Econ 110: Introduction to Economic Theory
22nd Class
3/25/11
what is money?
e.g. wikipedia page on it is fine: http://en.wikipedia.org/wiki/Money]
note this is first time I am using powerpoint; will start using it more in lectures going forward.
I always post both the pdf slides and the full powerpoint so that you can review it later, so don’t
feel like you need to copy everything down; just watch as it goes along and only write down
things that I do on the board or say as you feel the need
[start first part of powerpoint]
three functions of money: medium of exchange, store of value, unit of account
so money is anything that can fulfill these functions
why do people want money, i.e. what determines the demand for money?
transactions demand
plus two asset-holding motives:
precautionary demand
speculative demand
how much money is there?
show figures on monetary aggregates M1, M2
see for example the fed page on this: http://www.ny.frb.org/aboutthefed/fedpoint/fed49.html
[can get the most recent figures on the amounts from the federal reserve page from the money
stock measures on the side bar]
what determines the supply of money?
much of money today is created by the banking system (i.e. deposit accounts)
[start second part of powerpoint]
22-1
important to understand this process
set up a balance sheet example with a given reserve ratio and
derive the money multiplier = 1/rr
by going through a few rounds of deposit creation
how can the central bank, i.e. the Federal Reserve in our country, change the supply of money?
three main tools:
--reserve ratio (raise or lower)
--alter the interest rates at which banks borrow from the Fed (i.e. in order to meet their reserve
requirements)
--open market operations
discuss open market operations at more length. when the Fed buys bonds from the public; it
pays for them by creating money to pay for them, so buying bonds increases money supply
if it wants to reduce money supply it sells bonds to the public and retires the money it receives
out of the monetary system, so selling bonds decreases money supply
bring together both sides of the money market in a diagram to show how it determines interest
rates [draw diagram] [still have power point going here too]
22-2
3/25/11  
 
Although we commonly think of “money” as
being paper bills and metal coins, these are by
no means the only items that can act as
“money.”
Money must fulfill three functions:
 
 
 
 
Problem with barter system: “Coincidence of
wants.”
In a barter system, both people must have exactly what
the other person wants, exactly when and where it’s
wanted.
 
 
 
 
 
Medium of exchange eliminates this problem.
Definition: Anything used to facilitate trade
and avoid a straight barter system.
Anything can serve as money so long as people
are willing to accept it.
Standard unit of measurement of the value/
cost of goods, services, or assets.
Analogy: you go to WeShop and pay $5 for a
gallon of milk.
 
 
 
 
 
 
 
 
Medium of exchange
Store of value
Unit of account
US dollars are what is called fiat money: They
have no intrinsic value. Rather, their value is a
function of the US government saying they
have value.
This is true for most nations’ currencies: They
are backed only by the faith and credit of the
given country’s government.
“This note is legal tender for all debts, public
and private.”
Money need not be convertible into something
with intrinsic value (e.g., gold).
Yap (island in the Pacific Ocean) uses stones
ranging from 1.4 inches to 10 feet in diameter
Gallon : size :: dollar : price
Take away the price units: A gallon of milk simply
costs “5.” 5 what?
Another example: “GM incurred losses of 700
million in the second quarter.”
 
The dollar sign lends meaning to the phrase.
1 3/25/11  
Ithaca, NY, has its own currency, the Ithaca
HOUR.
 
 
 
 
 
 
One Ithaca HOUR is valued at $10
Ithaca HOURs cannot be converted to US dollars
Businesses that receive HOURs must spend them on
local goods and services
Ithaca inspired similar systems in Madison, WI, and
Corvallis, OR
And last but not least, the currently available
Canadian $1 million gold coin, which weighs
100kg and has a diameter of 50 cm.
 
Here is the Swedish 10-daler coin ca. 1720,
which was made of copper and weighed 43
pounds (and facilitated the introduction of
paper money)
Needed for transactions
transactions demand: Money demand in its most
simple form
 
Asset-holding motives:
 
 
 
 
 
M1, M2
M1: Physical currency + demand deposits (i.e.,
checking accounts)
M2: M1 + savings accounts + money market
accounts + small-denomination time deposits
(CDs under $100,000)
 
A balance sheet indicates a bank’s assets and
liabilities.
 
 
 
Precautionary demand (i.e., money people want in
case of emergency or if they are worried how long
they will live)
Speculative demand (need for cash to take
advantage of investment opportunities that may
arise in the future)
Assets = reserves + loans
Liabilities = deposits + capital (stockholders’ equity)
The two sides of the balance sheet must be
equal!
 
 
The accounting identity was developed in the 15th
century as a means for identifying accounting errors
Sometimes the right side (Liabilities) is broken into
liabilities (=deposits) & net worth (=equity/capital)
2 3/25/11  
Banks are required to keep a certain percentage of
their deposits in reserve.
 
 
 
 
The percentage they must keep is called the reserve ratio
(rr) and is set by the Fed.
Banks can choose to keep additional reserves beyond the
requirement.
Banks are free to lend out the rest of their deposits.
These loans make their way to other banks, which
in turn loan them out, and so on.
Fractional banking can lead to damaging “bank
runs,” such as what partially precipitated the Great
Depression (remember in Mary Poppins?)
3 3/25/11  
 
 
 
 
 
 
Policymakers at the Fed determine the US
money supply.
The Fed has three tools to change Ms:
 
 
 
 
 
 
When the Fed wishes to lower the money
supply, it sells bonds (government securities) to
the public. The money it receives from these
transactions is retired (removed from
circulation), so the net effect is to lower Ms.
Similarly, when the Fed wants to increase the
money supply, it buys bonds from the public.
The money multiplier acts to further increase
Ms as well. (Money multiplier also works
backwards when Fed sells bonds.)
Let’s bring money supply and money demand
together on one graph
Why is Md downward-sloping?
 
 
 
Reserve ratio
Discount rate (interest rate charged to banks that
borrow from the Fed)
Open-market operations (buying and selling bonds)
 
This cycle shows how banks can create money.
The money multiplier (mm) describes the total
increase in money resulting from a $1 initial
increase in reserves.
mm = 1/rr
So, for example, if rr = 20%, a $1 initial increase
will increase the money supply in total by $5.
Note that the effect of the money multiplier is
diminished if individuals increase their cash
holdings.
Think of interest rate as the cost of holding money
Money sitting in your wallet does not earn interest;
the higher the interest rate, the more interest is
foregone by holding onto money—so the
opportunity cost of holding money is higher.
As output (Y) increases, Md shifts/increases
(more money demanded for transactions)
4 Professor Joyce Jacobsen
Economics 110-01
Spring Semester 2010-11
Answers to Practice Problems from 3/23/11
I.
1) Y = 1000; C = 850
2) 4
II.
1) Y = 700; C = 550
2) 4
III.
1) Y = 625; C = 475
2) 2.5
Professor Joyce Jacobsen
Economics 110-01
Spring Semester 2010-11
Practice Problems 3/25/11
I. Suppose a country’s bank balance sheet looks like this:
Assets
Reserves
Loans
Liabilities
$10,000
$100,000
_______
$110,000
Deposits
Capital
$100,000
$10,000
_______
$110,000
1) What is the reserve ratio of this system?
2) What is the money multiplier?
II. Suppose the same starting balance sheet as in I. for each case:
1) If reserves decrease by $1,000, by how much do loans decrease? How much is total money
supply now?
2) If the central banking authority makes an open market purchase of $500 worth of securities,
what happens to the bank’s balance sheet?