CHAPTER 2
THE ROLE OF MONEY IN THE ECONOMY
“THE LACK OF MONEY IS THE ROOT OF ALL EVIL”
G. Bernard Shaw
WHAT IS MONEY ?
FUNCTIONS OF MONEY
 MEANS OF PAYMENT
 A STORE OF VALUE
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 A STANDARD OF VALUE (a unit of account)
DEFINITION OF MONEY SUPPLY
M1
currency outside banks and checking accounts
(the most liquid)
A LIQUID ASSET is something you can turn into the generally
acceptable medium of exchange quickly without taking a loss and
usually can be sold or liquidated on short notice only at a substantially
lower price.
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THREE DEFINITIONS OF THE MONEY SUPPLY
M1: currency outside banks +
demand deposits at banks (non-interest bearing checking
accounts) & Checkable deposits(NOW accounts)
at all thrift institutions +
travelers checks.
M2 : small denomination( under $100,000) time deposits +
MMDA shares +
MMMF shares
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M3 : Large denomination($100,000 and over)
time deposits +
institutional money market
mutual funds shares +
bank repurchase agreements +
eurodollars
WHO DETERMINES MONEY SUPPLY
Monetary Authority in most countries is called the CENTRAL BANK.
( Board of governors- FRS)
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THE IMPORTANCE OF MONEY I: MONEY VERSUS BARTER
BARTER ECONOMY is one without a medium of exchange or a
unit of account.
PRICE LEVEL AND MONEY
* The value of a unit of money is determined, by the prices of each
and everything- the average level of prices.
* If prices go up, a unit of money ($), is worth less because it will buy
less
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*If the prices go down, a dollar is worth more because it will buy
more.
* Thus the value of money varies inversely with the price level.
THE IMPORTANCE OF MONEY II:
FINANCIAL INSTITUTIONS AND MARKETS
MONEY contributes to economic development.
By saving and investment through funds from savers and borrowers.
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The only way an economy can grow is by allocating part if its resources
to the creation of new and more productive facilities.
Uncontrolled money can cause :
INFLATION (rising prices)
HYPERINFLATION ( prices rising at a fast and furious pace).
DEFLATION ( falling prices often associates with severe recessions or
even depressions, causes different but no less severe consequences)
If the price inflation is uncontrolled, money ceases to be a reliable store
of value and becomes less efficient medium of exchange.
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BANK RESERVES AND
THE MONEY SUPPLY
Banks can create money.
Once a bank is loaned up with no more excess reserves, its ability
to create money ceases.
HOW LARGE SHOULD THE MONEY SUPPLY BE?
We should have enough money so that we buy at current prices, all the
goods and services the economy is able to produce.
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VELOCITY
When FR increases the money supply, additional liquidity will be
spent on production goods and services increasing GDP.
The relationship between the increase in GDP, over a period of
time and the initial change in the money supply is important and
named as: the velocity of money.
Velocity = Total Money Supply
Total GDP
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Fed influences the supply of money and tries to control the flow of
spending . The flow of spending, however, depends not only on
money supply of money but also on the velocity of money and ,
FED can not control it easily.
An increase in the money supply is a necessary condition for the
continuation of inflation but it is probably not a sufficient condition.
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