March 29, 2011 Monetary theory Money should have only 1 meaning: CASH/ money substitute (Check) In common

speech the word money is used in 3 senses: cash, income and wealth Cash-used in terms Income-used in terms of earning Wealth- used in terms of worth; accumulated savings (bank deposits, stocks, bonds) Functions of money 1 Medium of exchange 2 Unit of account 3 Store of value Standard of value (unit of account) Money is the common instrument of exchange Money substitutes: checks, electronic transfers Credit cards are not included in the definition of money because it is a borrowing instrument; it borrows the purchasing power of the credit card issuer Credit can be defined as a liability or an instrument of debt. Also a medium to make a purchase without income. Income can be converted into cash, income=cash M1= currency in circulation+demand deposits+travelers checks H=high power money= to reserves+currency in circulation April 5, 2011

Chapter 2 Under the barter system money is not used. Problems with barter:

coincidence of wants:

a situation in which the good or services that one trader desires to obtain is the same as that which another desires to give up and an item that the second trader wishes to acquire is the same as that which the first trader desires to surrender you have to find somebody who wants to trade the item that you want to get AND who also wants the item that you have that you want to trade With barter there will be less specialization because of the difficulty of overcoming the coincidence of wants. If you can't find someone to trade with, you will have to produce it yourself Less specialization means less output and MORE SCARCITY Money facilitates trade and promotes specialization. Money differs from other assets in that it serves as a medium of exchange Functions of Money 1. Medium of exchange a. Money can be used for buying and selling goods and services b. without money we have the problems of barter and the coincidence of wants c. money allows for greater specialization and trade and productive efficiency 2. Unit of account: Prices are quoted in dollars and cents. 3. Store of value: money allows us to transfer purchasing power from present to future. it is the most liquid (spendable) of all assets, a convenient way to store wealth. Fiat money: money authorized by the central bank is defined as the nation s money and does not have to be exchanged for any commodity. An example of commodity money is Marlboro cigarettes in the late 1980s In the US Federal Reserve Notes are the definitive money One problem the barter system does not have is the problem of sellers not having anyone who would be able to but their product Credit Cards are not electronic funds transfer Specialization increases economic efficiency: individuals produce things they are good at producing. Because of such specialization, people create surpluses and need ways to trade the things they produce. The three possible allocations rely on barter, government allocation, and money. The problem with barter is that it cannot easily match the highly specific needs of buyers and sellers. Government

allocation often fails because it misallocates resources. Money works well in facilitating trade, allocating resources efficiently, and avoiding the need for matching each buyer and seller. In its role as a medium of exchange, money is a generally accepted means of payment. A particular item becomes a medium of exchange because people believe that it will be mutually acceptable. Money provides a unit of account so that all prices can be quoted in monetary terms. Money also reduces the costs of trading over time. As a store of value, money allows people to hold it today and buy things with it in the future. As a standard of deferred payment, money makes credit transactions possible. Definitive money is money that does not have to be converted into a more basic legal medium of exchange. In commodity money systems, commodities (such as gold) are definitive money. In fiat money systems, paper currency and coin issued by the government or central bank are definitive money. The payments system consists of ways to conduct transactions in the economy. Over time, payments systems have changed from simple (paper currency as the main method of payment) to complex (automatic clearing of payments by computer and electronic money). Financial assets are grouped into different monetary aggregates, depending on their liquidity - that is, how easily they can be traded for definitive money. The Federal Reserve System, the central bank of the United States, defines monetary aggregates and collects data on them. These aggregates include measures designed to reflect money's role as a medium of exchange (M1 and M2) and those designed to capture its role as a short-term store of value (M2). Money is the common commodity that measures the value of all other commodities Money is acquired by selling something; without people would use the bartering system If N=100 (number of commodities), then N(N-1) /2= 4,950 prices Classical view on money: Unit of account Medium of exchange Store of value Modern view of money: Medium of exchange Unit of account Store of Value Standard for deferred payment Conditions of Money: 1. 2. 3. 4. General acceptability Standardized quality (for the purpose of minimizing information of equivalents for trade) Durability; should be able to with stand use High value to weight; should be able to exchange for goods and services without being equal to its weight 5. Divisibility; the ability to be broken into smaller units and still have significant purchasing power

Types of money:

1. Commodity money ( gold, silver, tobacco, beaver skin etc.) 2. Minted money; can be 3. Fiduciary money: that depends for its value on confidence that it is an accepted medium of exchange. It originated as a paper certificate that was a promise to pay a certain amount of gold or silver to the bearer 4. Fiat money; law declares it legal tender Substitutions 5. Checks 6. Electronic transfers Classical definition of money: M= H or MB ( H= C + R) Modern definition of money: M1 = C + D = C + R + BC = H =BC M2 = C + D + SD + MMDA + MMMF Assets R BC (bank credit) BC 1 Liabilities D SD MMDA MMMS Problems money: Controllability: can/ should the central bank control money? If so how can it? It cannot be done the Fed can encourage banks to lend or not but cannot force them to April 12, 2011 Money Supply MS is a function of the interest rates and causes the ms to slope based on the change in interest rates. #14 out the book Assets Reserves:24, 000 BC: 176,000 Liabilities Deposits: 200,000

