What do the following words have in common?◦ Cheese◦ Dead Presidents◦ Dough◦ FEDS◦ Bones◦ Benjamins

Go to Dillards and buy a winter coat—Try to pay with a live chicken?

How about: 12 oranges, a Walrus tusk, a coffee mug and a picture of your cousin?

Then, you try to pay with a picture of an 18th century politician printed on green paper. What’s the difference????

Money—Anything that people commonly accept in exchange for goods and services.

3 Functions of Money:◦ A medium of exchange◦ A unit of account◦ A store of value

Medium of Exchange—is any item that sellers accept as payment for goods and services.◦ Buyers know that sellers will accept money in

payment for goods and services.◦ Restaurant workers are not paid in barbeque

sauce. $$$$◦ Teachers not paid in pencils. $$$$

Unit of Account/Standard of Value—Money provides people with a way to measure the relative value of goods and services. We measure in $ and Cents.◦ What is a TV worth? Bicycle? DVD player?◦ Helps consumers to compare prices◦ Helps clarify opportunity costs◦ Helps to compare businesses performance:

Profit of 300,000 bags of rice Profit of 500,000 hamburgers Profit of $100,000

Store of Value—2 things must be met ◦ Money must be nonperishable◦ Money must keep its value over time

If both conditions are met, people can accumulate their wealth for later use.

5 Major Characteristics of Money◦ Durability◦ Portability◦ Divisibility◦ Stability◦ Acceptability

Durability—the ability to be used over and over again.◦ Eggs? Gold/Silver? U.S. Dollars?

Portability—the ability to be carried from one place to another.

◦ Small, lightweight

Divisibility—the ability for money to be divided into smaller units.◦ Exact price comparisons can be made

Stability of Value—Must be stable in order to encourage saving.

Acceptability—People are willing to accept money in exchange for their goods/services.

Go to a drive through Ask the cashier the

following question:◦ Will you accept a federal

reserve note in payment for the food?

If they say no, then explain that federal reserve notes are money

M1 Coins and Paper Money—

◦ Coins minted by the U.S. Mint◦ Bills printed by the Bureau of Engraving◦ Paper bills are Federal Reserve NotesDemand Deposits—Also known as checking

accounts (or Checkable Deposits-largest part of M1).

Near Money—Assets such as savings accounts, and time deposits.

Near money because they cannot be immediately used to buy goods or pay debts.

M2 (currency plus easily turned into currency) M2=M1 plus:

◦ Savings Deposits-including money market accounts◦ Money Market Deposit Account (MMDA)-interest

bearing account that allows direct access but may have balance requirements and limit # withdrawals. Money is pooled to buy short term securities.

◦ Small (less than $100K) time deposits (Certificate of Deposit “CD”)

◦ Due to the extremely convertible nature of these funds due to technology change, the FED has recently decided to focus on M2 rather than M1.

M1=Paper and *Coin in circulation, *Checkable Deposits *Traveler’s Checks

M2=M1+Savings Deposits & Time Deposits<$100K

M3=M2+other deposits over 100K M3 not tracked by gov’t since 2006

Commercial Banks-primary depository institutions. Accept household and business deposits. Use deposits to make wide variety of loans—short term loans to business, consumer finance, auto and other durable goods.

Thrift Institutions- “thrifts” are Savings and Loans and Mutual banks that take consumer and business deposits and specialize in financing mortgages and some other loans.◦ Credit Unions-take deposits from and lend only to

“members” who often have a commonality (work for same firm, profession, etc)

Commodity Money—An item that has value of its own as a commodity and that can be used also as money. ◦ Diamonds, gold, silver, even salt!

Representative Money—Has value because it can be exchanged for something else of value.It has no intrinsic value. Bills that could be redeemed for gold/silver/ (Specie)

Fiat Money—Coin, paper money have been decreed to have value by the government.◦ The value ultimately stems from the citizens faith in the U.S. gov’t.

Currency—Coins, paper bills, used for trading

Token Money-coins made with Low cost materials to keep people from melting down.

What Backs It? FAITH and STUFF! Paper Money and Checkable Deposits are

debts.◦ Promise to pay◦ Owed by the Federal Reserve Banks◦ Debts of the commercial and thrift institutions

◦ This is a “management” solution to the money supply. Try to manage right amount of currency for a

particular volume of business.

Basing money on some commodity allows for too much “swing”.◦ If you back your money with gold and then there

is a huge new discover of gold then what happens?

