Chapter 3 What Is Money? Learning Objectives • Describe what money is • List and summarize the functions of money • Define the M1 and M2 money supplies • Introduce the Quantity Theory What is Money • Money (or the “money supply”): anything that is generally accepted as payment for goods or services or in the settlement of debts. Barter (1 of 2) • Economies can function without money, but its inefficient. • Barter - a system of exchange in which trade goods and services directly for other goods and services. Barter (2 of 3) There are four main sources of inefficiency in a barter economy: 1.A double coincidence of wants increases the transactions costs. Transactions costs - time or other resources that parties incur in the process of agreeing and carrying out an exchange of goods and services. 2.Each good has many prices. When there are N items: Number of prices = N(N – 1)/2. Coincidence of Wants This can get crazy Farmer wants haircut Cook wants furniture Mover needs to eat needs to move Writer wants corn Carpenter wants to read a novel Barber Barter (3 of 3) 3.A lack of standardization exists for goods and services. 4.It is difficult to accumulate wealth. The Invention of Money To improve on barter, people sought to identify a specific product that most people would accept in an exchange. •Commodity money - a good is used as money that also has value independent of its use as money. •Money allows people to specialize, so they become more productive, and earn higher incomes. Stocks and Flows • Money is a stock concept: – Wealth: the total collection of pieces of property that serve to store value (stock concept) – Income: flow of earnings per unit of time (a flow concept) – Money is and asset, it is a component of wealth Three Functions of Money • Medium of Exchange: – Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs) – Promotes specialization • A medium of exchange must: – – – – – be easily standardized be widely accepted be divisible be easy to carry not deteriorate quickly Three Functions of Money • Unit of Account: – Used to measure value in the economy – Reduces transaction costs • Store of Value: – Used to save purchasing power over time – Other assets also serve this function. – Money is the most liquid of all assets but loses value during inflation. Money - How We Use It Store of Value and Liquidity • Although other stores of value are generally better than money, we hold money because it is liquid. • Liquidity is a measure of the ease with which an asset can be turned into a means of payment. – The more costly it is to convert an asset into a means of payment (money), the less liquid it is. – Cash is perfectly liquid. – Stocks and bonds are somewhat less liquid. – Land is illiquid. Financial Institutions Use Liquidity on both sides of the Balance Sheet Market liquidity - the ability to sell assets for money. Funding liquidity - ability to borrow money to buy securities or make loans. Commercial Banks Loans deposits Investment Bank Bonds MBS Stocks Commercial Paper Repurchase Agreements Bonds Money Market Mutual Funds Commercial Shares/ paper “deposits” T-Bills Inseparability of the Store-of-Value and Medium-ofExchange Functions – Hyperinflation Example • During hyperinflation, individuals and firms frantically attempt to get rid of money because money fails as a store-of-value! • Merchants refuse to accept payment in money, insisting instead on payment in goods and services - money fails as a medium-of-exchange! • For money to function as a means of payment it must durable and capable of transferring purchasing power from one day to the next. Evolution of the Payments System • Commodity Money: valuable, easily standardized and divisible commodities (e.g. precious metals, cigarettes) • Fiat Money: paper money decreed by governments as legal tender Evolution of the Payments System • Checks: an instruction to your bank to transfer money from your account • Electronic Payment (e.g. online bill pay). • E-Money (electronic money): – Debit card – Stored-value card (smart card) – E-cash Will Bitcoin Become the Money of the Future? • Bitcoin is type of electronic money created in 2009. • By “mining,” Bitcoin is created by decentralized users when they use their computing power to verify and process transactions. • Although Bitcoin functions as a medium of exchange it is unlikely to become the money of the future because it performs less well as a unit of account and a store of value. Measuring Money • How do we measure money? • Which particular assets can be called “money”? • Construct “monetary aggregates” using the concept of liquidity: – M1 (most liquid assets) = currency + demand deposits + other checkable deposits + traveler’s