RD=10% of= rd/d RE= RE/D rD=RD/D =rD x D= RD/D x D = .10 x 200,000= Money Multiplier: d1= 1/r D2= 1/ rd=re D3= 1/ rd=re=cu BC1=(1-R)D1= (1-R)SQUAREDxD D2= (1-R)SQUAREDxD M= C+D H= C+R MB ALSO = C+R H= cuD+rdD H= (cu + rd) D D= [1/ cu+rd] x H M= C+D =( cu +1)D M1= [cu+1/cu+ rd] x H= M1x H Changes in M1= M1Xh Change in M1= change in M1xH+M1x change in H A change in H or M1 will change M1 the Fed uses open market operations to change H or the monetary base = buys securities change in H (MB) >0 = Sells securities change in H (MB) <0 Increases in the discount rate will not affect the monetary base d=r BC= (1-R)D D1= (1-R) D1= (1-R)D

Decreases in the discount rate will increase the monetary base The fed can change the monetary base by changing the reserve requirement When interest rates rise banks excess reserve deposit ratio will decrease M2= m1+ td =c +d+ td Things that effect the monetary base What actions might the fed take to deal with withdrawals? When people withdraw funds the multiplier decreases, ms decreases, and cu increases. The fed can lower the reserve rate, purchase securities (purchasing securities will change the monetary base) but lowering the reserve rate will not

If the government deficit is eliminated the monetary base will grow lower than other wise If the world bank makes a deposit with the fed that will cause the monetary base to decrease because the world bank does not print US money Raising the discount rate only discourages banks not to borrow and does not affect the monetary bases Deposits in the treasury decrease the monetary base. (page 426 account types) If the fed by Japanese yin the monetary base will increase because this would be an increase in foreign currency which is an asset to the fed 1791-1811 first bus 1816 2nd bus Crisis: 1873, 1884, 1893, 1907 Bank Runs Panics Contagion Fractional-Reserve Banking: Assets Reserves BC Risks: defaults, income Information costs Chapter 19 Liabilities Deposits

Federal reserve system established in 1913 an overseer of banks and lender of last resorts Constitution: Member banks Board of governors 7 members (appointed by the president fornon renewable 14 year terms) 12 original banks FOMC (Federal open market committee) 12 members 7 board of governor members 1 new york president (purchases or sells securities) Sells of securities increases the money supply (increases monetary base) the most effective component of monetary policy Functions: check clearing, manage currency in circulation (replace old money in circulation), discount lending, supervise and regulate member banks, The difference between national banks and state chartered banks is that national banks are required to be members of the federal reserve system. DIDMCA (1980) Legislation that past that allows nonmember banks to borrow from the fed. Principle agent problem: in general the manager is the agent (the fed) in a non-owner operated business and the principle (general public) is the owners/ stockholders. This is when the managers are not doing the things that the principles want. Principles are more concerned with profits. Political Business Cycle: when the president s term is coming to an end monetary expansionary policies are enacted. Interest rates are lowered. If the president is re-elected then after the election contractionary monetary policies go into effect In more developed countries there are more avenues for the government to raise capital (financial market development). The Central bank does not have to act as an arm of the government. Whereas less developed counties do not have developed economies so when the government needs to raise capital the go straight to the central bank and the central bank must find someone to buy the loans they make to the government. The pros and cons of the central bank to be independent: More independence equals low inflation. 3 principles of omo, effectiveness, and Know : What is money, types of money (commodity), fucntions of money, what type of commodities that fits into the functions Banking systems, assets and liabilities Depositary /Money supply process, multipliers, m1 m2, can the money supply be controls, determinants of the monetary base

Omo, the effect on interest rates, history of the fed, structure of the federal reserve system, the goals of monetary policies, ways of evaluation monetary policy, elements in chapter 20. 20 t/f 20 mc 2 essay questions Chapter 17 Factors that Determine the Money Multiplier: Changes in the Required Reserve Ratio Changes in the Currency Ratio Changes in the Excess Reserves Ratio Post Mid Term Notes Chapter 21 Targets of Monetary Policies Goals: control inflation rates, employment, real gdp, Intermediate and operating targets Intermediate targets: Intermediate targets are economic variables that are not directly controlled by the central bank. Although not directly controlled by the central bank, intermediate targets will often quickly adjust to policy changes and behave in a predictable manner relative to the Federal Reserve's economic goals. These targets pertain either to monetary growth or interest rates. M1, M2, Federal Funds Rate=> effects goals (inflations rates, employment) Operating targets: are the variables the central banks controls directly. Can change the discount rate, non-borrowed reserves.Operational targets are usually phrased in terms of the changes in the money
supply and non-borrowed reserves

Policy tools: open market operations

Velocity of money 1) 2) 3) 4) 5) 6) Hoarding (cash) Use of credit (card) Use of check Irregularity of receipts vs payments Density of population Rapidity of transportation

