ECON 102
Spring 2006
Dr. Ebru Guven Solakoglu
Fatih University
Week 6
Functions of Money
The Multiplier Model and AD – AS ............................................................................... 1
The functions of Money: ................................................................................................. 3
Measuring the Stock of Money: ...................................................................................... 4
The Demand for Money .................................................................................................. 4
Transaction Demand for Money: .................................................................................... 4
The Multiplier Model and AD – AS
A special case of the aggregate demand and supply:
Potential
real GDP
Total
spending
E
C+I
MULTIPLIER MODEL
C
Real GDP
Price level
AS
AS /AD MODEL
AD
Real GDP
The key assumption of multiplier model is that prices and wages are fixed in the short
run; because they are fixed, all the adjustments in the economy come through output
and employment. In other case, we assume AS curve is horizontal until full employment
is reached.
Extending the Simple Multiplier method by adding fiscal policy:
 How do the government purchases affect output?
Impact of Taxes:
Potential
real GDP
Total
spending
E
MULTIPLIER MODEL
C
C’
E’
Real GDP
Price level
AS
AS /AD MODEL
AD’
AD
Real GDP
As taxes increase disposable income decrease, this leads to decreases in consumption.
Holding the investment and government expenditures constant, GDP decreases, income
and employment decreases. AD curve shifts to the left and a new equilibrium point is
achieved E.
Impact of Government Purchases of Goods and Services:
Potential
real GDP
Total
spending
E’
C+I+G
MULTIPLIER MODEL
C+I
E
Real GDP
Price level
AS
AS /AD MODEL
AD
AD’
Real GDP
The functions of Money:
Money is anything that is generally accepted as payment in exchange for goods and
services. It also serves as a standard of value, a standard of deferred payment and a
store of value.
Why do we study the quantity of money?  because, it can affect the credit availability,
aggregate level and price level.
There are 4 major functions of money as we counted above:
1. A medium of exchange
a. Money is generally accepted as a medium of exchange
b. It eliminates the need for barter (inconvenient trading)
c. It cuts down on the transaction costs of trading
2. a standard of value
a. money provides a unit of account (i.e. dollar, euro, Turkish lira) that
serves as a standard for the measure of value
b. Value is a measure of what the person will sacrifice in order to obtain it
(i.e. how much is a car worth to you!)
3. A standard of deferred payment
a. Money contracts involve promises to make payments in the future
b. The unit of account for deferred payment of debts is money
c. Requires fairly constant purchasing power
4. A store of value
a. Money serves as a store of value that can be quickly converted into
goods and services
b. Money is completely liquid
c. Money can be converted into goods and services without any
inconvenience or cost. Therefore, it reduces the transaction costs of
conducting everyday business.
What money is not?
-
money is not a productive input (i.e. money is not capital, but it
can be used to purchase capital goods)
money is not income (i.e. income is a flow of currency over a
given period)
a credit card is not money (because, purchases with credit cards
imply that a debt is incurred, which must be paid with money at a
later time)
Commodity Money: An item that serves the functions of money, but also has an
intrinsic value as a marketable item. (i.e. tobacco, corn, etc in early times in US; gold,
silver in Europe)
Fiat Money: Money that is accepted to as a medium of exchange because of
government decree rather than because of its intrinsic value as a commodity.
Measuring the Stock of Money:
Money is a stock rather than a flow. A stock is a variable that can be measured only at a
given point in time.
The federal reserve system has developed several measures of the money stock:
M1: (narrowest measure)
Sum of currency + traveler’s checks + checkable deposits held by public.
M2: (broader measure)
M2 = M1 + near monies
[ near monies=assets that are easily converted into currency or demand deposits before
they can be used to make payments. They can be liquidated at low cost, it also involves
a little risk of loss. They include, money market deposit account at banks, money market
mutual fund accounts, savings account and small denomination certificates of deposit,
and certain other near monies.]
M3=M2 + large denomination ($100,000 or more) certificates of deposit and other larger
denomination liquid assets.
The Demand for Money
Why do we hold money? Why don’t we invest everything in stock s since we get (higher)
interest?  There are both benefits and costs of holding money. The opportunity cost of
holding a dollar in money over the year is the interest income that is foregone. The
higher the interest rate that can be earned in the next best alternative, the greater is the
opportunity cost of holding money.
Interest
rate
Money
demand
Quantity of money
demanded ($)
Transaction Demand for Money:
At any given level of interest rates, people demand a certain amount of money to carry
out the basic transactions associated with everyday business (i.e. paying rent, gasoline,
groceries, etc). Transaction demand for money is the sum of money people want to hold
per day as a convenience in paying their bills. The benefit for such behavior is to avoid
transaction costs of converting other assets to money.
The yearly transaction demand for money depends on the volume o transactions over
the year given level of interest rates. Therefore, in general, the greater the level of
nominal GDP, the greater is the transaction of demand for money. Also, since increase
in nominal GDP implies increase in real GDP and/or increase in price levels, we should
expect an increase in money demand during the periods of economic expansion (when
real GDP is increasing).
Therefore, people hold money because;
1. it is liquid
2. as a precaution
Precautionary demand for money happens when there is a lack of
synchronization between inflow of income and outflow of income. For
example greater the uncertainty about the future flows of income and
required payments, greater is the precautionary demand for money.
3. as a speculative motive
Speculative demand for money happens when there is uncertainty about the
future level of prices and interest rates, price of stock and bonds lead a
speculative motive for holding money. For example, prices of assets fluctuate
with economic conditions. If we expect bond prices to fall in the future, then
there will be an increase in speculative demand for money in that period.
4. transaction cost of obtaining currency and/or converting near monies to money.
a. For example, increase in the number of ATMs, increase in the number of
banks, decrease in ATM fees decrease the transaction costs and
therefore decrease the demand for money.