Chapter 1
The Financial System – Money and Prices
• What is Money?
– The Origins of Money
• Shells, stones, whiskey, tobacco, livestock
• Precious metals – Gold and Silver
Chapter 1
The Financial System – Money and Prices
• Characteristics of Money
• Scarcity
• Durability
• Divisibility
Chapter 1
The Financial System – Money and Prices
• Characteristics of Money
– Medium of Exchange
• Trade money for goods and services
– Store of Value
• Non-perishable
– Unit of Account
• A means of measuring wealth and value
Chapter 1
The Financial System – Money and Prices
• Physical Money
– Full-bodied Money
• Gold and Silver Coins
• Intrinsic Value
– Purity and weight
• Debased Coinage
Chapter 1
The Financial System – Money and Prices
• Physical Money
– Representative Money
• Redeemable for a defined amount of fullbodied money
• The U.S. Dollar prior to the 1930’s
• U.S. Silver Certificates
Chapter 1
The Financial System – Money and Prices
• Physical Money
– Fiat Money
• Value by government decree
• Legal tender Laws
• Federal Reserve Notes (FRN’s)
Chapter 1
The Financial System – Money and Prices
• Deposit Money
– A means to facilitate large transaction
– Store safely large deposits
– Transfers are facilitated by the country’s
financial mechanism (commercial banks,etc.)
Chapter 1
The Financial System – Money and Prices
• Money Definitions
– M1
• Currency and Checkable Deposits
– M2
• M1 + noncheckable deposits, MMMF’s
– M3
• M2 + large denomination time deposits,
institutional MMF’s
Chapter 1
The Financial System – Money and Prices
• Money Definitions
–L
• All liquid Assets as money
– MZM
• Zero Maturity Money
• Liquid Long term money
– DIVISIA MONEY
• Liquidity and At handedness
• A degree of measure based on liquidity
Chapter 1
The Financial System – Money and Prices
• Money Substitutes
– Debit Cards
• Represent some deposited amount
• Are money
– Credit Cards
• Are not money until we make a transaction
– Money Market Mutual Funds
• Checkable deposits managed in an asset pool
• Part of M2
Chapter 1
The Financial System – Money and Prices
• Quantity of Money and Monetarist Views
– “Too Much Money Chasing too few goods”
• Causing inflation
– Velocity of Money (Level of Activity/ MS)
• V = Y / M, where Y is GDP, M is Money Supply
– Y = p * y, price level and output
• Rearranged we see:
– MV=Y
Chapter 1
The Financial System – Money and Prices
• Quantity of Money and Monetarist Views
– Say’s Law
• Production creates its own demand
• People would not work if they didn’t intend to
buy anything
• At full employment there will be a link between
changes in the money supply and the price level
• “Inflation if everywhere and always a monetary
phenomenon” – Milton Friedman
Chapter 1
The Financial System – Money and Prices
• The Keynesian View
– Attempt to regulate aggregate output
through changes in interest rates, since
velocity is difficult to measure
– Changes in interest rates are hoped to effect
Consumption and Savings/Investment
– Ultimately change in the money supply
effects the availability of money and the level
of interest rates
Chapter 1
The Financial System – Money and Prices
• Effects of Money on the Economy
– Reduction in the supply of money reduces
overall spending, which slows the economy
– Increases in the money stock lead to lower
short term interest rates (this effect may not
last long)
– Too little money hampers growth, but
finding the right mix is difficult
Chapter 1
The Financial System – Money and Prices
• Effects of Money on the Economy
– The effect on the economy may differ
depending on the type of money used in
policy decisions
– Example: the new tax cut will increase the
level of what type of money when checks are
received
Chapter 1
The Financial System – Money and Prices
• Inflation and Money – Store of Value
– Value of money is viewed in relative terms as
compared to other the broad spectrum of
goods
Chapter 1
The Financial System – Money and Prices
• Inflation and Money – Store of Value
– Inflation: A general rise in the level of
prices
– Alternative definition: An increase in the
money supply which cause the value of
money to decline relative to the price of
other goods
• This is a commodity view of money
Chapter 1
The Financial System – Money and Prices
• Inflation and Money – Store of Value
– Inflation creates a wealth transfer effect as
some benefit at the expense of others
– Inflation may be seen as a tax generally on
those who can least afford to pay it
Chapter 1
The Financial System – Money and Prices
• Price Indexes
– Are used to measure the general change in
the value of money based on a comparison of
a selection of goods and services
• This is generally referred to as a Market Basket
of goods and services
Chapter 1
The Financial System – Money and Prices
• Price Indexes
( Pt  Pt 1 )
P 
 100
Pt 1
Chapter 1
The Financial System – Money and Prices
• Price Indexes
– To compare price indexes the bases (base
year values) must be equivalent
– Types of indexes
• CPI – Consumer Price Index
– Base 1982-1984
• PPI – Producer Price Index
– Base 1982
• GDP Deflator – A total economy index
– Base 1992
Chapter 1
The Financial System – Money and Prices
• Price Indexes
– To analyze changes in purchasing power
look at the reciprocal of the index
– Index equal 1.642
– Reciprocal equal 0.61
Chapter 1
The Financial System – Money and Prices
• Price Indexes
– Price Indexes are built using regression
models
– A shift in the intercept of the regression
model between different time periods
indicates the overall change in the price level