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Money, Prices, and the Federal Reserve. Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University. Introduction. Is Economics about Money? What is Money?. Introduction. Money Any asset that is generally accepted in making purchases Examples

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Money, Prices, and the Federal Reserve

Principles of Macroeconomics

Dr. Gabriel X. Martinez

Ave Maria University


Introduction l.jpg
Introduction

  • Is Economics about Money?

  • What is Money?

Chapter 23: Money, Prices, and the Federal Reserve


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Introduction

  • Money

    • Any asset that is generally accepted in making purchases

    • Examples

      • Paper Currency, (worthless) Coins, and Checking Accounts

      • But also

        • Bronze, Silver, and Gold

        • Cows, Clams, and Cocoa Beans

        • At different times and in different places, foreign currency, boulders, even tulip bulbs have been accepted as money.

Chapter 23: Money, Prices, and the Federal Reserve


Money and its uses l.jpg
Money and Its Uses

  • An asset is money if it is …

  • …A Medium of Exchange

    • If it is used in purchasing goods and services.

  • …A Unit of Account

    • If it is a basic measure of economic value.

  • …A Store of Value

    • If is serves as a means of holding wealth.

Chapter 23: Money, Prices, and the Federal Reserve


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Money and Its Uses

  • Why is barter inconvenient?

    • Double coincidence of wants.

      • Would a bartender accept an economics lecture?

    • Less specialization

      • People try to do everything by themselves.

  • How does money solve this problem?

    • Why is everyone willing to accept money?

    • What if people refuse to accept your “money”?

Chapter 23: Money, Prices, and the Federal Reserve


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Money and Its Uses

  • Is cash money?

  • Are checking accounts money?

  • Are savings accounts money?

  • Are 3-month certificates of deposit money?

  • Are 1-year, negotiable, CDs money?

  • Is a gold mine money?

  • Is a house money?

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • How do non-cash assets that are also money (e.g., checking accounts) come into existence?

Palazzo Ducale di Venetia

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • Republic of Venice

    • Central Bank issues 1 million guilders.

Colonna di San Todaro

Colonna di San Marco

Source of pictures:

www.VeNETia.it

Basilica di San Marco

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • People want to place their 1 million guilders in a bank

  • Why? Why do banks exist?

    • They are safer than your pocket or couch.

    • They are convenient (fund transfers, check-writing).

    • They may pay interest on your deposited funds.

    • They channel your savings to productive uses.

Chapter 23: Money, Prices, and the Federal Reserve


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Consolidated Balance Sheet of Venetian Commercial Banks (Initial)

Liabilities

Deposits 1,000,000 guilders

Assets

Currency 1,000,000 guilders

  • Central Bank issues 1 million guilders.

  • Citizens open accounts and deposit1 million guilders

  • Deposits are liabilities for the bank

  • The guilders are an asset for the bank

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • If a bank receives deposits and keeps them, those guilders are the bank’s reserves.

  • Bank Reserves

    • Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments

  • Suppose Reserves = deposits. Then we have 100% reserve banking.

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • Why keep Reserves?

    • Because if depositors want to withdraw some of their funds, the bank must have cash available.

  • Why not keep 100% Reserves?

    • Because a bank’s business is to lend out funds (i.e., its depositors’ savings).

  • How much should banks keep in Reserves?

    • The Central Bank’s requirement,

    • plus predicted withdrawals.

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • Reserves are not part of the money supply (they cannot be used for exchange with goods/services).

  • Deposits are part of the money supply (you can write checks on your checking deposits).

    • Remember checks are NOT money!

Chapter 23: Money, Prices, and the Federal Reserve



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Consolidated Balance Sheet of Venetian Commercial Banks (Initial)

Liabilities

Deposits 1,000,000 guilders

Assets

Currency 1,000,000 guilders

  • Central Bank issues 1 million guilders.

  • Citizens open accounts and deposit1 million guilders

  • Deposits are liabilities for the bank

  • The guilders are an asset for the bank

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Consolidated Balance Sheet of Venetian Commercial Banks

After One Round of Loans

Liabilities

Deposits 1,000,000 guilders

Assets

Currency (= reserves) 100,000 guilders

Loans to farmers 900,000 guilders

  • Fractional Reserve Banking System

  • Bankers agree they only need a reserve to deposit ratio of 10%

  • R = r D = 0.1 D

  • Required reserves = 100,000 guilders, 10% of deposits

  • Lend the excess reserves of 900,000 guilders

Chapter 23: Money, Prices, and the Federal Reserve


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Palazzo Ducale di Venetia

$

Bank 1

Source

http://www.dtsonline.com/media/img_investors.jpg

Chapter 23: Money, Prices, and the Federal Reserve


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Palazzo Ducale di Venetia

$

Bank 1

$

Bank 2

Chapter 23: Money, Prices, and the Federal Reserve


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$

Bank 1

$

Bank 2

$

Bank 3

Chapter 23: Money, Prices, and the Federal Reserve


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$

Bank 1

$

Bank 2

$

Bank 3

$

Bank 4

Chapter 23: Money, Prices, and the Federal Reserve


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1000

$

Bank 1

900

$

Bank 2

900

810

$

Bank 3

810

729

$

Bank 4

729

Chapter 23: Money, Prices, and the Federal Reserve


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Deposits

1000+

900

+

Notice how the original deposit of 1000 has gotten multiplied.

