ECONOMICS
What does it mean to me?
Part V:
•Money
•Monetary Equation of Exhange
•Creation of banking
READ Mankiw, Chapter 29, 30,
Morton Unit 4
In any society, money
is the asset, commodity
or token, that serves as
a medium of exchange.
The Father of Capitalism, Adam
Smith, defined money as a
commodity or token that
everyone will accept for the
things they have to sell.
Different societies may have
different monies, such as gold
coins in medieval Europe, cowrie
shells in West Africa, or wampum
in Native American societies of
North America.
MONEY SHOULD BE:
•Stable
•Portable
•Durable
•Uniform
•Divisible
•Recognizable
Three types of money:
•Commodity money
•Fiat money
•Fiduciary money
COMMODITY MONEYS
have value in nonmonetary uses equivalent
to the monetary value of
the commodity.
Well known examples are gold,
copper, and silver…..but cowrie
shells, tobacco, and cigarettes
have all been used.
FIAT MONEY is a monetary
standard that people are required
by law to accept as a medium of
exchange and/or standard of
deferred payment.
It is money by the “fiat” -- the
command--of the sovereign.
It is usually known as paper
money.
FIDUCIARY MONEY is when a bank
issues credible promises to pay in
some other form of money, and the
promise is transferable, they can
circulate as money.
It is based on the trust people have that
a bank will keep faith and pay as
promised.
Two major instances of fiduciary
money are bank notes and checking
accounts.
FIAT and FIDUCIARY
MONEYS are tokens, of
course, as distinct from
commodity moneys. These
token moneys are the most
important kinds of money in
the world.
Currency is the paper bills and
coins in the hands of the public.
Demand deposits are balances
in bank accounts that depositors
can access on demand by
writing a check
What about credit cards?
Economists do not regard
credit cards as money, because
a credit card is not an asset.
Having a credit card, or a “line of
credit” means that XYZ bank is willing
to loan you the money, and the credit
card is proof of that fact.
Many people use credit cards for
routine payments, and pay their bills
within the “grace period”, and never
pay interest. This has proved very
convenient, however, banks do not
find it very profitable.
Now people are using DEBIT CARDS,
which takes the amount directly from
your checking account. They are
used just like a credit card but, there
is no loan.
For an economist, the distinction between
a credit card and a debit card is crucial.
DEBIT CARD transactions draws on
assets that were there all along.
CREDIT CARD transactions create liabilities--not
assets-- for the buyer, and the liability only
comes into existence when the transaction
takes place.
WHERE THERE ARE NO
ASSETS, THERE IS NO
MONEY.
WHAT IS THE MONEY SUPPLY?
Economists have compromised on the case for and against
including & excluding savings accounts, CDs, and money
market mutual funds by defining the money supply with two
categories:
M1- currency, checkable deposits,
travelers checks, demand deposits,
NOW accounts, ATS accounts,
credit union share draft accounts.
The major component of M1
money is checkable deposits.
M2- M1 money PLUS savings
accounts, time deposits, and money
market mutual funds, overnight
repurchase agreements, overnight
eurodollar deposits. M2 money is also
called “near money” because it is not as
liquid as M1.
M3- M2 money plus large time deposits,
repurchase agreements longer than one
day, eurodollars with maturities longer
than one day.
. Credit card balances
are NOT part of M1, M2,
or M3 money
Figure 1: Money in the U.S. Economy (2001)
Billions
of Dollars
M2
$5,455
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($4,276 billion)
M1
$1,179
0
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($599 billion)
• Currency
($580 billion)
• Everything in M1
($1,179 billion)
Copyright©2003 Southwestern/Thomson Learning
CASE STUDY (pg. 633):
Where Is All The Currency?
In 2001 there was about $580 billion of
U.S. currency outstanding.
– That is $2,734 in currency per adult.
Who is holding all this currency?
