Economics for Leaders
Lesson 9:
Money & Inflation
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What is Money?
Money is ANYTHING that is generally
accepted in payment for goods and services.
woodpecker skulls, whale’s teeth
stones, shells, beads, feathers
tobacco, fur, corn, barley, liquor
gold, silver, bronze, copper
magic beans, golden eggs
paper, coins
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Voluntary Transactions
Increase Well-being
Money…
is a unit of account ($1, $2, $3…)
is a store of value (I can use it later)
is a common language
The value of money comes from what we can
get with it.
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I can’t believe he ripped up $5
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Voluntary Transactions
Increase Well-being
Money…
is a medium of exchange
is widely accepted for purchases
is a common language
The value of money comes from what we can
get with it.
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Voluntary Transactions
Increase Well-being
Money…
lowers transaction costs
increases the # of transactions
is a common language
The value of money comes from what we can
get with it.
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Voluntary Transactions
Increase Well-being
We understand what money is (agreeable).
We are confident money can be subsequently
exchanged for goods & services (trusted).
The value of money comes from what we can
get with it.
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I can’t believe he ripped up $5
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Money Reduces
Transaction
Costs of
Exchange
No double
coincidence of
wants and desires
Does anybody
want some econ?
Barter may work, but…
it’s inconvenient and time consuming
The Case of the PENNY
MB > MC??
Shredding Paper Money
MB > MC??
In the U.S. today, money is…
currency & coin, demand deposits
savings deposits
time deposits
M1, M2, M3 (liquidity)
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Why hold “CASH” money?
transactions
precautionary reasons
store of wealth
you could hold interest-earning assets
instead such as certificates of deposit, stocks,
bonds, real estate.
holding money has an opportunity cost
liquidity
The Market for Money (S & D)
What determines interest rates?
Who are the suppliers?
Anyone with excess money balances.
Who are the demanders?
Anyone with constrained money balances.
What is the equilibrium?
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What determines interest rates?
Rates change within markets in response to
changes in supply and demand for funds.
↑ S or
↓S
↑ D or
↓D
Relative scarcity!
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What determines interest rates?
Rates also differ as a result of the degree of risk and
the length of time of loan.
The Money Supply
Total available purchasing power in the
economy at a point in time.
M1, M2 & M3
How much money is there?
How Much Money is Out There?
St. Louis Federal Reserve Bank (FRED): http://research.stlouisfed.org/fred2/categories/24
Why do we worry about the
money supply?
Experience has shown us that the money
supply is the most important factor
affecting general price levels.
Inflation
Inflation must be taken seriously because
it alters incentives and people’s economic
behavior, and consequently, it negatively
impacts the economy as a whole.
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Inflation
A general, sustained increase in the price level.
The erosion or decline of purchasing power.
Econ 101, lending, borrowing and inflation
– A short lesson
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Measuring Inflation: The CPI
The Bureau of Labor Statistics
Determines the items in the market basket
Calculates the CPI:
CPI
=
Price of basket in current year
Price of basket in base year
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X 100
CPI base year = 100
Suppose CPI year 1 = 110
What does it mean?
10% increase in prices that year
Average Annual Inflation Rate = % change in
CPI / # years
CPI
year 2
= 114 (be careful)
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Inflation Reduces the Value
of the Dollar
Price Level
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Same Products – Higher Prices
Bureau of Labor Statistics: http://www.bls.gov
Bureau of Labor Statistics: http://www.bls.gov
What sector has
seen the largest price
increases since 1990?
Energy
Food
College Tuition
Medical Care
Housing
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Bureau of Labor Statistics: http://www.bls.gov
What Causes Inflation ?
All periods of significant
sustained inflation have been
accompanied by increases in
the money supply
Manage the Money Supply:
The Job of the Federal
Reserve System!
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How does the Fed manage
the money supply and
facilitate economic activity?
Do banks have all of your money on hand?
Could we all have all of our money at once?
Trusted and agreed upon value.
The Banking System
&
The Money Supply
Commercial banks’ ability to make loans
Fed tools for influencing banks’
willingness to make loans:
reserve requirement
discount rate
open market operations
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Monetary Policy
The actions undertaken by the Federal
Reserve, to influence the availability and
cost of money and credit to help promote
national economic goals.
The Federal Reserve Act of 1913 gave the
Federal Reserve responsibility for setting
monetary policy.
Board of Governors: discount rate, reserve
requirement
Open Market Committee: open market
operations.
The Banking System
&
The Money Supply
$100
John
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$100
Money Supply =
$100
Money Supply = $100 + $90 + $81 = $271
John
Lending creates additional purchasing power
by increasing the money supply
Money Supply = $100 + $90 + $81 = $271
Open Market Operations
The most important tool of the Fed in
controlling the money supply.
It can be, and is, used on a daily basis.
Its effect is immediate.
It can be used to target interest rates.
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Fed buys/sells government securities
to alter the availability of money
to the public.
How does it work?
Fed
Sally’s Bank
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Sally
Open Market Operations:
When the Fed Sells Bonds
Fed
Sally
Fed Sells
Bonds
Who ends up with the money?
Who ends up with the bond?
What happened to the money supply?
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Open Market Operations:
When the Fed Buys Bonds
Fed
Sally
Fed Buys
Bonds
Who ends up with the money?
Who ends up with the bond?
What happened to the money supply?
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Open Market Operations allows the
Fed to manage interest rates
Open Market
Operations
Buy bonds:
Open Market
Operations
Sell bonds:
Bank deposits
Bank deposits
Bank reserves
Bank reserves
The supply of money to
lend
The supply of money to
lend
Interest rates
Interest rates
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A sound & well-managed money supply is
one of the keys to the wealth of nations
Hyperinflation in Zimbabwe
A Zimbabwean friend who runs a business
recently told me, “If you don’t get a bill
collected in 48 hours, it isn’t worth collecting,
because it is worthless. Whenever we get
money, we must immediately spend it, just
go and buy what we can. Our pension was
destroyed ages ago. None of us have any
savings left.”
http://davidcoltart.com/archive/2008/376
“Dying Silently in Zimbabwe,” by Michael
Gerson, Washington Post, Feb 20, 2008
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