism in AD-AS
1. The economy is self-regulating
2. Changes in velocity and the money supply can change aggregate
demand
3. Changes in velocity and the money supply will change the price level
and Real GDP in the short run, but only the price level in the long run
4. Can a change in velocity offset a change in the money supply? The
monetarist view is that:
• Changes in velocity are not likely to offset changes in the money supply
• Changes in the money supply will largely determine changes in aggregate demand
and thus changes in Real GDP and the price level
Inflation
Types
In general, inflation refers to any increase in the price level; but this
can be differentiated between two types of increases: a one-shot
increase and a continued increase

One-Shot Inflation
A one-time increase in the price level; an increase in the price level
that does not continue
One-Shot Inflation: Demand
One-Shot Inflation: Supply
One-Shot Inflation
Confusing Demand-Induced and Supply-Induced One-Shot Inflation. These
are easy to confuse because
• In a demand induced one-shot inflation, AD curve shifts rightward
because the money supply increased
• Employers, however, are unaware of that; what they see is part (b) in
which they end up paying higher wages to their employees and the
SRAS curve shifts leftward; they mistakenly conclude that the rise in the
price level originated with a supply-side factory (higher wage rates), not
with a demand-side factor (an increase in the money supply)
Continued Inflation
Continued Inflation: A continued increase in the price level
Suppose the CPI for years 1 to 5 is as follows:

Each year, the CPI is higher than the year before

Continued Inflation
From One-Shot Inflation to Continued Inflation
• Continued increase in AD can turn one-shot inflation into continued
inflation

The Effect of Continued Declines in SRAS

• Could happen, but isn’t likely
• Today, both the CPI and Real GDP are higher than in previous years,
which means that there is continued inflation, but that this has been
accompanied by a generally rising Real GDP
Continued Inflation
Continued Inflation
The Big Question
• If continued increases in aggregate demand cause continued inflation, what causes
continued increases in aggregate demand?
• Economists widely agree that the only factor that can change continually in such a
way as to bring about continued increases in aggregate demand is the money supply

Can You Get Rid of Inflation with Price Controls?

• Not really; there are consequences of price ceilings below the equilibrium price; one is
that nonmoney rationing devices will be used, which results in long lines
Money and Interest Rates
What’s affected by a change in M?
Changes in the money supply or changes in the rate of growth of the
money supply can affect:
1. the supply of loans
• more bank reserves, banks can give more loans
2. real GDP
3. the price level
4. the expected inflation rate
• as a result of the effect on the price level
Interest and the Market for Loanable Funds
Market for Loanable Funds
Demand for Loanable Funds (𝑫𝑳𝑭 )
Downward sloping. Borrowers borrow more at low interest rates

Supply of Loanable Funds (𝑺𝑳𝑭 )

Upward sloping. Lenders lend more at high interest rates

𝑺𝑳𝑭 is based on savings, while 𝑫𝑳𝑭 on borrowing. Essentially, the market

for LF is the interaction between the supply of savings and the demand
for loans.
The Money Supply, the Loanable Funds Market
and Interest Rates
Liquidity Effect: The change in
the interest rate due to a change
in the supply of loanable funds

• The central bank does an open

market purchase, it increases
reserves, banks can give more
loans, increasing supply of
loanable funds.
The Money Supply, the Loanable Funds Market
and Interest Rates
Income Effect: The change in the
interest rate due to a change in
Real GDP

1. RGDP and SLF

• RGDP increase can increase DLF,
consequently, SLF
2. RGDP and DLF
• RGDP increase, more profitable
opportunities, firms issue more
bonds
The Money Supply, the Loanable Funds Market
and Interest Rates
Price-Level Effect: The change in
the interest rate due to a change
in the price level

• Recall what causes AD. With

respect to the interest-rate
effect, as price rises, purchasing
power falls, people may increase
demand for credit to buy goods
The Money Supply, the Loanable Funds Market
and Interest Rates
Expectations Effect: The change in the
interest rate due to a change in the
expected inflation rate
1. increase in DLF
• Debtors will want to borrow as a result
of expected inflation in the future,
purchasing power in the future would be
lesser, so they’re willing to pay a higher
interest rate now
2. decrease in SLF
• Creditors will require a higher interest
rate to compensate for lesser purchasing
power with which the loan will be repaid
What Happens to the Interest Rate as the
Money Supply Changes?
• A change in the money supply affects the economy in many ways:
changing the supply of loanable funds directly, changing Real GDP
and therefore changing the demand for and supply of loanable
funds, changing the expected inflation rate, and so on

• The timing and magnitude of these effects determine the changes

in the interest rate
Nominal and Real Interest Rates
Nominal Interest Rate: The interest rate actually charged (or paid) in the market; the
market interest rate;
Nominal interest rate = Real interest rate + Expected inflation rate

Real Interest Rate: The nominal interest rate minus the expected inflation rate. When
the expected inflation rate is zero, the real interest rate equals the nominal interest rate
Real interest rate = Nominal interest rate - Expected inflation rate

When you borrow with expected inflation rate that turns out to be the actual inflation
rate, you are repaying money that is 𝑘 less than money you borrowed.