Unit+Four

=Unit Four=

1. Definitions of money and its creation


Money is defined in general terms as anything widely accepted as the medium of exchange. There are two types of money: commodity money and fiat money. 1. **Commodity money** – any commodity that has intrinsic value, such as precious metals (gold), animal pelts, or cigarettes. 2. **Fiat money** – Tokens that are intrinsically valueless and therefore have value by government decree, such as the U.S. dollar or the euro.

The Fed, however, defines the money supply as three monetary aggregates: M1, M2, and M3.

Money Definition **M1** 1. **Currency** – coins and paper money in the hands of the public a. Coins – token money b. Paper money – Form of Federal Reserve Notes issued by the Federal Reserve System with the authorization of congress. 2. **All Checkable** **Deposits** – all deposits in commercial banks and thrifts a. Convenient, facilitate bill payment and the transfer of ownership of bank deposits b. Require endorsement to protect against theft c. Institutions that offer checkable deposits: commercial banks, savings and loan associations, mutual savings banks, credit unions, and thrifts. 3. Note: Currency and checkable deposits owned by the U.S. government, commercial banks, Federal Reserve banks, etc. are excluded from M1 to avoid double counting.

Money Definition **M2** 1. M2 consists of all the components of M1 plus near-monies. 2. **Near-monies** – Liquid financial assets that may be readily converted into M1 money a. Savings deposits, including money market deposit accounts b. Small-time deposits (less than $100,000) that become readily available at maturity c. Money market mutual funds

Money Definition **M3** 1. M3 consists of all the components of M2 plus large-time deposits 2. **Large-time deposits** (greater than $100,000) are usually used for saving and owned by businesses.

[|Quiz on U.S. Currency!]



2. Functions of money
1. A **medium of exchange** that is usable for buying and selling goods and services. 2. A monetary **unit of account** that serves as a tool for measuring the relative worth of goods and services. Money facilitates comparison and taxation, and defines debt and GDP. 3. The most liquid store of value that allows people to **transfer their purchasing power** from the present into the future.

In order to function, money must be accepted by the people, portable, divisible, uniform, familiar, and durable. Without money, people would resort to bartering, which requires a double coincidence of wants.

3. Relationship of money supply to nominal gross domestic product (GDP)
The money supply is directly proportional to the nominal gross domestic product (GDP), based on the monetary equation of exchange that was made famous by Irving Fisher. Nominal GDP is equal to all final transactions that take place within a year.

Equation: **MV = PQ**

M: Amount of money in circulation (money supply M1) V: Income velocity of money (also, the number of times $1 changes hands from final consumer to final consumer. P: The average price level (Price Index) Q: Real GDP (value of final goods and services)

Note: Real GDP (Q) times the Price Index (P) is equal to nominal GDP. In other words, PxQ = nominal GDP.

Therefore, a larger money supply corresponds to a larger nominal GDP, but also to higher inflation (larger Price Index).

[|Buckle Up, It Could be a Bumpy 2008]

4. Creation of money and the deposit expansion multiplier
The growth of the money supply is determined by the actions of the Fed, the commercial banking system, and the public. The Fed sets the reserve requirement and the discount rate, and conducts open market operations. The commercial banking system loans money and accepts deposits, and determines the use of excess reserves. The public hold deposits and cash.

Banks do not try to create money, but the nature of their normal profit-seeking activities result in money creation because of the fractional-reserve banking system. Banks must hold a fraction of their money as reserves. The required amount is set by the Fed and is called the **reserve requirement**. The rest of their money is called excess reserves, and may be loaned out. New deposits are created as a result of the loans, and money is created.

The demand deposits that are created are a multiple of the required reserves, as shown by the equation **R = rD**, where R is the required reserves, r is the percent reserve requirement, and D is the demand deposits that are created.

The deposit expansion multiplier measures the amount of demand deposits created as a multiple of the reserve requirement. This is given by the equation **1/r**, where r is the reserve requirement. In sum, the deposit creation process is based on the fact that banks only keep a fraction of what the receive as reserves, and lend the excess out again. Smaller reserves lead to the creation of a larger number of checkable deposits, and vice versa. In the real world, the multiplier is less than 1/r because banks hold excess reserves, and the public holds cash.

