What Is Money and Why Do We Need It? Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset Anything of value owned by a person or a firm. The Functions of Money • Medium of exchange : buy stuff with money
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Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.
Asset Anything of value owned by a person or a firm.
The Functions of Money
Criteria for an asset to be a medium of exchange:
1 It must be acceptable to most people.
2 It should be of standardized quality.
3 It should be durable.
4 It should be valuable relative to its weight.
5 It should be divisible.
Currency is fine… “fiat money”
Checking account balances are just as good.
Electronic “money” is even better.
Precious metals serve when confidence falters.
Many Iraqis continued to use currency with Saddam’s picture on it, even after he was forced from power.
M1: The Narrowest Definition of the Money Supply
M1 includes means of payment:
1 Because balances in checking accounts are in the money supply, banks play an important role in the way money supply increases and decreases.
What about Credit Cards and Debit Cards?
You haven’t paid until you write a check to your bank.
M2: A Broader Definition
of the Money Supply
M1: The Narrowest Definition
of the Money Supply
Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.
Change in bank reserves
RR x Change in deposits
Real world deposit multiplier is less than the simple multiplier.
The Organization of the Federal Reserve System
Federal Reserve Districts
Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.
To manage the money supply, the Fed uses three monetary policy tools:
1 Open market operations: Fed buys and sells gov’t securities
Federal Open Market Committee (FOMC) sets target federal funds rate.
“Federal funds” are reserves that banks borrow and lend to each other.
Fed buys bonds to increase the supply of reserves and lower the fed funds rate.
2 Discount policy: Fed lends to banks @ discount rate
injects reserves into banking system directly
3 Reserve requirements: lowering reserve requirement converts required reserves to excess reserves
Two other actors—the nonbank public and banks—
also influence the money supply.
Connecting Money and Prices: The Quantity Equation
M × V = P × Y
Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.
We can transform the quantity equation from:
Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output
Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output
If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation one last time:
Inflation rate = Growth rate of the money supply − Growth rate of real output
Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation.
Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.
High Inflation in Argentina
Money Growth and Inflation in Argentina
During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.
Open market operations
Quantity theory of money
Required reserve ratio
Simple deposit multiplier
Velocity of money
Federal Open Market
Federal Reserve System
Fractional reserve banking system