The Role of Money in the Macroeconomy - PowerPoint PPT Presentation

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The Role of Money in the Macroeconomy

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The Role of Money in the Macroeconomy. Introduction of the Concepts ... A 'base' amount of money that serves as the foundation for a nation's monetary system. ... – PowerPoint PPT presentation

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Title: The Role of Money in the Macroeconomy


1
The Role of Money in the Macroeconomy
  • Introduction of the Concepts

2
Financial Markets/Institutions
  • Bringing together of buyers and sellers of
    financial securities to establish prices
  • Provides a mechanism for those with excess funds
    (savers) to lend to those who need funds
    (borrowers)
  • Includes banks, savings and loans, credit unions,
    investment banks and brokers, mutual funds, stock
    and bond markets

3
Money
  • Currency bills and coins
  • Includes demand deposits (checking accounts)
    issued by banks
  • Plays a key role in influencing the behavior of
    the economy as a whole and the performance of
    financial institutions and markets

4
Monetary Economy
  • Facilitates transactions within the economy
  • Principal mechanism through which central banks
    attempt to influence aggregate economic activity
  • Economic Growth
  • Employment
  • Inflation

5
Banking
  • Place where savers can invest their funds to earn
    interest with a minimum of risk.
  • Make loans to individuals and small businesses

6
Banks
  • Banks serve as the principal caretaker of the
    economys money supply, and along with other
    financial intermediaries, provide important
    source of funds.
  • Banks are intimately involved in how the Federal
    Reserve influences overall economic activity

7
Monetary Policy
  • The Fed directly influences the lending and
    deposit creation activities of banks

8
Flow of funds from lenders to borrowers
9
What is the proper amount of money for the
economy?
  • Sir William Petty (162387) wrote in 1651
  • To which I say that there is a certain measure
    and proportion of money requisite to drive the
    trade of a nation, more or less than which would
    prejudice the same
  • Too much money will lead to inflation
  • Too little money will result in an inefficient
    economy

10
Functions of Money
  • Standard of value
  • or unit of account for all the goods and services
    we might wish to trade.
  • Medium of exchange
  • it is the only financial asset that virtually
    every business, household, and unit of government
    will accept in payment of goods and services.
  • Store of value
  • reserve of future purchasing power.

11
Liquid Asset
  • Something that can be turned into a generally
    acceptable medium of exchange, without loss of
    value
  • Liquidity is a continuum from very liquid to
    illiquid
  • Currency and checking accounts are most liquid
    assets

12
Monetary Base
  • A base amount of money that serves as the
    foundation for a nations monetary system.
  • Under a gold standard, the amount of gold
    bullion.
  • In a fiat money system, the sum of currency in
    circulation plus reserves of banks and other
    depository institutions.

13
The Monetary Base
  • Currency
  • Coins and paper money.
  • Reserves
  • Cash held by depository institutions in their
    vaults or on deposit with the Federal Reserve
    System.
  • Monetary Base Currency Reserves

14
The Use Of Coins
  • Seigniorage
  • The difference between the market value of money
    and the cost of its production, which is gained
    by the government that produces and issues the
    money.
  • Debasement
  • A reduction in the amount of precious metal in a
    coin that the government issues as money.

15
Monetary Aggregate
  • A grouping of assets sufficiently liquid to be
    defined as a measure of money.

16
What is the money supply?
  • M1
  • currencychecking accounts
  • M2
  • M1 savings accounts small CDs MMDA MMMF
  • M3
  • M2 large CDs

17
Who Determines Our Money Supply?
  • Federal Reserve is responsible for execution of
    national monetary policy
  • Created by Congress in 1913
  • Twelve district Federal Reserve Banks scattered
    throughout the country
  • Board of Governors located in Washington, D.C.

18
Who Determines Our Money Supply?
  • Fed influences the total money supply, but not
    the fraction of money between currency and demand
    deposits which is determined by public
    preferences
  • Fed implements monetary policy by altering the
    money supply and influencing bank behavior

19
Barter
  • Direct exchange of goods/services for other
    goods/services
  • Very inefficient and limited economy
  • No medium of exchange or unit of account
  • Requires double coincidence of wantsI have
    something you want and you have something I want
  • Items must have approximate equal value
  • Need to determine the exchange rate between
    different goods/services

20
Money
  • Any commodity accepted as medium of exchange can
    be used as money
  • Frees people from need to barter
  • Makes exchange more efficient
  • Permits specialization of laborsell ones labor
    to the market in exchange for money to purchase
    goods/services

