Transcript Chap01

CHAPTER 1
MONEY AND INFLATION
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What is money?

Money is a generalized claim on all other assets.
It must be acceptable, scarce, desirable, and
divisible.
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Three Properties of Money
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Medium of Exchange--A financial asset (money)
is used to trade (exchange) real assets (goods
and services).
Store of Value--Money serves as a means of
storing purchasing power.
Unit of Account--All prices are denominated in
terms of the monetary unit, such as the dollar.
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Types of Assets that Serve as
Money
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Physical or Full-Bodied Money -- Assets with real or
intrinsic value that serve as money as long as their
value in exchange exceeds their value in use.
Representative Money -- Assets with little or no
intrinsic value, such as currency and cheap metal
coins, that represent claims on assets with intrinsic
value.
Deposit or Credit Money -- Assets without either
intrinsic value or representative value. Credit
money (deposit liabilities of banks) are backed by
financial assets, such as loans or securities.
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Definition of the Money Supply

The Transaction Approach--Any definition of the
money supply relating money to current
spending.
– Money (M1) is special--It is the medium of
exchange in the economy. Money is obtained for
the purpose of spending.
– All other assets must be converted to money (M1)
before "spending".
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Definition of the Money Supply
(continued)

The Store of Value Approach--Any definition of
the money supply associating money to its ability
to store or hold purchasing power through time.
Spending may occur now or later.
– Money serves as a store of purchasing power.
– Monetarists believe that liquid, near-money
financial assets, such as M2, M3, serve as means
to "store" purchasing power.
– MZM is a definition of money that includes those
parts of M2 and M3 that can be obtained
immediately.
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Current Definitions of Money and
the Money Supply
DEFINITION
BILLIONS
Currency and
travelers
checks
M1
MZM
M2
M3
L
$ 457.0
1,072.0
3,789.0
4,293.0
5,776.0
7,062.0
PERCENTAGE DEGREE OF
LIQUIDITY1
OF L
6.5
Highest
15.2
53.6
60.8
81.8
100.0




Lowest
Source: Federal Reserve Bank of St. Louis monetary data for September 1998.
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Liquidity of an Asset--The ease or
cost of converting an asset to money.
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Transaction Costs--Costs involved in converting
an asset to money (brokerage fees).
Price Risk--Potential loss of value involved in the
conversion (sale) of an asset to money.
The liquidity of an asset is inversely related to
transaction costs and to the price risk of an
asset. The higher the transaction costs and the
greater the price variation of an asset, the less
the liquidity of an asset.
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Money and Money Substitutes
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Credit Cards Versus Debit Cards
– Deposit balances, a part of the money supply, are
liabilities (credit balance) of depository institutions.
– A check, paper or electronic order, transfers
(debits) deposits to new owners and their
designated bank.
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Money and Money Substitutes
(continued)
– Debit cards, used in automatic teller machines
(ATM), point of sale terminals where payment is
made electronically, or in a paper-based system
when something is purchased. A debit to a credit
deposit balance reduces the balance. Hence, the
name, debit card.
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Money and Money Substitutes
(continued)
– Credit cards are preapproved lines of credit.
When used, the bank is making a loan (asset) and
paying someone (deposit). Later, the credit card
user pays off the loan with a check (debit to their
deposit account). Credit card usage is not a
money or deposit transfer. It is a loan/deposit
transaction, increasing the money supply, until the
credit card bill is paid.
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Money and Money Substitutes
(continued)

Money Market Mutual Funds (MMMF) and Stock
and Bond Mutual Funds
– MMMF are investment companies that issue $1
shares in return for money to invest in liquid, shortterm, high quality debt securities.
– MMMF balances are a store of value and are a
part of the M2 money supply definition, not the M1
definition of transaction balances.
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Money and Money Substitutes
(concluded)
– Mutual funds, other than MMMF, also have checkwriting services, though the value of the MF
shares vary with the value of the asset, stocks,
bonds, commodities, etc.
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Role of Money in an Economy
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To facilitate efficient (lowest cost) exchange
between economically specialized persons.
Barter is inefficient and does not facilitate
exchange. There are many barter prices for an
item in a barter economy; only one price in a
money economy.
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Transmission Mechanism for
Monetary Policy: Keynesian View
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The value of money is evidenced
in its purchasing power.
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Sustained decreases in the ratio (exchange
value) between money (financial assets) and
goods and services (real assets) represent a
decline in the purchasing power of money.
The value of money can be measured by the
change in price levels. Inflation is an increase in
the general price level over time. The value of
money can be measured by inflation.
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Price Index--A measure of the price
levels at a particular point in time.
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A broadly determined market basket of goods
and services is assembled and priced for the
(base year) starting point.
Using the base year as 100, subsequent prices
for the market basket are compared to the "base"
year.
Changes in the price index measures the inflation
or deflation rate and thus the changing value of
money.
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Widely Used Price Indices
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The Consumer Price Index (CPI) -- The price of a
broad consumer market basket of new, final
goods and services. Updated monthly.
Producer Price Index (PPI) -- A set of prices for a
cross section of intermediate (not final) goods.
Updated monthly.
Gross Domestic Product Deflator -- A set of
prices for all goods and services included in
GDP. Updated quarterly.
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Annual Rate of Inflation (CPI) for
the Economy (1965-1998)
14.0
Percentage Change
12.0
10.0
8.0
6.0
4.0
2.0
0.0
1965
75
85
95
Source: Economic Report of the President, 1991 and Federal Reserve Bank of St. Louis FRED data base after 1990.
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Using Price Indices--Comparing
nominal (current market prices) and real
(purchasing power) values.
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Nominal values are price-weighted measures of
goods and services. Nominal values increase
and decrease as prices rise and fall, respectively.
In the base year (period) of a price index, the
nominal value equals the real value.
Real values are nominal values adjusted
(deflated) for price level changes. With
increases in the price level (measured by the
price index), the real values decline.
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Using Price Indices (concluded)

Nominal prices may be deflated to a common base
year to determine the real value with:
PI 1
D1  D2 
PI 2
–
–
–
–
D1 = dollars in Period 1 (Place 1) purchasing-power units.
D2 = dollars in Period 2 (Place 2) purchasing-power units.
PI1 = price index for Period 1 (Place 1).
PI2 = price index for Period 2 (Place 2).
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Inflation Summary--Continued increase
in average price levels.
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With unanticipated inflation, wealth transfers from
savers to borrowers in financial markets.
Persons with fixed incomes are able to buy less
in periods of inflation.
Interest rates, the time price of money, increase
with inflation.
Inflation is associated with periods of high money
supply growth relative to the growth of the
economy.
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