Macroeconomics - ECO 2013

1. Macroeconomics - ECO 2013 Fall 205 – 1 Term August 24 – December 16, 2005

2. Chapter 13: Money & Banking • When working properly, the monetary system provides lifeblood of the circular flows of income & expenditure. • Well-operating monetary system helps economy achieve full employment & efficient use of resources. • Malfunctioning monetary system creates severe fluctuations in the economy’s levels of output, employment & prices, distorting the allocation of resources

3. The Functions of Money • Mediums of Exchange for buying & selling goods & services • Unit of Account, yardstick for measuring the relative worth of a variety of goods, services & resources. • Price of each item stated only in terms of the monetary unit • Money aids rational decision making by enabling buyers & sellers to easily compare the prices of various goods, services, and resources. • Store of value enables transfer of purchasing power from present to future • Store some of wealth as money

4. The Supply of Money • Money Definition M1 • Money Definition M2 • Money Definition M3

5. Money Definition M1 • Narrowest definition • Consists of: • Currency (coins & paper money) in hands of public • Coins are token money: Intrinsic value (of the metal contained in the coin) < face value • All checkable deposits (in commercial banks & “thrifts” or savings on which checks can be drawn) • Money, M1 = Currency + Checkable Deposits

6. Money Definition M2 • Broader definition • Near-monies are certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits • Savings deposits, including money market deposit accounts (MMDA) • Small time deposits (<$100,000) • Money market mutual funds (MMMF) • Money, M2 = M1 + Savings Deposits including MMDAs + Small time Deposits (<$100,000) + MMMFs)

7. Money Definition M3 • Includes large time deposits (>$100,000) • Certificates of deposit • Money, M3 = M2 + large time deposits (>$100,000)

8. Credit Cards • Not really money • Means of obtaining a short-term loan from commercial bank or other financial institution that issued the card • Means of deferring or postponing payment for a short period

9. What “backs” the money supply? • Government’s ability to keep its value stable provides the backing • Money is debt; paper money is a debt of Federal Reserve Banks & checkable deposits are liabilities of banks & thrifts b/c depositors own them • Value of money arises not from intrinsic value, but its value in exchange for goods & services

10. Value of Money • Acceptable as a medium of exchange • Currency is legal tender or fiat money; must be accepted by law • Relative scarcity of money compared to goods & services will allow money to retain its purchasing power • Money’s purchasing power determines its value. Higher prices mean less purchasing power.

11. Inflation & Acceptability • Excessive inflation may make money worthless & unacceptable • Worthless money leads to use of other currencies that are more stable • Worthless money may lead to barter exchange system.

12. Stabilization of Money’s Value • The government tries to keep supply stable w/ appropriate fiscal policy • Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow

13. The Demand for Money: Two Components • Transactions demand, Dt is money kept for purchases, will vary directly w/ GDP • Asset demand, Da is money kept as store of value for later use, varies inversely w/ interest rate, since that is price of holding idle money • Total demand, Dm will equal quantities of money demanded for assets & transactions

14. The Money Market • Sm represents money supply • Vertical line b/c monetary authorities & financial institutions have provided the economy w/ particular stock of money • Intersection of demand & supply determines equilibrium price

15. The Federal Reserve Bank & The Banking System • Board of Governors of the Federal Reserve System (“the Fed”) • Board directs 12 Federal Reserve Banks which control lending activity of nation’s banks & thrift institutions • Federal Open Market Committee (FOMC) • Sets Fed’s monetary policy & directs purchase & sale of government securities in the open market, “open-market operations”

16. Fed Functions & The Money Supply • Issuing currency • Setting reserve requirements & holding reserves • Lending money to banks • Providing for check collection • Acting as fiscal agent • Supervising banks • Controlling money supply

17. Federal Reserve Independence • Protects Fed from political pressures to effectively control money supply & maintain price stability • Political pressures on Congress & Executive Branch result in inflationary fiscal policy, including tax cuts & special-interest spending, but Fed can take actions to increase interest rates when higher rates are needed to stem inflation • Countries w/ independent central banks have lower rates of inflation, on average, than countries w/ little or no independence

18. Recently Developments in Money & Banking • Relative decline of banks & thrifts • Consolidation among banks & thrifts • Convergence of services provided by financial institutions • Globalization of financial markets • Electronic transactions

19. Last Word: The Global Greenback • Two-thirds of all U.S. currency is circulating abroad • U.S. profits when dollars stay overseas • Black markets & illegal activity overseas are usually conducted in dollars b/c are such a stable form of currency • The dollar is a reliable medium of exchange, measure, & store of value that facilitates transactions everywhere • All dollars will not return to the U.S.

20. Chapter 13 Study Questions • 1: Functions of Money • 5: Backing Money

21. Next Class • Chapter 14: How Banks and Thrifts Create Money • Chapter 15: Monetary Policy

22. Quiz on Ch. 9 – 12, 16