Macroeconomics - ECO 2013

Fall 205 – 1 TermAugust 24 – December 16, 2005

Chapter 13: Money & Banking

When working properly, the monetary system provides lifeblood of the circular flows of income & expenditure.Well-operating monetary system helps economy achieve full employment & efficient use of resources.Malfunctioning monetary system creates severe fluctuations in the economy’s levels of output, employment & prices, distorting the allocation of resources

The Functions of Money1. Mediums of Exchange for buying & selling

goods & services2. Unit of Account, yardstick for measuring

the relative worth of a variety of goods, services & resources.

Price of each item stated only in terms of the monetary unit

Money aids rational decision making by enabling buyers & sellers to easily compare the prices of various goods, services, and resources.

3. Store of value enables transfer of purchasing power from present to future

Store some of wealth as money

The Supply of Money

Money Definition M1Money Definition M2Money Definition M3

Money Definition M1

Narrowest definitionConsists of: Currency (coins & paper money) in hands of

public Coins are token money: Intrinsic value (of the metal

contained in the coin) < face value All checkable deposits (in commercial banks &

“thrifts” or savings on which checks can be drawn)

Money, M1 = Currency + Checkable Deposits

Money Definition M2Broader definition Near-monies are certain highly liquid financial assets

that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits

Savings deposits, including money market deposit accounts (MMDA)Small time deposits (<$100,000)Money market mutual funds (MMMF)

Money, M2 = M1 + Savings Deposits including MMDAs + Small time Deposits (<$100,000) + MMMFs)

Money Definition M3

Includes large time deposits (>$100,000) Certificates of deposit

Money, M3 = M2 + large time deposits (>$100,000)

Credit Cards

Not really moneyMeans of obtaining a short-term loan from commercial bank or other financial institution that issued the cardMeans of deferring or postponing payment for a short period

What “backs” the money supply?

Government’s ability to keep its value stable provides the backingMoney is debt; paper money is a debt of Federal Reserve Banks & checkable deposits are liabilities of banks & thrifts b/c depositors own themValue of money arises not from intrinsic value, but its value in exchange for goods & services

Value of Money

Acceptable as a medium of exchangeCurrency is legal tender or fiat money; must be accepted by lawRelative scarcity of money compared to goods & services will allow money to retain its purchasing powerMoney’s purchasing power determines its value. Higher prices mean less purchasing power.

Inflation & Acceptability

Excessive inflation may make money worthless & unacceptableWorthless money leads to use of other currencies that are more stableWorthless money may lead to barter exchange system.

Stabilization of Money’s Value

The government tries to keep supply stable w/ appropriate fiscal policyMonetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow

The Demand for Money: Two Components

Transactions demand, Dt is money kept for purchases, will vary directly w/ GDPAsset demand, Da is money kept as store of value for later use, varies inversely w/ interest rate, since that is price of holding idle moneyTotal demand, Dm will equal quantities of money demanded for assets & transactions

The Money Market

Sm represents money supply Vertical line b/c monetary authorities

& financial institutions have provided the economy w/ particular stock of money

Intersection of demand & supply determines equilibrium price

The Federal Reserve Bank & The Banking System

Board of Governors of the Federal Reserve System (“the Fed”)Board directs 12 Federal Reserve Banks which control lending activity of nation’s banks & thrift institutionsFederal Open Market Committee (FOMC) Sets Fed’s monetary policy & directs

purchase & sale of government securities in the open market, “open-market operations”

Fed Functions & The Money Supply

Issuing currencySetting reserve requirements & holding reservesLending money to banksProviding for check collectionActing as fiscal agentSupervising banksControlling money supply

Federal Reserve Independence

Protects Fed from political pressures to effectively control money supply & maintain price stabilityPolitical pressures on Congress & Executive Branch result in inflationary fiscal policy, including tax cuts & special-interest spending, but Fed can take actions to increase interest rates when higher rates are needed to stem inflationCountries w/ independent central banks have lower rates of inflation, on average, than countries w/ little or no independence

Recently Developments in Money & Banking

Relative decline of banks & thriftsConsolidation among banks & thriftsConvergence of services provided by financial institutionsGlobalization of financial marketsElectronic transactions

Last Word: The Global Greenback

Two-thirds of all U.S. currency is circulating abroadU.S. profits when dollars stay overseasBlack markets & illegal activity overseas are usually conducted in dollars b/c are such a stable form of currencyThe dollar is a reliable medium of exchange, measure, & store of value that facilitates transactions everywhereAll dollars will not return to the U.S.

Chapter 13 Study Questions

1: Functions of Money5: Backing Money

Next Class

Chapter 14: How Banks and Thrifts Create MoneyChapter 15: Monetary Policy

Quiz on Ch. 9 – 12, 16