checks Measuring Money • M2 adds to M1 other assets that are not so liquid • M2 = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares The Federal Reserve’s Monetary Aggregates Value as of July 3, 2017 ($ billions) 1,481.5 Blank M1 = Currency + Traveler’s checks 2.0 + Demand deposits 1,501.5 + Other checkable deposits 574.8 Total M1 3,559.8 M2 = M1 Blank + Small-denomination time deposits + Savings deposits and money market deposit accounts + Money market mutual fund shares (retail) Total M2 357.7 8,923.9 673.7 13,515.1 https://www.federalreserve.gov/rele ases/h6/current/default.htm Does It Matter Which Definition of the Money Supply We Use? M1 and M2, 1970-2016 M1 has experienced much more instability than has M2. Source: Federal Reserve Bank of St. Louis. The Quantity Theory of Money: A First Look at the Link Between Money and Prices Irving Fisher and the Equation of Exchange • The equation of exchange states that the quantity of money (M) multiplied by the velocity of money (V), equals the price level (P) multiplied by the level of real GDP (Y). MV=PY • PY equals nominal GDP, so V = PY/M • Irving Fisher asserted that V is constant and turned the equation of exchange (an identity) into the quantity theory of money. • Quantity theory of money is a theory about the connection between money and prices that assumes that the velocity of money is constant. The Quantity Theory Explanation of Inflation • We use the quantity equation expressed in percentage changes: % Change in M + % Change in V = % Change in P + % Change in Y. • Under the Quantity Theory: % Change in V = 0 • The percentage change in the price level is inflation, so that: Inflation rate = % Change in M – % Change in Y How Accurate Are Forecasts of Inflation Based on the Quantity Theory? (1 of 2) The Relationship between Money Growth and Inflation over Time and Around the World Panel (a) shows the relationship between M2 growth and inflation for the U.S. from the 1870s to the 2000s. Panel (b) shows the relationship between M1 growth and inflation for 36 countries during the 1995-2011 period. How Accurate Are Forecasts of Inflation Based on the Quantity Theory? (2 of 2) • Velocity is erratic in the short run, so the quantity theory does not provide accurate short-run forecasts of inflation. • Panel (a) of Figure 2.3 shows that most of the variation in U.S. inflation rates across decades comes from variation in money growth. • Panel (b) of Figure 2.3 shows that countries where the money supply grew rapidly tended to have high inflation rates. • Zimbabwe's inflation rate of 15 billion percent during 2008 is an example of hyperinflation. Hyperinflation is extremely high inflation rates; >50% per month. The Hazards of Hyperinflation • Examples of hyperinflation are years during the Civil War, Germany during the early 1920s, Argentina during the 1990s, and Zimbabwe in recent years. • Prices rose so rapidly that money purchased fewer and fewer goods and services each day. • Households and firms responded by refusing to accept money. • As a result, economic activity contracted sharply and unemployment soared. What Causes Hyperinflation? • The quantity theory indicates that hyperinflation is caused by the money supply (M) rising more rapidly than real output (Y). • Why, then, do central banks allow the money supply to rise? • Hyperinflation occurs usually when governments spend more than they collect in taxes. • A country can monetize the government’s debt by forcing its central bank to print money. Should Central Banks Be Independent? • The more independent a central bank is, the more it can resist political pressures to increase the money supply, and so the lower the country’s inflation rate is. • Critics of the Fed’s independence argue that it violates democratic principles and that its actions exceed the authority granted under federal law. • As we will see in later chapters, the debate over the Fed may result in important changes in a key part of the financial system. The Relationship between Central Bank Independence and the Inflation Rate Source: Alberto Alesina and Lawrence H. Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking, Vol. 25, No. 2, May 1993, pp. 151–162. Copyright 1993 by Ohio State University Press (Journals). Reproduced with permission of Ohio State University Press via Copyright Clearance Center Central bank independence is measured by an index ranging from 1 (minimum independence) to 4 (maximum independence). Where Are All the U.S. Dollars? • Currency = $1.3 trillion (Three-fourths of this is in $100 bills.) • Population is 321 million • $4,050 of U.S. currency held per person in the United States. • Where are all these dollars and who is holding them?
