Principles of Economics by Fred M Gottheil

What is Money? • Note that money is a man-made invention: before money, people used barter

Inefficiency of Barter • Time consuming due to the need for the double coincidence of wants

What is Money? • Any commonly accepted good that acts as a: • medium of exchange • a measure of value (unit of account) • a store of value

What is commodity money? • Actual products that became acceptable as money, thus had 2 purposes to it: to be used as a product or as money

What is M1 Money? • Currency (held outside of banks) • Demand Deposits • Traveler’s checks • Other checkable deposits

What is M2 Money? • M1 plus less-immediate forms of money, such as savings accounts, money market mutual funds, money market deposit accounts, and small-denomination time deposits ©1999 South-Western College Publishing

Measures of Money • Large time deposits M3 + • Money market accounts • Savings deposits • Small time deposits • Miscellaneous moneys M2 + • Checkable deposits • Travelers checks • Currency MI 23 ©1999 South-Western College Publishing

Monetary Theory • How does monetary policy affect the economy? • Differing views on this

Begin with the old quantity theory of money, based on the equation of exchange

Note that Q = real GDP, PQ equals nominal GDP

Example, suppose PQ, nominal GDP = 8 trillion If the money supply equals 1 trillion, what is velocity? Answer: 8

Conclusion of the old quantity theory • If V and Q treated as constants, then M affects only P-price level is proportional to the money supply

If V is constant, and if Q is not affected by M, then M can only affect P--this is the conclusion of old classical theory Prices Money Quantity Velocity MV = PQ 36 ©1999 South-Western College Publishing

Monetarism, a modern version of the classical quantity theory • Monetarists, V not constant , but stable or predictable • Q tends in the long run to move to its full employment level • Monetarists tend to be critical of allowing the money supply to be too volatile

Milton Friedman, best known monetarist • Argues that bad monetary policy worsened the great depression • Calls for a monetary rule on the part of the Fed, constant growth in the money supply regardless of what is going on in the economy

How do the Keynsians view Velocity? • Even though they agree that spending and saving are basically stable, velocity is also effected by interest rates and expectations

What factors can lead to a rise in velocity? • Increased use of electronic banking • Use of credit cards • Getting paid more frequently • Higher rates of inflation • Higher interest rates

Must look at the demand for money • Why hold money instead of other assets?

What is the Transactions Demand for Money? • The quantity of money demanded by households and businesses to transact their buying and selling of goods and services ©1999 South-Western College Publishing

Speculative Motive Individuals may choose to hold bonds over money: Because the market value of interest-bearing bonds is inversely related to the interest rate, investors may wish to hold bonds when the interest rates are high with the hope of selling them when interest rates fall.

Due to speculative motive, money demand varies inversely with interest rates

Now put in a money supply curve, have equilibrium

Principles of Economics by Fred M Gottheil