Ch. 6 Money and Prices: Key Concepts for Economics Students

Money

Anything widely accepted as a medium of exchange so people can trade without direct barter.

Barter

Requires a double coincidence of wants (A wants B and B wants A). Money eliminates that problem.

Adam Smith's Definition of Wealth

A country's wealth = lands, houses, consumables, not merely gold/silver.

Historical Examples of Money

Items that served as money include labor, cattle, salt, cowry shells, cod, tobacco, sugar, iron, copper, gold & silver.

Strange Examples of Money

Rai stones (Yap), cigarettes or mackerel in prisons show that what counts as money depends on acceptability and convention.

Medium of Exchange

A function of money that is widely accepted and convenient.

Unit of Account

A common measure that prices are quoted in.

Store of Value

Holds purchasing power over time.

Commodity Money

Has intrinsic value (e.g., gold).

Fiat Money

Declared money by government (e.g., modern paper/fiat dollar).

M1

Most liquid money, including paper currency outside banks, checking account balances, savings account balances (checkable), and money-market deposit accounts (checkable).

M1 Example

$19 trillion (note: was $3.9T in Feb 2020).

Total U.S. Income

$30 trillion.

Board of Governors

7 members (14-year terms), Chair appointed every 4 years (Senate confirmed).

Federal Reserve Banks

12 Federal Reserve Banks (districts).

Federal Open Market Committee

Board of Governors + NY Fed President + 4 rotating district presidents → sets monetary policy.

Open Market Operations

Fed buys/sells U.S. government bonds; buying injects money and increases money supply, selling withdraws money and decreases money supply.

Required Reserve Ratio

Fraction of deposits banks must keep (example: 10%); lower ratio allows banks to lend more, increasing money supply.

Discount Rate

Rate Fed charges banks for emergency loans; more of a signal, borrowing from Fed can be stigmatizing.

Interest on Reserve Balances

leads banks to park funds at Fed, decreasing lending and money supply.

Federal Funds Rate

Rate banks lend reserves to each other; policy actions influence this market rate.

Money Creation

The process by which banks lend money and create deposits, influenced by the reserve ratio.

Simple Money Multiplier

Total possible money created = injection × (1/r), where r is the reserve ratio.

Reserve Ratio

The fraction of deposits that a bank must hold as reserves, expressed as a percentage.

Multiplier

Calculated as 1 / r; for a reserve ratio of 0.10, the multiplier is 10.

Total Max Money

The maximum amount of money that can be created from an initial injection, calculated as initial injection × multiplier.

Price Index

A measure that compares the cost of a fixed market basket of goods in a focal period to a base period.

Price Index Formula

PI = (Cost of market basket in focal period ÷ Cost of basket in base period) × 100.

Consumer Price Index (CPI)

A price index compiled by BLS using a weighted basket of goods and services to measure inflation.

CPI Base Normalization

CPI base is commonly normalized to 100 for the period 1982-1984 in BLS series.

PCE Price Index

the Fed's preferred measure of inflation, may exclude volatile items.

Inflation Calculation

Inflation between two periods is calculated as (CPI_Y2 / CPI_Y1) − 1.

Inflation Example

If CPI_2020 = 260 and CPI_2023 = 300, then Inflation = (300 / 260) − 1 = 0.1538 or approximately 15.38%.

Total Spent Calculation

Compute Total Spent in each period by multiplying price by quantity and summing items.

Weighted Sum Effect

In CPI calculations, if one item's price falls while others rise, the weighted sum captures the net effect.

CPI Data Usage

Practice pulling CPI values from BLS data and calculating percent changes using the inflation formula.

Money vs Wealth

Money is not the same as wealth; real wealth consists of goods and services.

Functions of Money

medium of exchange, unit of account, and store of value.

Fed Tools for Money Supply

The Fed uses various tools to affect the money supply, including open market operations.

Inflation and Purchasing Power

Too much money chasing the same goods tends to raise prices, leading to inflation that erodes purchasing power.

CPI Calculation Skill

A practical skill is the ability to compute CPI and inflation from basket costs and understand money multiplier logic.

Caveats of Money Multiplier

Real-world factors such as currency holdings, excess reserves, and borrower demand can attenuate the simple money multiplier.

Nominal Incomes and Inflation

High inflation can be harmful even if nominal incomes rise, as it erodes the purchasing power of money.