ECONOMICS. Part V: Money Monetary Equation of Exhange Creation of banking. What does it mean to me? READ Mankiw, Chapter 29, 30, Morton Unit 4

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1 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

2 In any society, money is the asset, commodity or token, that serves as a medium of exchange.

3 Part V - The Real Economy, Money & Prices in the Long Run Ch 12 - Production & Growth, pgs Ch 13 - Saving, Investment and the Financial System. Pgs Ch 14 - Basic Tools of Finance, Pgs Ch 15 - Unemployment, Pgs Ch 16 - Monetary System, Pgs Ch 17 - Money Growth and Inflation, Pgs

4 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.

5 MONEY SHOULD BE: Stable Portable Durable Uniform Divisible Recognizable

6 Three types of money: Commodity money Fiat money Fiduciary money

7 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.

8 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.

9 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.

10 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.

11 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

12 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.

13 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.

14 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.

15 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.

16 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.

17 . Credit card balances are NOT part of M1, M2, or M3 money

18 Figure 1: Money in the U.S. Economy (2001) Copyright 2003 Southwestern/Thomson Learning Billions of Dollars $5,455 M2 Savings deposits Small time deposits Money market mutual funds A few minor categories ($4,276 billion) $1,179 0 M1 Demand deposits Traveler s checks Other checkable deposits ($599 billion) Currency ($580 billion) Everything in M1 ($1,179 billion)

19 CASE STUDY (pg. 633): Where Is All The Currency? In 2001 there was about $5.80 trillion 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)

20 The four functions of money are: Medium of exchange Unit of account Standard of deferred payment Store of value

21 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.

22 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.

23 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.]

24 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.

25 LIQUIDITY Liquidity is the ease with which an asset can be converted into the economy s medium of exchange.

26 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

27 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.

28 Other kingdoms did the same thing. By 1000 AD, metallic coin monetary systems had spread through much of the old world.

29 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.

30 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

31 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.

32 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.

33 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.

34 A bank that issues bank notes is known as a BANK OF ISSUE..and Fred s Goldsmith Shop has become a bank of issue.

35 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.

36 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.

37 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.

38 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.

39 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.

40 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.

41 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.

42 MONETARY EQUATION OF EXCHANGE

43 This theory of money is comprised of four elements: V M P Q Velocity of money Amount of money in circulation Price Level Real GDP or real value of all goods and services.

44 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.

45 This equation V = (P x Q)/M can be rewritten as: M x V = P x Q 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).

46 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

47 Present Value vs. Future Value Also covered in Investment Chapters

48 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.

49 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.

50 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.

51 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.

52 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.

53 To Monetary Policy Presentation Compiled by Virginia Meachum, Economics Teacher, Coral Springs High School Sources: Bank of Fred (