Lecture 22:money October 27, 2010
What is money? • Although we commonly think of “money” as being dollar bills and coins, these are by no means the only items that can act as “money.” • Money must fulfill three functions: • Medium of exchange • Store of value • Unit of account
Medium of exchange • Problem with barter system: “Coincidence of wants.” In a barter system, both people must have exactly what the other person wants, exactly when and where it’s wanted. • Medium of exchange eliminates this problem. • Definition: Anything used to facilitate trade and avoid a straight barter system. • Anything can serve as money so long as people are willing to accept it.
Store of value • US dollars are what is called fiat money: They have no intrinsic value. Rather, their value is a function of the US government saying they have value. • This is true for most nations’ currencies: They are backed only by the faith and credit of the given country’s government. • “This note is legal tender for all debts, public and private.” • Money need not be convertible into something with intrinsic value (e.g., gold).
Unit of account • Standard unit of measurement of the value/cost of goods, services, or assets. • Analogy: I go to WeShop and pay $10 for a gallon of milk. • Gallon : size :: dollar : price • Take away the price units: A gallon of milk simply costs “10.” 10 what? • Another example: “GM incurred losses of 700 million in the second quarter.” • The dollar sign lends meaning to the phrase.
Mildly amusing examples • Yap (island in the Pacific Ocean) uses stones ranging from 1.4 inches to 12 feet in diameter
Mildly amusing examples • Yap (island in the Pacific Ocean) uses stones ranging from 1.4 inches to 12 feet in diameter • Cigarettes are often used in prison as money • Ithaca, NY, has its own currency, the Ithaca HOUR. • One Ithaca HOUR is valued at $10 • Ithaca HOURs cannot be converted to US dollars • Businesses that receive HOURs must spend them on local goods and services • Ithaca inspired similar systems in Madison, WI, and Corvallis, OR
What determines money demand? • Needed for transactions Money demand in its most simple form • Asset-holding motives • Precautionary (i.e., money people want in case of emergency) • Speculative (need for cash to take advantage of investment opportunities that may arise)
Measures of money • M1, M2, M3 • M1: Physical currency + demand deposits (i.e., checking accounts) • M2: M1 + savings accounts + money market accounts + small-denomination time deposits (CDs under $100,000) • M3: M2 + all other CDs + repurchase agreements • M1 and M2 are the most commonly used measures • M3 conveys no additional information about economic activity, according to Fed, though some politicians (Ron Paul) have criticized its decision to cease collecting M3 statistics in March ’06.
Balance sheet • A balance sheet indicates a bank’s assets, liabilities, and net worth. • Assets = reserves + loans • Liabilities = deposits + net worth • Net worth = assets – liabilities (accounting identity) • Both sides of the balance sheet must balance! • The accounting identity was developed in the 15th century as a means for identifying accounting errors
Money creation • Banks are required to keep a certain percentage of their deposits in reserve. • The percentage they must keep is called the reserve ratio and is set by the Fed. • Banks can choose to keep additional reserves beyond the requirement. • Banks are free to lend out the rest of their deposits. These loans make their way to other banks, which in turn loan them out, and so on. • Downside: This can lead to “bank runs,” such as what partially precipitated the Great Depression. • Example!
Money creation • This cycle shows how banks can create money. • The money multiplier describes the total increase in money resulting from a $1 increase in MS by the central bank. • Money multiplier = 1/rr • So, for example, if rr = 20%, a $1 increase in Ms by the central bank will increase the money supply in total by $5. • Note that the effect of the money multiplier is diminished if individuals increase their cash holdings.
What determines money supply? • Policymakers at the Fed determine the US money supply. • The Fed has three tools to change Ms: • Reserve ratio • Discount rate (interest rate charged to banks that borrow from the Fed) • Open-market operations (buying and selling bonds)
Open-market operations • When the Fed wishes to lower the money supply, it sells bonds (government securities) to the public. The money it receives from these transactions is retired (removed from circulation), so the net effect is to lower Ms. • Similarly, when the Fed wants to increase the money supply, it buys bonds from the public. The money multiplier acts to further increase Ms as well. (Money multiplier also works backwards when Fed sells bonds.)
Money supply, demand • Let’s bring money supply and money demand together on one graph! • Why is Md downward-sloping? • Think of interest rate as the cost of holding money • Money sitting in your wallet does not earn interest; the higher the interest rate, the more interest is foregone by holding onto money—so the opportunity cost of holding money is higher. • As output (Y) increases, Md increases (demanded for transactions)