The Role of Money in the
Macroeconomy
Introduction of the Concepts
Financial Markets/Institutions
Bringing together of buyers and sellers of
financial securities to establish prices
Provides a mechanism for those with
excess funds (savers) to lend to those
who need funds (borrowers)
Includes banks, savings and loans, credit
unions, investment banks and brokers,
mutual funds, stock and bond markets
Money
Currency – bills and coins
Includes demand deposits (checking
accounts) issued by banks
Plays a key role in influencing the behavior
of the economy as a whole and the
performance of financial institutions and
markets
Monetary Economy
Facilitates transactions within the
economy
Principal mechanism through which
central banks attempt to influence
aggregate economic activity
– Economic Growth
– Employment
– Inflation
Banking
Place where savers can invest their funds
to earn interest with a minimum of risk.
Make loans to individuals and small
businesses
Banks
Banks serve as the principal caretaker of
the economy’s money supply, and along
with other financial intermediaries, provide
important source of funds.
Banks are intimately involved in how the
Federal Reserve influences overall
economic activity
Monetary Policy
The Fed directly influences the lending
and deposit creation activities of banks
Flow of funds from lenders to
borrowers
What is the proper amount of
money for the economy?
Sir William Petty (1623–87) wrote in 1651
“To which I say that there is a certain
measure and proportion of money requisite
to drive the trade of a nation, more or less
than which would prejudice the same”
– Too much money will lead to inflation
– Too little money will result in an inefficient economy
Functions of Money
Standard of value
– or unit of account for all the goods and services we
might wish to trade.
Medium of exchange
– it is the only financial asset that virtually every
business, household, and unit of government will
accept in payment of goods and services.
Store of value
– reserve of future purchasing power.
Liquid Asset
Something that can be turned into a generally
acceptable medium of exchange, without loss
of value
Liquidity is a continuum from very liquid to
illiquid
Currency and checking accounts are most liquid
assets
Monetary Base
A “base” amount of money that serves as
the foundation for a nation’s monetary
system.
Under a gold standard, the amount of gold
bullion.
In a fiat money system, the sum of
currency in circulation plus reserves of
banks and other depository institutions.
The Monetary Base
Currency:
– Coins and paper money.
Reserves:
– Cash held by depository institutions in their
vaults or on deposit with the Federal Reserve
System.
Monetary Base = Currency + Reserves
The Use Of Coins
Seigniorage:
– The difference between the market value of
money and the cost of its production, which is
gained by the government that produces and
issues the money.
Debasement:
– A reduction in the amount of precious metal in
a coin that the government issues as money.
Monetary Aggregate
A grouping of assets sufficiently liquid to be
defined as a measure of money.
What is the money supply?
M1
– currency+checking accounts
M2
– M1 + savings accounts + small CDs +MMDA
+MMMF
M3
– M2 + large CDs
Who Determines Our Money
Supply?
Federal Reserve is responsible for
execution of national monetary policy
– Created by Congress in 1913
– Twelve district Federal Reserve Banks
scattered throughout the country
– Board of Governors located in Washington,
D.C.
Who Determines Our Money
Supply?
Fed influences the total money supply, but
not the fraction of money between
currency and demand deposits which is
determined by public preferences
Fed implements monetary policy by
altering the money supply and influencing
bank behavior
Barter
Direct exchange of goods/services for
other goods/services
– Very inefficient and limited economy
– No medium of exchange or unit of account
– Requires double coincidence of wants—”I
have something you want and you have
something I want”
– Items must have approximate equal value
– Need to determine the “exchange rate”
between different goods/services
Money
Any commodity accepted as medium of
exchange can be used as money
Frees people from need to barter
Makes exchange more efficient
Permits specialization of labor—sell one’s
labor to the market in exchange for money
to purchase goods/services
Money
Prices, expressed in money terms, permit
comparison of values between different
goods
Must retain its value—the value of money
varies inversely with the price level
(inflation)
If money breaks down as a store of value
(hyperinflation), economy resorts to barter
How Large Should the Money
Supply Be?