Saving= Supply capital= Y (1-t)-C-change in H= change in FA demand Purchase of securities leads to a change in H (High power money) Also leads to an increase in the supply of credit If a firm issues stocks or bonds they are the demanders of capital When the central bank purchases financial assets increases the supply of money (funds for lending) This increase causes credit to flow more freely. With an excess supply of credit banks are willing to lower interest rates to entice potential consumers (in the short run) this causes a shift in the credit supply 1.) A change in the quantity of money (an increase) is as known as the liquidity (the readiness to convert to cash) effect 2.) When prices rise business incomes will increase because of the increase in the supply of credit When prices increase the demand to borrow rises. a consumer may be willing to borrow funds in order to make purchases because their current income doesn t allow them to buy like they want to. Businesses will be willing to borrow when prices increase in order to produce more of the products with higher prices. (income effect) causes the opposite of liquidity effect When people save less because prices are higher this effects the amount of money available to loan and causes interest rates to increase. Expectation effect Income effect: is the change in an individual's or economy's income and how that change will impact the quantity demanded of a good or service. The relationship between income and the quantity demanded is a positive one, as income increases, so does the quantity of goods and services demanded. Monetary policies (central bank actions): Sale of securities will lead to a contraction in the money supply and in the supply of credit An excess demand in capital causes interest rates to rise If credit contracts people have less spending power resulting in falling prices, causing business profits to decrease (incomes). If business profits are falling it causes the demand for capital to fall. (long run) If the public expects prices to continue to decrease they will save more and have more purchasing power causing interest rates to decrease.

If businesses expect more profits the demand for capital increases. Small economy Chapter 21 goals and instruments of monetary polices: operating targets immediate, price stabilization, demand for money, Cambridge equation: P= H K Y Fisher equation: P= H + V Y (I) V

H demand = kPy Fixed wage rates, interest contracts, rental contracts (mechanisms) When Revenue rises profits rise because fixed elements (wages, interest rates, and rental contract) have not changed Profits = revenue costs When profit increase firms will hire more people causing employment. An increase in the quantity of money is going to cause the demand of money to rise (not by the full amount of the increase) in the short run In the long run when contracts are revised employment that took place because of the increase in profits retracts and the rate of both employment and output will decrease. As a result the demand for money decreases. Described by the Cambridge scholars as Forced Savings Mechanism savings is forced because people with fixed incomes must save due to higher prices. With increased savings interest rates will fall. Why do high prices causes higher employment and production in the short run? It is because prices are rising more than expected as a result the rate of employment should fall.

An increase in central bank money causes prices, profits, employment, wages rates, and the demand for money to rise in the short run. In the long run when contracts are revised input cost rise causing profits and employment, and the demand for money to rise. Philips curve analyzes wages only A decrease in the money supply (quantity of money) results in prices falling. When prices are falling revenue and profits also fall. However wages and rentals remain the same, this leads to employers laying off employees. Wages may decrease and allow employers to hire again. If wage rates decrease and employment increases then the rate of employment will return to equilibrium in the long run. 1. Neutrality of money: change in ms = change in price (in the long run) 2. Non neutrality of money: change in money supply = change in prices, output, and employment (in the short run). Monetarism (Friedman) claims the money supply will change when prices, output, and employment change. The changes for output and employment can be long and variable (anywhere between months and years) The classics did not assume full employment as a requirement for a change in price 3 type of unemployment 1. Frictional 2. Structural 3. Cyclical Wage contracts have 0 inflation embedded in them. In the short run in the Philips curve unemployment will decrease if inflation increases. 7 schools of thought New classicals Neoclassical Keynesians New Keynesians Post Keynesians Real business cycle theorists Austrians In the short run what happens when the fed decreases money supply unexpectedly? Interest rates will rise because the demand for credit decreases and the amount of loanable funds also decreases (chapter 6)

Output will decrease because the amount of credit is limited which in turn causes investment to decrease as well Employment will decrease because less output means less people can be hired Prices will decrease based on the Cambridge equation = P = H/KY Long run effects if the fed decreases money supply Interest rates would return to their original rates because the demand for credit increases as businesses produce at the natural level. When prices of input goods rises businesses borrow more. When the prices of input goods decrease businesses don t borrow as much. Output returns to its original level Employment returns to original level because businesses rehire Prices will return to their original levels because of the forced saved mechanism which allows wage contracts to be revised to reflected the slow rate of growth To hold down interests the fed would have to increase the amount of credit (money supply; loanable funds) this will increase prices Is it possible to trade off more inflation for higher output in the short run (Philips curve)? Yes it is with the expectation of inflation at 0 unemployment will decrease and total output will increase Can higher inflation be traded for higher output in the long run? No because wages will be revised to keep up with inflation Having a target rate of low inflation poses a danger of encountering deflation. That is the reason why the fed does not target an inflation rate of 0. Inflation is bad in the short run and deflation is bad in the short run Open economy