◦ What happens if there is a long lasting decline in gold production?

Money has value when:◦ Accepted—as long as it is accepted for exchange◦ Legal Tender —this is strengthened b/c the

government designated Federal Reserve notes so they must legally be accepted (or else the institution forfeits the right of charging interest).

◦ Relative Scarcity –value depends, like anything else on Supply and Demand

Purchasing Power of the Dollar◦ Amount a dollar will buy varies inversely with

price level.◦ When CPI goes up, value of dollar goes down.◦ When CPI goes down, value of dollar goes up!

◦ Formula: Dollar’s Value=1/Price level = 1/P Note: convert CPI to a dollar equiv 120 CPI=$1.2

◦ If given a price level in base 100 form, then just divide that into one to determine buying power.

◦ If CPI is 120, then 1/1.20=current value of dollar

If inflation is high, demand for dollar goes down b/c it is less acceptable to people as a store of value and unit of account b/c not stable.

Rapid declines may cause it to cease being used altogether (post WWI Germany).

Stabilization of money’s value requires:◦ 1. Appropriate fiscal policy◦ 2. Intelligent management of money supply

(monetary policy)

In the US Managing Money supply is three way approach:a. Legislation(incl. forming of Fed Reserve 1913)b. Government Policyc. Social Practice

Currency and Checkable Deposits are forms of indebtedness to you:◦ If you buy a coat and write a check, then the

check is a transfer of banks indebtedness from you to the merchant.

◦ The ability of the banks to honor such claims depends on there not being too many versions.

◦ This is why banking/checking heavily regulated—to smooth out the process.

Monetary Authorities make a particular amount of money available given the nation’s real interest rate. This is Sm ◦ Vertical assumes fixed

quantity of money available.

◦ Real Interest Rate-

Sm

Why do people want to hold wealth in money?◦ 1. Make purchases

Transactions Demand-(mortgage, groceries, doctor, etc) Main Determinant for Dt is nominal

GDP. The larger the total money value of all

goods and services in an economy, the larger the quantity of money needed to negotiate transactions.

Why nominal? Firms/households want MORE $ if prices rise or if real output increases. In both there is a larger dollar volume required.

Vertical b/c demand for it depends on nominal GDP which is a fixed amount of “stuff”

2. Asset Demand for Money◦ *Because of the store of value function◦ People hold financial assets to:

Increase liquidity (how easily you can convert wealth to other forms)—money is most liquid

Increase their buying power when prices expected to decline.

Disadvantage-inflation eats at value, if interest doesn’t keep up with inflation.

Opportunity costs occur when you hold money—you give up interest earned in exchange for liquidity.

As interest rates fall you want more money, as they increase you want less—so curve follows traditional demand shape.

Money Market-◦ When you combine supply of money and demand

for money on one graph you have the money market!

◦ Just as in product markets, where supply and demand meet is the price equilibrium (interest rate is the price).

◦ So: A decline in money will lead to increased interest rates

What causes Shifts in Demand?◦ Change in real GDP, ◦ Change in the price

level, or◦ Change in transfer

costs◦ Example

A increase the quantity of money demanded at any interest rate r, increasing the demand for money from D1 to D2. The quantity of money demanded at interest rate r rises from M to M′. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left

Bond prices Adjust to Money Supply/Demand

1.Lower bond prices mean higher interest rates (returns).2.Higher bond prices mean lower interest rates (returns)

Bond—institutions borrow money by issuing bonds.

Maturity—the point at which a bond “comes due”—when the interest promised will be paid. So, if you buy a 5 year bond at $10 @5%

$10,000 bond at 5% interest will yield $50◦ (.05x$10,000)

◦ But what if the market changes over the 5 years? ◦ What if the dollars aren’t worth what they were before?

If Money Supply Declines:◦ Bond prices on existing bonds will decrease so yield is

higher:

◦ $50 return/$667 price paid=7 ½ % yield

If Money Supply Increases:$50 return/$2000 price=2 1/2 % return

So, bond prices are inversely related to interest rates, and prices are inversely related.

Pennies:◦ Content: 90% Zinc; 10% Copper◦ Melted down: Penny worth @ 3 cents

Nickels:◦ Content 70% Copper; 30% Zinc◦ Melted down: Nickel worth @ 8 cents

Penalty for melting:◦ 10 years in prison and big fine◦ Cannot ship out of country > $100 in

pennies/nickels