– Currency held abroad
– Currency held by illegal entities (drug
dealers, tax evaders, and other
criminals)
The four functions of
money are:
•Medium of exchange
•Unit of account
•Standard of deferred payment
•Store of value
MEDIUM OF EXCHANGE
Whatever people usually
give in exchange for the
things they buy is the
medium of exchange. This
is the function that defines
money.
UNIT OF ACCOUNT
The unit in which values are
stated, recorded and
settled. This may seem a
subtle difference between
this and medium of
exchange, but there are a
few cases in which the
difference is expressed.
STANDARD OF DEFERRED
PAYMENT
The unit in which debts are stated,
usually the same as medium of
exchange, but not always. Deferred
payment means a payment made in the
future, not now.
[During periods of inflation, people may accept
paper money for immediate payment, but
insist on some other medium for deferred
payment because the medium of exchange
would lose much of its value in the
meanwhile.]
STORE OF VALUE
This is something people keep in order
to maintain the value of their wealth.
While it would usually be the same as
medium of exchange, in inflationary
times other media might be substituted,
such as jewelry, land or collectable
goods. In this sense, money is “set
aside” for the future.
LIQUIDITY
Liquidity is the ease with
which an asset can be
converted into the economy’s
medium of exchange.
The Early History of Money
Money has been used for over 3000 years.
City-states in the ancient near east had
extensive trade from city to city, and they
used precious metals as a medium of
exchange. When trades were settled a
certain amount of metal could be used to
settle the difference.
PROBLEMS:
•Quality control
•Determining quantity of the metal
•Determining purity of the metal
The answer was quality control and
certification. The early Kings of Lydia
standardized the hunks of metal and
guaranteed their quality by stamping
the king’s picture on them. These
were the first coins. This made a very
rich and powerful kingdom even more
rich and powerful. Croesus and
Midas -- of all king the most
proverbially wealthy ones -- were
among the kings of Lydia.
Other kingdoms did the
same thing.
By 1000 AD, metallic coin
monetary systems had
spread through much of
the old world.
The Chinese were the innovators
for the next step. The Chinese
invented printing, and not too
much later, they also invented
paper money. By 1000 AD, paper
money was widespread
throughout China. They
abandoned it about 1500 AD, in
the general decline of Chinese
society after the Mongol
conquest.
Paper money was to evolve
much more indirectly in
Europe.
We will tell a version of the
history of European money:
The story of the
BANK OF FRED
Fred is the only goldsmith in a small
medieval city. As a goldsmith, he has a
strong vault to keep his supplies. He
also stores the gold owned by other
citizens for a small fee.
A business that stores money for a fee
is called a BANK OF DEPOSIT.
Fred gives his
customers RECEIPTS
for their deposits.
After a while, some of Fred’s
customers use the receipts for the
gold they have deposited to make
payments and settle debts.
For example, John may hand over a receipt in
payment for a wagon, and the wagon-maker
may go down to Fred’s Bank and take out his
gold. Or, he may leave the gold on deposit and
pass the receipt on to the cooper to pay for
some barrels.
In this way, receipts begin to circulate
as money.
The receipts have become BANK NOTES.
Each receipt says:
Fred the Goldsmith
will pay to the
bearer, on demand,
one gold florin.
…and these
receipts are
acceptable in
Fred’s town
because people
have faith that
Fred can and will
honor that
promise.
These bank-notes are “fiduciary money.”
A bank that issues bank notes
is known as a
BANK OF ISSUE
…..and Fred’s
Goldsmith Shop
has become a
bank of issue.
Then Fred makes a discovery. He
finds that only a small percent of his
receipts or bank notes are cashed in
for gold in any given period.
Fred figures he can issue more
notes than he has gold in his vaults,
since he can meet the small daily
demand for redemption out of gold
in the vaults.
One day, Ronald the Peasant comes
in to ask for a loan. Ronald wants to
buy a second ox team to cultivate a
larger field.
Fred doesn’t have any
gold to loan -- so he
writes out some banknotes instead.
The ox-seller accepts the bank-notes in
payment for the ox, and at the end of the year,
Ronald the Peasant sells some of his crop to
repay the loan with interest.