Because Deposits are part of money, the money supply has grown by $3439

810

+

729

3439

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Consolidated Balance Sheet of Venetian Commercial Banks

After One Round of Loans

Liabilities

Deposits 1,000,000 guilders

Assets

Currency (= reserves) 100,000 guilders

Loans to farmers 900,000 guilders

  • Fractional Reserve Banking System

  • Bankers agree they only need a reserve to deposit ratio of 10%

  • R = r D = 0.1 D

  • Required reserves = 100,000 guilders, 10% of deposits

  • Lend the excess reserves of 900,000 guilders

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans

Liabilities

Deposits 1,900,000 guilders

Assets

Currency (= reserves) 1,000,000 guilders

Loans to farmers 900,000 guilders

  • Loan proceeds are redeposited

  • Reserves = 100,000 + 900,000 = 1,000,000 guilders

  • Deposits = 1,900,000 guilders

  • Money supply = Deposits = 1,900,000 guilders

  • Excess reserves = Reserves – 0.1 * Deposits

  • Excess reserves= 1,000,000 – 0.1 * 1,900,000

  • Excess reserves= 1,000,000 – 190,000 = 810,000

  • Banks can lend the excess 810,000 guilders

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Consolidated Balance Sheet of Venetian Commercial Banks

After Two Rounds of Loans and Redeposits

Liabilities

Deposits 1,900,000 guilders

Assets

Currency (= reserves) 190,000 guilders

Loans to farmers 900,000 guilders

Loans to merchants 810,000 guilders

  • Lend excess reserves

  • Reserves = 190,000 guilders

  • Deposits = 1,900,000 guilders

  • Money supply = Deposits = 190,000 guilders

  • Loans = 900,000 + 810,000 = 1,710,000

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Consolidated Balance Sheet of Venetian Commercial Banks

After Two Rounds of Loans and Redeposits

Liabilities

Deposits 2,710,000 guilders

Assets

Currency (= reserves) 1,000,000 guilders

Loans to farmers 900,000 guilders

Loans to merchants 810,000 guilders

  • Loan proceeds are redeposited

  • Reserves = 190,000 + 810,000 = 1,000,000 guilders

  • Deposits = 1,900,000+ 810,000 =2,710,000 guilders

  • Money supply = Deposits = 2,710,000 guilders

  • Excess reserves = Reserves – 0.1 * Deposits

  • Excess reserves= 1,000,000 – 271,000 = 729,000

  • Excess reserves = 729,000 guilders

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Also Reserves = original injection of Reserves by Central Bank =

1 million

Notice Reserves = 10% of D

DD=10*DR

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Also Reserves = original injection of Reserves by Central Bank =

1000

Notice Reserves = 10% of D

DD=10*DR

Chapter 23: Money, Prices, and the Federal Reserve


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The Process of Deposit Creation

Final Consolidated Balance Sheet of Venetian Commercial Banks

Liabilities

Deposits 10,000,000 guilders

Assets

Currency (= reserves) 1,000,000 guilders

Loans to farmers 9,000,000 guilders

  • Observations

  • Lending will continue to keep the reserve to deposit ratio = 10%

  • When loans = 9,000,000 guilders

    • Deposits = 10,000,000 guilders

    • Reserves = 1,000,000 guilders

    • Reserve to deposit ratio = 10%

    • No excess reserves

  • The money supply = 10,000,000 guilders

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The use of a fractional-reserve banking system allows the money supply to grow as a multiple of the reserves.

  • In Venice, with a 10% reserve-deposit ratio,1 guilder in reserve can support 10 guilders in deposit.

    • The CB creates currency, which is kept by banks as reserves. As long as banks have reserves, they can make loans, which are redeposited and become money.

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • Summary

    • R = r D

    • Bank reserves/bank deposits = desired reserve-deposit ratio

    • R / D = r

    • Bank deposits = bank reserves/desired reserve-deposit ratio

    • D = R / r

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The Central Bank can control the amount of money in an economy by

    • Printing more (or fewer) dollar bills.

