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 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. THREE DEFINITIONS OF THE MONEY SUPPLY M1: currency + demand deposits at banks & at all thrift institutions + travelers checks. M2 : small denomination time deposits + MMDA shares + MMMF shares M3 : Large denomination($100,000 and over) time deposits + institutional money market mutual funds shares + bank repurchase agreements + eurodollars WHO DETERMINES MONEY SUPPLY Monetary Authority in most countries is called the CENTRAL BANK. THE IMPORTANCE OF MONEY I: MONEY VERSUS BARTER BARTER ECONOMY is one without a medium of exchange or a unit of account. PRICE LEVEL AND MONEY * The value of a unit of money is determined, by the prices of each and everything- the average level of prices. * If prices go up, a unit of money ($), is worth less because it will buy less *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. 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 HYPERINFLATION. If the price inflation is uncontrolled, money ceases to be a reliable store of value and becomes less efficient medium of exchange. 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 haveenough money so that we buy at current prices, all the goods and services the economy is able to poduce. 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. INFLATION An increase in the money supply is a necessary condition for the continuation of inflation but it is probably not a sufficient condition.