Chapter 1 The Financial System – Money and Prices

1. Chapter 1The Financial System – Money and Prices • What is Money? • The Origins of Money • Shells, stones, whiskey, tobacco, livestock • Precious metals – Gold and Silver

2. Chapter 1The Financial System – Money and Prices • Characteristics of Money • Scarcity • Durability • Divisibility

3. Chapter 1The Financial System – Money and Prices • Characteristics of Money • Medium of Exchange • Trade money for goods and services • Store of Value • Non-perishable • Unit of Account • A means of measuring wealth and value

4. Chapter 1The Financial System – Money and Prices • Physical Money • Full-bodied Money • Gold and Silver Coins • Intrinsic Value • Purity and weight • Debased Coinage

5. Chapter 1The Financial System – Money and Prices • Physical Money • Representative Money • Redeemable for a defined amount of full-bodied money • The U.S. Dollar prior to the 1930’s • U.S. Silver Certificates

6. Chapter 1The Financial System – Money and Prices • Physical Money • Fiat Money • Value by government decree • Legal tender Laws • Federal Reserve Notes (FRN’s)

7. Chapter 1The Financial System – Money and Prices • Deposit Money • A means to facilitate large transaction • Store safely large deposits • Transfers are facilitated by the country’s financial mechanism (commercial banks,etc.)

8. Chapter 1The Financial System – Money and Prices • Money Definitions • M1 • Currency and Checkable Deposits • M2 • M1 + noncheckable deposits, MMMF’s • M3 • M2 + large denomination time deposits, institutional MMF’s

9. Chapter 1The Financial System – Money and Prices • Money Definitions • L • All liquid Assets as money • MZM • Zero Maturity Money • Liquid Long term money • DIVISIA MONEY • Liquidity and At handedness • A degree of measure based on liquidity

10. Chapter 1The Financial System – Money and Prices • Money Substitutes • Debit Cards • Represent some deposited amount • Are money • Credit Cards • Are not money until we make a transaction • Money Market Mutual Funds • Checkable deposits managed in an asset pool • Part of M2

11. Chapter 1The Financial System – Money and Prices • Quantity of Money and Monetarist Views • “Too Much Money Chasing too few goods” • Causing inflation • Velocity of Money (Level of Activity/ MS) • V = Y / M, where Y is GDP, M is Money Supply • Y = p * y, price level and output • Rearranged we see: • MV=Y

12. Chapter 1The Financial System – Money and Prices • Quantity of Money and Monetarist Views • Say’s Law • Production creates its own demand • People would not work if they didn’t intend to buy anything • At full employment there will be a link between changes in the money supply and the price level • “Inflation if everywhere and always a monetary phenomenon” – Milton Friedman

13. Chapter 1The Financial System – Money and Prices • The Keynesian View • Attempt to regulate aggregate output through changes in interest rates, since velocity is difficult to measure • Changes in interest rates are hoped to effect Consumption and Savings/Investment • Ultimately change in the money supply effects the availability of money and the level of interest rates

14. Chapter 1The Financial System – Money and Prices • Effects of Money on the Economy • Reduction in the supply of money reduces overall spending, which slows the economy • Increases in the money stock lead to lower short term interest rates (this effect may not last long) • Too little money hampers growth, but finding the right mix is difficult

15. Chapter 1The Financial System – Money and Prices • Effects of Money on the Economy • The effect on the economy may differ depending on the type of money used in policy decisions • Example: the new tax cut will increase the level of what type of money when checks are received

16. Chapter 1The Financial System – Money and Prices • Inflation and Money – Store of Value • Value of money is viewed in relative terms as compared to other the broad spectrum of goods

17. Chapter 1The Financial System – Money and Prices • Inflation and Money – Store of Value • Inflation: A general rise in the level of prices • Alternative definition: An increase in the money supply which cause the value of money to decline relative to the price of other goods • This is a commodity view of money

18. Chapter 1The Financial System – Money and Prices • Inflation and Money – Store of Value • Inflation creates a wealth transfer effect as some benefit at the expense of others • Inflation may be seen as a tax generally on those who can least afford to pay it

19. Chapter 1The Financial System – Money and Prices • Price Indexes • Are used to measure the general change in the value of money based on a comparison of a selection of goods and services • This is generally referred to as a Market Basket of goods and services

20. Chapter 1The Financial System – Money and Prices • Price Indexes

21. Chapter 1The Financial System – Money and Prices • Price Indexes • To compare price indexes the bases (base year values) must be equivalent • Types of indexes • CPI – Consumer Price Index • Base 1982-1984 • PPI – Producer Price Index • Base 1982 • GDP Deflator – A total economy index • Base 1992

22. Chapter 1The Financial System – Money and Prices • Price Indexes • To analyze changes in purchasing power look at the reciprocal of the index • Index equal 1.642 • Reciprocal equal 0.61

23. Chapter 1The Financial System – Money and Prices • Price Indexes • Price Indexes are built using regression models • A shift in the intercept of the regression model between different time periods indicates the overall change in the price level