Chapter 14 Chapter 13 in 4th Edition

1
Chapter 14 (Chapter 13 in 4th Edition)

• Objectives
• Define money.
• What are the different types of money.
• What are financial intermediaries.
• How do financial intermediaries create money.
• Define the money (or deposits) multiplier.
• See how quantity of money and Aggregate Demand
  are related.

2
Money

• Money is anything that is accepted as a medium of
  payment
• Money exists for three reasons
• Medium of exchange
• Unit of account
• Store of value
• Money as we know it is convenient, not necessary.
  It has no intrinsic value, its value derives
  from its common acceptance by all economic
  agents, in exchange for goods.
• There are various types of money. Depending on
  liquidity, it can be classified into the
  following categories
• M1 currency and checking accounts deposits
• M2 M1 plus savings accounts and money market
  deposits
• M3 M2 plus Treasury bills and other short term
  bonds

3
Money (cont.)

• In 1996 there was about 380 billion worth of
  notes outstanding.
• Given the population of about 200 million adults,
  that works out to an average of 1900 per person.
• Where is all that cash?
• Abroad.
• In the pockets of drug dealers.
• Financial Intermediaries
• A financial intermediary is any institution that
  accepts deposits and makes loans (Banks, Savings
  Loans institutions, Money Market Mutual Funds).
• Deposits are liabilities while loans are assets.
• Financial Intermediaries make money by charging a
  higher interest on loans than they pay on
  deposits
• FIs have to hold reserves (Cash Deposits with
  the FED)

4
Financial Intermediaries

• Profits and Risks
• Lending is risky, since the borrower could
  potentially declare bankruptcy. So a bank should
  evaluate a prospective borrowers ability to pay
  back quite carefully.
• Often, the riskier the borrowers venture, the
  higher the interest rate charged. Typically
  credit cards have the highest interest because
  they have the highest risk of default.
• Financial institutions regularly write-off some
  loans as bad debts. This is a source of loss for
  the bank.
• Creating Money
• Financial Intermediaries do not only facilitate
  the circulation of money, they also create money
  every time they lend

5
Financial Intermediaries (cont.)

• Suppose a bank lends 80 to one of its customers.
  The person who borrows the money, spends it on
  some goods.
• The people who sell the good, deposit this money
  in a bank. The bank now lends the money once
  again, and so on ..
• We say that financial intermediaries multiply
  money supply.
• The ability of a bank to create money is limited
  by the reserve requirement.
• The Reserve Requirement is the amount of deposits
  that cannot be used for loans.
• The money multiplier (or deposit multiplier) is
• Where D is deposits and R is reserves

6
Money and Aggregate Demand

• How are money and Aggregate Demand Related?
• If more money is put in circulation (by the FED
  or by banks, through lending), there is more
  money for people to spend.
• This pushes the aggregate demand curve out.
• In the short run, this leads to an increase in
  price, and an increase in GDP.
• In the long run, however, GDP comes back to the
  level of potential GDP, and all the increase in
  money supply leads to is increase in prices.
• Since money does not affect GDP in the long run,
  money is said to be neutral

7
Money and AD (cont.)

• Money Supply and Aggregate Demand.

LRAS
P
P
SRAS
P
P
AD
AD
YY
Y
Y
8
The Quantity Theory of Money.

• Consider the Equation of the Exchange
• So,
• Where M is money and V is the velocity of
  circulation of money
• We know that money does not affect Y, let us also
  assume that money does not affect velocity. Then
• This is the quantity theory of money money
  affects only prices in the long run, and it does
  so one for one

9
The Quantity Theory of Money.

• In the long run output is not constant it
  increases because of growth
• More output means that more money is necessary to
  be able to purchase the new goods
• In this case the quantity theory of money says
  that the optimal increase in money equals the
  expected increase in output plus the desired
  increase in prices
• For example, assume the expected increase in
  output is 3 and the desired inflation is 1.5
• Then the optimal increase in money is 4.5
  (assuming velocity is constant)
• If money does not change, prices decline by 3 (a
  situation of deflation).