      • It gives them out by exchanging them for government bonds or by lending them to banks.

    • Changing the reserve requirement ( r ).

Chapter 23: Money, Prices, and the Federal Reserve


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Exercise 23.2

  • Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 1m guilders.

  • How does the money supply change?

    • Since we are still assuming people don’t hold currency, the 1m guilders must be held as reserves by the banking system.

    • Without currency, money supply = deposits.

    • Deposits = (1/r)*Reserves

    • DDeposits = (1/r)*DReserves

    • 10m = 10*1m = (1/0.10)*1m

Chapter 23: Money, Prices, and the Federal Reserve


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Exercise 23.2

  • Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 2m guilders.

  • How does the money supply change?

    • Without currency, money supply = deposits.

    • Deposits = (1/r)*Reserves

    • DDeposits = (1/r)*DReserves

    • 20m = 10*2m = (1/0.10)*2m

Chapter 23: Money, Prices, and the Federal Reserve


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Exercise 23.2

  • Suppose banks’ desired reserve/deposit ratio is 5%, and the CB prints 1m guilders.

  • How does the money supply change?

    • Deposits = (1/r)*Reserves

    • DDeposits = (1/r)*DReserves

    • 20m = 20*1m = (1/0.05)*1m

Chapter 23: Money, Prices, and the Federal Reserve



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Commercial Banks and the Creation of Money

  • Money Supply = Currency + Deposits

  • Money Supply = Currency + R / r

  • Currency + Reserves = Central Bank Money

    • If the Central Bank prints $1000, all of it must be held either in Currency or in Reserves.

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The Money Supply with Both Currency and Deposits

    • Suppose residents choose to hold 500,000 guilders as currency

    • If the CB issues 1 million guilders, people deposit 500,000 in the banks

    • Reserve-deposit ratio = 10%

    • Bank deposits = 500,000/0.10 = 5,000,000

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The Money Supply with Both Currency and Deposits

    • Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000

      • But before we found that currency = 0,

        10,000,000 = 0 + 10,000,000

    • The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The Money Supply at Christmas

    • Currency = 500

    • Bank reserves = 500

    • Reserve-deposit ratio = 0.20

    • Money supply= 500 + 500/.20= 500 + 2,500= 3,000

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The Money Supply at Christmas

    • If Xmas shoppers withdraw 100

    • Money supply= (500+100) + (500 – 100)/0.20= 600 + 400/0.20= 600 + 2,000= 2,600

Chapter 23: Money, Prices, and the Federal Reserve


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Commercial Banks and the Creation of Money

  • The Money Supply at Christmas

    • Observation

      • When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5.

      • In general, when people make withdrawals, the money supply contracts by a multiple of the withdrawal.

      • Fall in Money Supply= (1/r) x Withdrawal – increase in cash held by public

Chapter 23: Money, Prices, and the Federal Reserve



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Central Banks

  • Two Main Responsibilities

    • Monetary policy

    • Oversight and regulation of financial markets

Chapter 23: Money, Prices, and the Federal Reserve


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Central Banks

  • Their primary mission is to promote low inflation, economic growth, and stable financial markets.

  • The Bank of England was founded in 1694.

  • The US Federal Reserve System, 1913.

  • Many Latin American countries founded central banks in the 1920s.

Chapter 23: Money, Prices, and the Federal Reserve


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Central Banks

  • Controlling the Money Supply: Open-Market Operations

    • The primary function of Central Banks is monetary policy.

    • CBs control the money supply by changing the supply of bank reserves.

Chapter 23: Money, Prices, and the Federal Reserve


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Central Banks

  • Controlling the Money Supply: Open-Market Operations (OMOs)

    • Open-market operations are the most important method of changing the supply of bank reserves.

  • The “Market” in OMOs is the Market for Government or Central Bank Bonds.

    • The CB exchanges bonds for currency.

Chapter 23: Money, Prices, and the Federal Reserve


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Central Banks

  • Bond

    • A legal promise to repay a debt, usually including both the principal amount and regular interest payments.

Source: www.rainfall.com/ posters/WWI/catalog11.htm

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Operations

  • Increasing The Money Supply

    • The Fed purchases US government bonds from the public.

    • The people deposit the funds they get from their sale of bonds to the Fed.

    • The increase in deposits increase bank reserves.

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Operations

  • Increasing The Money Supply

    • The increase in reserves will lead to an expansion of the money supply as banks make more loans.

    • Recall

      • The change in the money supply is a multiple of the change in reserves.

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Operations

  • Reducing The Money Supply

    • The CB sells government bonds to the public.

    • The CB presents the checks from the sale of the bonds to the banks for payment.

    • The bank’s reserves will fall when they clear the checks.