[|The Money Has to Come From Somewhere]

Economics resources (topic: money): [|The Library of Economics and Liberty - Money]

An interesting connection: [|The Economics of the Wizard of Oz]

__B. Monetary Policy and Aggregate Demand__

 * 1) Tools of the central bank
 * 2) **Open Market Operations** (OMOs) are the buying and selling of bonds by the Federal Reserve to manipulate the economy. A bond is the government's promise that if you hand over your money for a slip of paper, they will repay you in full later on in life.
 * 3) **Change the reserve requirement** is another effective tool of the Federal Reserve. By increasing the reserve requirement, the Federal Reserve is dictating that banks must send a larger amount of money to the Federal Reserve as an insurance.
 * 4) **Change the discount rate** acts as a signalling move. The discount rate is the rate at which the Federal Reserve loans out to banks. While banks are hesitant to borrow from the Federal Reserve, the act of lowering or raising the reserve requirement acts as a signal to other banks. Banks will follow suit when the Federal Reserve manipulates the discount rate.
 * 5) How the Federal Reserve's tools change the money supply
 * 6) **Open Market Operations**: When the Reserve //sells// bonds, they are enforcing a contractionary policy by taking money away from the public and investing it into bonds. When the Reserve //buys// bonds, they are forcing an expansionary policy by giving the public money and taking it out of the government.
 * 7) **Change the reserve requirement**: When the Federal Reserve increases the reserve requirement, there are less funds available to loan out to the public, so a contractionary policy is enacted. When the Federal Reserve lowers the reserve requirement, they increase the amount of funds available to loan out, and enforce an expansionary policy.
 * 8) **Change the discount rate**: When rates increase, a contractionary policy begins. When the rate decreases, an expansionary policy begins.
 * 9) How the interest rate is determined in the money market
 * 10) The loanable funds graph determines the interest rate of money given a money supply and demand. As supply increases with a constant demand, the interest rate will decrease.
 * 11) [[image:http://www.stchas.edu/faculty/gbowling/images/MSupMDuprnc.gif]]
 * 12) The transmission mechanisms of changes in the money supply to output and the price level
 * 13) The idea of the transmission mechanisms of changes explains the ripple effect in our economy. For example, the Fed could begin the ripple by //buying// bonds. When they buy bonds, the money supply increases. With a larger amount of money available, interest rates will fall. With lower interest rates, the Aggregate Demand curve will shift to the left. With that shift, the real GDP will increase. Price level will lower as an overall effect as the interest rates lower. **The exact opposite of this ripple could also occur, if the Federal Reserve sells bonds instead of buying them.**

__C. Real versus Nominal Interest Rates__
1. Definition of real and nominal interest rates- A real interest rate is adjusted for inflation. The formula for a real interest rate is (1+r)/(1+i)-1. Where "r" stands for nominal interest rate and "i" is inflation. A nominal interest rate is the interest rate that hasn't been changed for inflation.

2. Fisher equation- This equation is 1+n=(1+i)(1+r), where "i" equals inflation and "r" stands for the real interest rate. "n" also stands for the nominal interest rate. The hypothesis that goes along with the equation states that "i" and "n" move together, therefore "r" will always be relatively stable in the long-run. The equation and hypothesis were formulated by Irving Fisher.

3. Short-run effects of monetary policy on real and nominal interest rates- Monetary policies that try to keep short-run, real interest rates low will actually cause higher nominal interest and a sharp increase in inflation. This policy will also reduce the value of the dollar which causes the U.S. to spend more on imports.

4. Long-run effects of monetary policy on real and nominal interest rates- These interest rates reflect what the public thinks the Fed will do in the future. For example, if the Fed chooses not to contain inflation, the general public will be concerned about increased inflation rates. So, they will add premiums to long-run rates, which will increase the interest rates. If the Fed focuses on keeping inflation under control, then interest rates will be cheaper because people will feel confident that they will be paid back in full.

http://moneyterms.co.uk/ http://www.frbsf.org/publications/federalreserve/monetary/affect.html