The Monetary System Notes

Money

What is Money?

• "Money" is the economic term for assets widely used to make and receive payments for goods and services.
• Money forms have varied: shells, gold, cigarettes.

Functions of Money in a Modern Economy:

1. Medium of Exchange: Money facilitates trade by being traded for goods and services.
   • Barter is inefficient due to the difficulty and time-consuming nature of finding a trading partner (double coincidence of wants).
   • Money offers a universally acceptable way of trading, reducing time and effort.
   • Money enables specialization, removing the need for individuals to produce all their necessities (food, clothing, shelter).
2. Unit of Account: Money serves as a standard yardstick for expressing the relative prices of goods and services.
   • Since goods and services are commonly exchanged for money, it's natural to express economic value in monetary terms.
3. Store of Value: Money allows people to transfer purchasing power into the future.
   • While other assets may offer higher returns, money also serves as a medium of exchange.
   • Most people use money as a short-term store of value for small amounts due to lower interest earnings compared to bank deposits.

Fiat Money

• The U.S. dollar and other national currencies are examples of fiat money.
• Definition: An asset used as legal tender by government decree, not backed by a physical commodity like gold.
• In theory, any object with a limited supply could function as fiat money.

Measures of Money

• Two main official measures of money stock (monetary aggregates):
  1. M1: Narrowest definition, includes currency in circulation, traveler’s checks, and checking account balances.
     • All components are used in payments, making M1 the closest to the theoretical description of money.
  2. M2: Includes everything in M1 plus savings deposits, small time deposits (less than $100,000$), and money market deposit accounts.

Money, Prices, and GDP

• Velocity: the circulation rate of money
• Nominal GDP = $17.31$ trillion
• Money supply = $11.49$ trillion
• Velocity = Nominal GDP / Money supply = $17.31$ trillion / $11.49$ trillion = $1.5$
• Money supply / Nominal GDP = $11.49$ trillion / $17.31$ trillion = 0.66$

Gross Domestic Product (GDP)

• GDP Definition: The market value of final goods and services produced within a country's borders during a specific period.
• Key aspects to know:
  • Quantity produced
  • Value of the production (price)

Nominal vs. Real GDP

• Nominal GDP: Total value of production using prices from the same year the output was produced.
• Real GDP: Total value of production using fixed prices from a particular base year.
• Growth rate of nominal GDP = Growth rate of real GDP + Growth rate of prices
• Growth rate of nominal GDP = Growth rate of real GDP + Inflation rate

The Quantity Theory of Money

• Assumes that the circulation rate of money (velocity) is constant in the long run: Velocity = Nominal GDP / Money Supply = constant
• A constant ratio implies that money and nominal GDP grow at the same rate:
• Growth rate of money supply = Growth rate of nominal GDP

Quantity Theory Equation

• Growth rate of money supply = Inflation rate + Growth rate of real GDP
• Rearranging terms, the quantity theory predicts the rate of inflation:
• Inflation rate = Growth rate of money supply – Growth rate of real GDP
• Inflation = gap between money supply growth rate and GDP growth rate.

Inflation

Causes of Inflation

• The quantity theory of money suggests inflation occurs when the growth rate of the money supply exceeds the growth rate of real GDP.
• Inflation rate = Growth rate of money supply – Growth rate of real GDP

Distinctions

• Inflation: A situation of rising prices.
• Deflation: A situation of falling prices (negative inflation).
• Hyperinflation: Extreme inflation where prices double within three years.

Effects of Inflation

• Not all prices and wages move together under inflation.
• Some relative prices, including real wages and real interest rates, can change.
• This leads to winners (those benefiting from unexpected gains) and losers (those suffering from unexpected losses).

Real Interest Rate

• The annual real or inflation-adjusted cost of a 1 loan.
• Accounts for the decline in the value of one dollar due to the increase in the overall price level.
• Fisher Equation: r = i – π
  • r = real interest rate
  • i = nominal interest rate
  • π = inflation rate
• Optimizing economic agents compare what they pay back to what they borrowed, adjusting the dollars borrowed for a year’s worth of inflation.

Winners and Losers from Unexpected Inflation

• Winners:
  1. Homeowner paying a mortgage at a fixed nominal interest rate.
  2. Firm owners (shareholders) paying wages not indexed for inflation.
• Losers:
  1. Bank receiving mortgage payments at a fixed nominal interest rate.
  2. Worker receiving a wage not indexed for inflation.
  3. Retiree receiving a pension not indexed for inflation.

Social Benefits of Inflation

1. Generating government revenue from printing currency (seigniorage).
2. Stimulating economic activity:
   • A fall in the real wage increases firms’ willingness to employ workers.
   • Increases in the price of output shift the labor demand to the right.

Social Costs of Inflation

1. Inflation Tax: Decline in the value of cash holdings due to inflation.
2. Raising logistical costs: frequent price changes (menu costs).
3. Distorting relative prices.

• Inflation can lead to counterproductive policies such as price controls (higher prices in the underground economy).

Costs Associated with Deflation

• High real interest rates that can’t be offset by lowering the nominal interest rate.
• Real burden of debt, which is fixed in nominal terms, rises when prices fall.

German Hyperinflation of 1922–1923

• Historical timeline and money supply data

Historical Timeline

• 1919: Germany signs the Treaty of Versailles, ending World War I.
  • The treaty imposed large reparation payments.
• 1923: Post-war Germany did not make the payments, and France occupied the Ruhr.
  • Germany could only meet 844.03$$43.824.0$$2.0$$2.03.8$$2.0$$1.81$$1$$% reduction in long-term expected real interest rates.
  • In most cases, inflationary expectations stay about the same.

  Key Ideas

  1. Money has three key roles: serving as a medium of exchange, a store of value, and a unit of account.
  2. The quantity theory of money describes the relationship between the money supply, velocity, prices, and real GDP.
  3. The quantity theory of money predicts that the inflation rate will equal the growth rate of the money supply minus the growth rate of real GDP.
  4. The Federal Reserve, the U.S. central bank, has a dual mandate—low inflation and maximum employment.
  5. The Federal Reserve holds the reserves of private banks.
  6. The Federal Reserve’s management of private bank reserves enables the Fed to do three things:
     • Set a key short-term interest rate
     • Influence the money supply and the inflation rate
     • Influence long-term real interest rates.