21
Money
  • Prices, expressed in money terms, permit
    comparison of values between different goods
  • Must retain its valuethe value of money varies
    inversely with the price level (inflation)
  • If money breaks down as a store of value
    (hyperinflation), economy resorts to barter

22
How Large Should the Money Supply Be?
  • Purchase goods/services economy can produce, at
    current prices
  • Generate level of spending on Gross Domestic
    Product (GDP) that produces high employment and
    stable prices
  • Monetary Policy is used as a countercyclical
    toolvary the money supply to influence economic
    activity

23
Increases in the Money Supply Alters Publics
Liquidity and Influences Spending
  • Direct Impactexcess liquidity is spent on
    goods/services
  • Indirect Impactpurchase financial assets which
    lowers interest rates which stimulates business
    investment and consumer spending
  • However, changes in liquidity may alter demand
    for money and not influence GDPpeople hoard the
    additional money
  • Publics reaction to changes in liquidity is not
    consistent, so Fed cannot always judge impact of
    a change in money supply

24
Velocity
  • When the Fed increases the money supply,
    recipients of this additional liquidity probably
    will spend some on GDP
  • Over time there will be a multiple increase in
    spending

25
Velocity of Money
  • The number of times the money supply turns over
    in a period of time to support spending on output
  • The Fed has no control over the velocity of money
    since this is dependent on behavior of the public
  • It is possible the public will choose to hold
    onto the additional liquidity (hoarding of money)
  • Ultimately, the Fed needs to be concerned whether
    the additional spending which results from
    increased money supply will result in higher
    production or higher prices

26
Velocity of Money
  • Velocity is the way in which the quantity of
    money is related to economic activity.
  • The speed with which money is spent.
  • Velocity changes in spending/quantity of money
    ?GDP/?M.
  • If Velocity 5, then if M increases by 10
    billion, GDP will rise by 50 billion.

27
Money and Inflation
  • InflationPersistent rise of prices
  • HyperinflationPrices rising at a fast and
    furious pace
  • DeflationFalling prices, usually during severe
    recessions or depressions
  • Inflation reduces the real purchasing power of
    the currencycan buy fewer goods/services with
    the same nominal amount of money

28
Money, The Economy, and Inflation
  • Economists generally agree that, in the long-run,
    inflation is a monetary phenomenoncan occur only
    with a persistent increase in money supply
  • Increase in money supply is a necessary
    condition for persistent inflation, but it is
    probably not a sufficient condition

29
Examples
  • Case 1Economy in a recession.
  • Expanding money supply may lead to more
    employment and higher output
  • Case 2Economy near full employment/output.
  • Expanding money supply can lead to higher
    output/employment, but also higher prices
  • Case 3Economy producing at maximum.
  • Expanding money supply will most likely lead to
    increasing inflation.

30
Money and Inflation
  • To return to the 1940s, the smallest bill would
    be 10 and the smallest coin would be a dime.

31
Hyperinflation Example
  • Hyperinflation occurred in Germany after World
    War I, with inflation rates sometimes exceeding
    1000 percent per month. By the end of
    hyperinflation in 1923, the price level had risen
    to more than 30 billion times what it had been
    just two years before. The quantity of money
    needed to purchase even the most basic items
    became excessive. Near the end of the
    hyperinflation, a wheelbarrow of cash would be
    required to pay for a loaf of bread. Money was
    losing its value so rapidly that workers were
    paid and given time off several times during the
    day to spend their wages before the money became
    worthless. No one wanted to hold on to money,
    and so the use of money to carry out transactions
    declined and barter became more and more dominant.

32
Who creates money?
  • The Federal Reserve
  • Depository Institutions
  • The Public

33
Fractional Reserve System
  • Required Reserves
  • Excess Reserves

34
How a bank creates money
  • Assets Claims
  • Reserves Transactions Deposits
  • Securities Savings Deposits
  • Loans CDs
  • Equity

35
Money and Banking in the Digital Age
  • Cybertechnologies
  • Technologies that connect savers, investors,
    traders, producers, and governments via computer
    linkages.
  • Electronic money (e-money)
  • Money that people can transfer directly via
    electronic impulses.
  • Wire transfers
  • Payments made via telephone lines or through
    fiber-optic cables.

36
Money in the Digital Economy
  • Electronic Payments
  • Automated clearinghouses
  • Institutions that process payments electronically
    on behalf of senders and receivers of those
    payments.
  • Point-of-sale (POS) transfer
  • Electronic transfer of funds from a buyers
    account to the firm from which a good or service
    is purchased at the time the sale is made.
  • Automated bill payment
  • Direct payment of bills by depository
    institutions on behalf of their customers.
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