Fred has created money out
of nothing (but TRUST)!
Creating money is very
profitable as his profits
come from INTEREST on
the loans.
A Bank of Issue creates fiduciary money,
either in the form of bank-notes or some other
form, and lends them at a profit.
Since the money is created from nothing, the
interest may be mostly profits.
In competitive banking,
competition may limit bank
profits. But the Bank of Fred,
a monopoly bank in a small
medieval town, faces no limit
from competition.
But there is one problem all the
same……...
If too many customers want to redeem their
bank notes all at once, the bank may not
have the cash. This is called a
“RUN” on the bank.
The Bank of Fred will
then be unable to redeem
its notes, faith in them
will collapse, and the
bank-notes will cease to
be money.
Therefore, Fred must keep enough gold coins in
reserve to avoid this danger. These reserves set
a limit to the amount of money that Fred can
create.
If experience has taught Fred that he needs to keep
one Florin in the vault for every three banknotes he
has issued, Fred will adopt a
RESERVE RATIO
A ratio of reserves to
money issue -- of 1/3.
This determines how much money Fred
can issue….
In some systems of
fiduciary money, the
law sets a minimum
reserve ratio but in
others, the reserve
ratio is a matter of the
banker’s best
judgment.
MONETARY
EQUATION
OF
EXCHANGE
This theory of money is comprised of four
elements:
V
Velocity of money
M
Amount of money in circulation
P
Price Level
Q
Real GDP or real value of all goods
and services.
In economics, the VELOCITY of money is the
speed at which a dollar can travel from one
person to another within a year.
The equation is:
V = (P x Q)/M
For example, suppose an economy produces 1000
hats a year at $20 a hat. The quantity of money in the
economy is $500.
V = (20 x 1000)/500
or
40
This means that an average dollar will be exchanged
between 40 people within the average year.
This equation V = (P x Q)/M can be rewritten as:
MxV=PxQ
Because the velocity (V) of money is relatively stable
over time, the Federal Reserve changes the quantity
of money (M) to affect change in Q and P.
Since Q (or GDP) is primarily affected by resources
(L,L,C,E), money will not affect the output.
The result is an change in the price level (P).
Therefore, if we increase the money supply too
rapidly, it results in inflation.
If we decrease the money supply too rapidly, it
results in recession.
All we need an institution in charge of
regulating the money supply………
Present Value vs.
Future Value
Also covered in Investment Chapters
Finance is the field that studies
how people make decisions
regarding the allocation of
resources over time and the
handling of risk.
Present value refers to the amount of
money today that would be needed to
produce, using prevailing interest rates,
a given future amount of money.
PRESENT VALUE: MEASURING THE TIME
VALUE OF MONEY
• The concept of present value
demonstrates the following:
– Receiving a given sum of money in the
present is preferred to receiving the same sun
in the future.
– In order to compare values at different points
in time, compare their present values.
– Firms undertake investment projects if the
present value of the project exceeds the cost.
PRESENT VALUE: MEASURING THE TIME
VALUE OF MONEY
• If r is the interest rate, then an amount X to
be received in N years has present value
of:
X/(1 + r)N
• Because the possibility of earning interest
reduces the present value below the
amount X, the process of finding a present
value of a future some of money is called
discounting.
PRESENT VALUE: MEASURING THE TIME
VALUE OF MONEY
• Future Value
– The amount of money in the future that an
amount of money today will yield, given
prevailing interest rates, is called the future
value.
PRESENT VALUE: MEASURING THE TIME
VALUE OF MONEY
RULE OF 70
• According to the rule of 70, if some variable
grows at a rate of x percent per year, then
that variable doubles in approximately 70/x
years.
To Monetary Policy Presentation
Compiled by Virginia Meachum, Economics Teacher, Coral
Springs High School
Sources: Bank of Fred (http://williamking.www.drexel.edu/top/Prin/txt/money/MOH1.html)