What Is Money Money assets that are widely used and accepted as payment The functions of money Medium of exchange Unit of account Store of value Copyright 2014 Pearson Education Inc All rights reserved 7 1 What Is Money The functions of money Medium of exchange Barter is inefficient double coincidence of wants Money allows people to trade their labor for money then use the money to buy goods and services in separate transactions Money thus permits people to trade with less cost in time and effort Money allows specialization so people don t have to produce their own food clothing and shelter Copyright 2014 Pearson Education Inc All rights reserved 7 2 What Is Money The functions of money Unit of account Money is basic unit for measuring economic value Simplifies comparisons of prices wages and incomes The unit of account function is closely linked with the medium of exchange function Countries with very high inflation may use a different unit of account so they don t have to constantly change prices Copyright 2014 Pearson Education Inc All rights reserved 7 3 What Is Money The functions of money Store of value Money can be used to hold wealth Most people use money only as a store of value for a short period and for small amounts because it earns less interest than money in the bank Copyright 2014 Pearson Education Inc All rights reserved 7 4 What Is Money Measuring money the monetary aggregates Distinguishing what is money from what isn t money is sometimes difficult Copyright 2014 Pearson Education Inc All rights reserved 7 5 What Is Money Measuring money The M1 monetary aggregate Currency and traveler s checks held by the public Transaction accounts on which checks may be drawn All components of M1 are used in making payments so M1 is the closest money measure to our theoretical description of money Copyright 2014 Pearson Education Inc All rights reserved 7 6 What Is Money Measuring money The M2 monetary aggregate M2 M1 less moneylike assets Additional assets in M2 savings deposits small 100 000 time deposits noninstitutional MMMF balances money market deposit accounts MMDAs Copyright 2014 Pearson Education Inc All rights reserved 7 7 Table 7 1 U S Monetary Aggregates April 2012 Copyright 2014 Pearson Education Inc All rights reserved 7 8 What Is Money The money supply Money supply money stock amount of money available in the economy Copyright 2014 Pearson Education Inc All rights reserved 7 9 What Is Money The money supply How does the central bank of a country increase the money supply Use newly printed money to buy financial assets from the public an open market purchase To reduce the money supply sell financial assets to the public to remove money from circulation an openmarket sale Open market purchases and sales are called openmarket operations Copyright 2014 Pearson Education Inc All rights reserved 7 10 What Is Money The money supply How does the central bank of a country increase the money supply Could also buy newly issued government bonds directly from the government i e the Treasury This is the same as the government financing its expenditures directly by printing money This happens frequently in some countries though is forbidden by law in the United States Copyright 2014 Pearson Education Inc All rights reserved 7 11 The Demand for Money The demand for money is the quantity of monetary assets people want to hold in their portfolios Money demand depends on expected return risk and liquidity Money is the most liquid asset Money pays a low return People s money holding decisions depend on how much they value liquidity against the low return on money Copyright 2014 Pearson Education Inc All rights reserved 7 12 The Demand for Money Key macroeconomic variables that affect money demand Price level Real income Interest rates Copyright 2014 Pearson Education Inc All rights reserved 7 13 The Demand for Money Price level The higher the price level the more money you need for transactions Prices are 10 times as high today as in 1935 so it takes 10 times as much money for equivalent transactions Nominal money demand is thus proportional to the price level Copyright 2014 Pearson Education Inc All rights reserved 7 14 The Demand for Money Real income The more transactions you conduct the more money you need Real income is a prime determinant of the number of transactions you conduct So money demand rises as real income rises Copyright 2014 Pearson Education Inc All rights reserved 7 15 The Demand for Money Real income But money demand isn t proportional to real income since higher income individuals use money more efficiently and since a country s financial sophistication grows as its income rises use of credit and more sophisticated assets Result Money demand rises less than 1 to 1 with a rise in real income Copyright 2014 Pearson Education Inc All rights reserved 7 16 The Demand for Money Interest rates An increase in the interest rate or return on nonmonetary assets decreases the demand for money An increase in the interest rate on money increases money demand This occurs as people trade off liquidity for return Copyright 2014 Pearson Education Inc All rights reserved 7 17 The Demand for Money The money demand function Md P L Y i 7 1 Md is nominal money demand aggregate P is the price level L is the money demand function Y is real income or output i is the nominal interest rate on nonmonetary assets Copyright 2014 Pearson Education Inc All rights reserved 7 18 The Demand for Money The money demand function Alternative expression Md P L Y r e 7 2 A rise in r or e reduces money demand Alternative expression Md P L Y r e Copyright 2014 Pearson Education Inc All rights reserved 7 3 7 19 Asset Market Equilibrium The asset market equilibrium condition M P L Y r e 7 9 real money supply real money demand M is determined by the central bank e is fixed for now The labor market determines the level of employment using employment in the production function determines Y Given Y the goods market equilibrium condition determines r Copyright 2014 Pearson Education Inc All rights reserved 7 20 Asset Market Equilibrium The asset market equilibrium condition With all the other variables in Eq 7 9 determined the asset market equilibrium condition determines the price level P M L Y r e 7 10 The price level is the ratio of nominal money supply to real money demand For example doubling the money supply would double the price level Copyright 2014 Pearson Education Inc All rights reserved 7 21