REED ECONOMICS 314 - Money,Inflation,Growth,and Cycles

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Economics 314 Coursebook, 2008 Jeffrey Parker 8 MONEY, INFLATION, GROWTH, AND CYCLES Chapter 8 Contents A. Topics and Tools .................................................................................2 B. Money...................................................................................................3 What is money?................................................................................................3 Money supply and money demand......................................................................4 Money as a social institution ..............................................................................5 Why don’t the Ramsey and Diamond economies need money?..............................5 Why do real economies need money?...................................................................7 C. Highlights in the History of Money ....................................................9 D. Defining Money in Modern Economies............................................12 E. Monetary Policy and the Supply of Money .......................................15 Assets and liabilities in a simple monetary system..............................................15 Money, the monetary base, and the money multiplier........................................17 Monetary policy and interest rates....................................................................19 F. Theories of the Demand for Money .................................................20 Quantity theory: Money in the classical macro model ........................................20 The evolution of money-demand theory............................................................22 Keynes’s three motives for money demand.........................................................24 The money-demand decision ............................................................................24 Baumol and Tobin’s transactions-demand model ..............................................25 Modeling precautionary demand......................................................................28 Is there a speculative demand for money? .........................................................30 An integrated model of money demand.............................................................32 G. Money in Economic Growth Models ................................................34 Simple macroeconomics of money and growth ...................................................34 Building money into the microfoundations of growth models..............................35 H. Suggestions for Further Reading.......................................................368 — 2 The nature and history of money......................................................................36 I. Works Cited in Text..........................................................................36 A. Topics and Tools We have now completed half a semester of analysis of macroeconomic mod-els and we have yet to introduce one of the principal variables of macro analysis: money. How did the Ramseys and Diamonds of these worlds buy and sell things without money? What, if not money, did they borrow and lend in order to exe-cute their precisely calibrated lifetime consumption plans, maintaining their knife-edge balance on the saddle path? We answer that question below by demonstrating that the highly artificial as-sumptions of these models freed their occupants from needing money, and in doing so we will explore the reasons why money is needed when we abandon these assumptions. This leads us to discuss money’s role in modern economies and what physical and virtual commodities fulfill that role. The basic definition of money and its role in the economy is standard con-tent in both introductory and intermediate macroeconomics courses, which means that the typical reader of Romer’s textbook will have studied this material twice and need no review. Because you are using Romer at a much earlier stage of your macroeconomics education, we’ll have to fill in a lot of basic information here in this chapter that would normally appear in the textbook. To summarize the basic theory of money in stark brevity: Money is de-manded by households and firms as the medium with which to accomplish trans-actions in the markets for goods and labor. The supply of money comes from the banking system. The ability of the banking system to create monetary assets de-pends in part on the amount of “base money” provided by the central bank, which is an agency of the national government. In the short run, imbalances be-tween the demand for money and its supply are likely to be resolved by changes in interest rates, though in the long run changes in the general price level may supplant these interest-rate effects. Changes in interest rates affect the demand for investment, consumption, and saving, so monetary conditions may have a substantial impact on aggregate demand.8 — 3 B. Money As noted above, the basic story of how the monetary system works is one of the glaring omissions–for our purposes–from Romer’s text. Given his intended audience of economics graduate students, there is probably no need to cover these basics. However, since we are using it in an undergraduate context, we cannot take for granted that everyone is fully up to speed on what money is and the various theories of why people demand it. This coursebook chapter fills in some basic information about the monetary system. We can introduce monetary issues only briefly here. Students who would like to learn more details about the monetary system and monetary policy should consider enrolling in Economics 341: Monetary and Fiscal Policy. What is money? Everyone “knows” what money is, but putting a precise definition on it can be a little tricky. Economists usually define money functionally–by what it does rather than as a specific commodity or set of commodities. The two most com-mon (and very closely related) functions of money are: • means of payment, and • medium of exchange. An asset is a means of payment if receiving it from the buyer in a transaction ex-tinguishes all of the buyer’s obligations to pay for the commodity being pur-chased. If you handed Lois a $20 bill as payment for the coursebook, you owe nothing further and thus the $20 bill was accepted as a means of payment. While means of payment and medium of exchange are often used inter-changeably, Goodhart (1989) makes a subtle distinction


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