Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-1 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 valueCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-2 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 donʼt have to produce their own food, clothing, and shelterCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-3 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 donʼt have to constantly change pricesCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-4 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 bankCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-5 What Is Money? • Measuring money—the monetary aggregates – Distinguishing what is money from what isnʼt money is sometimes difficultCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-6 What Is Money? • Measuring money – The M1 monetary aggregate • Currency and travelerʼs 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 moneyCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-7 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. 7-8 Table 7.1 U.S. Monetary Aggregates (April 2012)Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-9 What Is Money? • The money supply – Money supply = money stock = amount of money available in the economyCopyright ©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? • 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 open-market sale • Open-market purchases and sales are called open-market operationsCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-11 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. 7-12 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 – Peopleʼs money-holding decisions depend on how much they value liquidity against the low return on moneyCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-13 The Demand for Money • Key macroeconomic variables that affect money demand – Price level – Real income – Interest ratesCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-14 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 levelCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-15 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 risesCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-16 The Demand for Money • Real income – But money demand isnʼt proportional to real income, since higher-income individuals use money more efficiently, and since a countryʼs 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 incomeCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-17 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 returnCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-18 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 assetsCopyright ©2014 Pearson Education, Inc. All rights reserved. 7-19 The Demand for Money • The money demand function – Alternative expression: Md = P × L(Y, r + πe) (7.2) • A rise in r or πe reduces money demand – Alternative