Purchase goods/services economy can
produce, at current prices
Generate level of spending on Gross
Domestic Product (GDP) that produces
high employment and stable prices
Monetary Policy is used as a
countercyclical tool—vary the money
supply to influence economic activity
Increases in the Money Supply Alters Public’s
Liquidity and Influences Spending
Direct Impact—excess liquidity is spent on
goods/services
Indirect Impact—purchase financial assets
which lowers interest rates which stimulates
business investment and consumer spending
However, changes in liquidity may alter demand
for money and not influence GDP—people
hoard the additional money
Public’s reaction to changes in liquidity is not
consistent, so Fed cannot always judge impact
of a change in money supply
Velocity
When the Fed increases the money
supply, recipients of this additional liquidity
probably will spend some on GDP
Over time there will be a multiple increase
in spending
Velocity of Money
The number of times the money supply turns
over in a period of time to support spending on
output
The Fed has no control over the velocity of
money since this is dependent on behavior of
the public
– It is possible the public will choose to hold onto the
additional liquidity (hoarding of money)
Ultimately, the Fed needs to be concerned
whether the additional spending which results
from increased money supply will result in higher
production or higher prices
Velocity of Money
Velocity is the way in which the quantity of
money is related to economic activity.
The speed with which money is spent.
Velocity = changes in spending/quantity of
money = ΔGDP/ΔM.
If Velocity = 5, then if M increases by $10
billion, GDP will rise by $50 billion.
Money and Inflation
Inflation—Persistent rise of prices
Hyperinflation—Prices rising at a fast and
furious pace
Deflation—Falling prices, usually during
severe recessions or depressions
Inflation reduces the real purchasing
power of the currency—can buy fewer
goods/services with the same nominal
amount of money
Money, The Economy, and
Inflation
Economists generally agree that, in the
long-run, inflation is a monetary
phenomenon—can occur only with a
persistent increase in money supply
Increase in money supply is a necessary
condition for persistent inflation, but it is
probably not a sufficient condition
Examples
Case 1—Economy in a recession.
– Expanding money supply may lead to more
employment and higher output
Case 2—Economy near full employment/output.
– Expanding money supply can lead to higher
output/employment, but also higher prices
Case 3—Economy producing at maximum.
– Expanding money supply will most likely lead to
increasing inflation.
Money and Inflation
To return to the 1940s, the smallest bill
would be $10 and the smallest coin would
be a dime.
Hyperinflation Example
Hyperinflation occurred in Germany after World War I,
with inflation rates sometimes exceeding 1000 percent
per month. By the end of hyperinflation in 1923, the
price level had risen to more than 30 billion times what it
had been just two years before. The quantity of money
needed to purchase even the most basic items became
excessive. Near the end of the hyperinflation, a
wheelbarrow of cash would be required to pay for a loaf
of bread. Money was losing its value so rapidly that
workers were paid and given time off several times
during the day to spend their wages before the money
became worthless. No one wanted to hold on to money,
and so the use of money to carry out transactions
declined and barter became more and more dominant.
Who creates money?
The Federal Reserve
Depository Institutions
The Public
Fractional Reserve System
Required Reserves
Excess Reserves
How a bank creates money
Assets
Reserves
Securities
Loans
Claims
Transactions Deposits
Savings Deposits
CDs
Equity
Money and Banking in the
Digital Age
Cybertechnologies:
– Technologies that connect savers, investors, traders,
producers, and governments via computer linkages.
Electronic money (e-money):
– Money that people can transfer directly via electronic
impulses.
Wire transfers:
– Payments made via telephone lines or through fiberoptic cables.
Money in the Digital Economy
Electronic Payments
– Automated clearinghouses:
Institutions that process payments electronically on behalf of
senders and receivers of those payments.
– Point-of-sale (POS) transfer:
Electronic transfer of funds from a buyer’s account to the firm
from which a good or service is purchased at the time the sale
is made.
– Automated bill payment:
Direct payment of bills by depository institutions on behalf of
their customers.