    • The money supply will fall by a multiple of the decrease in reserves.

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Purchase

  • Open-Market Purchase

    • The purchase of government bonds from the public by the CB for the purpose of increasing the supply of bank reserves and the money supply.

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Purchase

New money becomes a part of the bank’s reserves

Fed pays for BOND purchase with a check, which is depositedin a commercial bank

Additional lending increases the money supply

Reserves are the basis for additional lending

D → L → D → L → D → L → …

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Sale

  • Open-Market Sale

    • The sale by the CB of government bonds to the public for the purpose of reducing bank reserves and the money supply

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Sale

Fed receive a check (drawn on a commercial bank deposit) in exchange for the Bond.

Open market sale reduces the supply of bank reserves

Fewer reserves are available to back new loans

Reduction in lending means that fewer dollars will be created.

Chapter 23: Money, Prices, and the Federal Reserve


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Open Market Operations

  • Suppose the CB wants to increase the money supply using open-market operations.

    • Currency = 1,000 shekels; Reserves = 200

    • Reserve-deposit ratio = 0.2

    • Money supply = 1,000 + 200/0.2 = 2,000 shekels

  • What should the CB do?

  • Chapter 23: Money, Prices, and the Federal Reserve


    Open market operations58 l.jpg
    Open Market Operations

    • An Open Market Purchase increases Reserves and the Money Supply

      • Open market purchase = 100

      • Reserves increase to 300

      • Money supply = 1,000 + 300/0.2 = 2,500 shekels

    Chapter 23: Money, Prices, and the Federal Reserve



    Money and prices60 l.jpg
    Money and Prices

    • “Inflation is always and everywhere a monetary phenomenon”

      -- Milton Friedman

    • This is true in the long run and if inflation is very high.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices61 l.jpg
    Money and Prices

    Price of 1 radio = 4 oranges

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices62 l.jpg
    Money and Prices

    Price of 1 radio = 6 oranges

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices63 l.jpg
    Money and Prices

    Price of 1 radio = 3 oranges

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices64 l.jpg
    Money and Prices

    • Assume an economy where dollar bills are used only once a year (“velocity” = 1); and where annual real GDP = 10 million houses.

    • Suppose Ms=$10bn. What will P be?

    • MV = PY

    • $10bn x 1 = P x 10 million houses

    • P = $1 thousand / house

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices65 l.jpg
    Money and Prices

    • Now suppose Ms=$20bn. What will P be?

    • MV = PY

    • $20bn x 1 = P x 10 million houses

    • P = $2 thousand / house

    • If M doubles, P doubles. M/P doesn’t change.

    • Why doesn’t this happen in the short run?

      • Because M affects P through the goods, money, and labor market, over time.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices66 l.jpg
    Money and Prices

    • Velocity

      • The speed at which money circulates.

        • The number of times a dollar bill is used in one year.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices67 l.jpg
    Money and Prices

    • Velocity

      • The speed at which money circulates

        • The number of times a dollar bill is used in one year.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices68 l.jpg
    Money and Prices

    • Money and Inflation in the Long Run

      • Quantity equation

        M x V = P x Y

    It’s a definition, so it’s always true.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices69 l.jpg
    Money and Prices

    • Money and Inflation in the Long Run

      • Assume V & Y are constant over the time period

    This is a definition, so it’s always true.

    This is a theory, so it may or may not be true.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices70 l.jpg
    Money and Prices

    • Money and Inflation in the Long Run

      • Why should we assume V & Y are constant?

      • Y is determined by human capital, technology, etc.. This theory says economic growth is unrelated to the quantity of money.

      • V is determined by institutions, etc.. This theory says that the need for transactions (which use money) is also unrelated to the quantity of money.

      • So if we change M, we assume V or Y won’t change. Then assume they are constant.

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices71 l.jpg
    Money and Prices

    • Money and Inflation in the Long Run

      • If the Fed increases M by 10%, then prices must increase by 10%.

      • High rates of money growth are associated with high rates of inflation.

      • Too much money is chasing too few goods.

    Chapter 23: Money, Prices, and the Federal Reserve


    Inflation and money growth in latin america 1995 2001 l.jpg
    Inflation and Money Growth in Latin America, 1995-2001

    Chapter 23: Money, Prices, and the Federal Reserve


    Money and prices73 l.jpg
    Money and Prices

    • If high rates of money growth lead to inflation, why do countries allow their money supplies to rise so quickly?

      • In the case of Ecuador, because of the need for a lender of last resort!

      • The Central Bank had to print billions of sucres to try to save the banks from failing … which caused the economy, and the banks, to collapse.

    Chapter 23: Money, Prices, and the Federal Reserve