A. Functions performed by money

1. Medium of Exchange

Allows trade to occur, barter is inefficient. Most commonly accepted by individuals in the economy.

2. Store of Value

Can be used to hold wealth form one period to the next as opposed to various goods which might not be storable.

3. Unit of Account

Basic unit for measuring economic value. Allows for comparison between different consumption goods, prices wages and incomes.

B. Measuring Money

There is no single measure on money in the economy, generally measured by a group of money aggregates. M1, M2, M3, and L are all aggregates established by the Fed.

1. M1= Currency + travelers checks held by the public + demand deposits (pay o interest) + checkable deposits (pay some interest)

Is the most liquid measure of money and closest to the theoretical definition of money.

2. M2= M1 Savings deposits including passbook saving + Time deposits of a fixed term+ Repurchase agreements (overnight loans made by selling a security and agreeing to repurchase it the next day)

Not as liquid as M1

3. M3= M2 + Large denomination time deposits (>100,000) + money market funds held by institutions.

4. L = M3 + short term treasury securities + Commercial paper (short-term debt of corporations+ US savings bonds.

5. Weighted Aggregate

Composed of al possible asset weighted by how close they resemble money:

Currency has a higher weight than treasury bonds…

Not widely used, Fed had no weighted aggregates.

C. The Money Supply

1. Money supply or money stock is the amount of money available in the economy. It is controlled by the central bank of the country, in the case of the United States it is the Federal Reserve.

2.How does the Federal Reserve change the money supply?

a. Open market operations—The buying and selling of securities by the federal Reserve on the "open market". They purchase these securities from individuals and institutions, the Fed is not issuing securities or buying treasury bonds directly from the government.

When the Fed purchases securities on the "open market" it must use its cash reserves (money which was out of circulation). therefore the money supply will increase.

When the Fed sells these securities on the "open market" individuals and institutions pay for them with cash which the Fed then hold in reserve removing it from circulation, reducing the money supply.

b. Reserve Requirements

The Fed set a minimum fraction of each type of deposit that banks must hold in reserve.

If the reserve requirements are increased the banks hold more money in reserve decreasing the amount which is available for lending.

If the reserve requirements are decreased banks hold less money in reserves increasing the amount available for lending.

c. Discount Window Lending

The Federal Reserve provides short- term loans to banks to enable then to meet depositors’ demands and reserve requirements. The Fed sets the discount rate which rate of interest changed on the loans.

When the Fed increases the discount rate is discourages banks from borrowing, reducing the money supply.

When the Fed decreases the discount rate banks are more willing to borrow so the money supply will increase.

3. Will use M as the variable to represent the money supply in our models representing a monetary aggregate.

People allocate their wealth among various assets based upon:

A. Expected Return- will want the highest expected return keeping other things equal

B. Risk- will want the lowest amount of risk keeping on other things equal

C. Liquidity – Liquidity is the ease of access to the wealth for example cash is very liquid, while stocks are less liquid while some assets such as homes are not liquid. Prefer more liquidity other things being equal.

D. Asset Demand

1. Individuals must weight the above three concerns when deciding how to allocate their wealth

2. Trade of between Risk and Return. Generally the more liquid and the less risky an assets is the lower return offers.

Money is the most liquid assets and provides the lowest return (cash provides no return, checking deposits pay a low interest rate.)

A. Demand for money is the amount of money people want to hold in their portfolio

Key ingredients of money demand is how individuals value liquidity

Also depends upon how individuals values risk, return and liquidity

B. Key macroeconomics variables that affect money demand

1. Price Level

A higher price level requires a higher level of money to complete transactions

Nominal money demand will be proportional to the price level

2. Real Income

Determines the amount of transactions you can conduct- money demands increases as real income increases.

Money demand does not change in proportion to the real income, sense higher income individuals use money differently.

3. Interest Rates

An increase in interest rates or return on non monetary assets will decrease the demand for money,

An increase on the return to money will increase the demand for money

Nominal vs. real interest rates

C. The money Demand Function

1. M^d= PL(Y,i)

where M^d is the money demand, P is the price, L is the money demand function, Y is the real income output, I is the nominal interest rate on nonmonetary assets.

2. Nominal money demand is proportional to the price level

3. As real income increases the demand for money increases

4. Alternative expression M^d=PL(Y,r+π^e) a rise in r or π will reduce money demand

5. Alternative expression M^d /P= L(Y, r+π^e) The real money demand function

D. Other factors affecting money demand

1. Wealth

2. Risk- Increases risk may increase money demand

Times of erratic inflation bring increased risk to money

3. Liquidity of alternative assets: Deregulation, competition, and innovation have given other assets more liquidity, reducing the demand for money.

4. Payment technologies: Credit cards, ATMs, and other financial innovations reduce money demand.

E. Elasticities of money demand

1. How strong are the various effects on money demand?

2. Elasticity: The percentage change in money demand caused bu a one percent in some factor

3. Income elasticity of money demand

a. Positive higher income increases money demand

b. less than one: Higher income increases money demand less than proportionately

c. Goldfeld’s results income elasticity= 2/3

4. Interest elasticity of money demand is small and negative

5. Price elasticity of money demand is equal to one

F. Velocity and the quantity theory

1. Velocity measures the number of times a dollar is spent in the economy or how much money "turns over" during a period.

2. MV=PY where: M is the money supply V is velocity, P is the price level and Y is real output (PY will then be nominal output)

3. Quantity theory of money

a. M^d / P= kY

b. Constant velocity which Is not affected by income or interest rates

c. M1 velocity is not constant, M2 is closer to being constant

A. Asset Market Equilibrium

1. divided all assets into two categories: money and nonmonetary assets

a. Money pays interest rate i^m and supply is fixed at M

b. Nonmonetary assets include stocks, bonds, land … pay an interest rate equal to (i=r+π^ε) the supply of nonmonetary assets is fixed at NM

2. Asset Markey is in equilibrium when hew quantity of money supplied is equal to the quantity of money demanded.

a. Aggregates wealth is the sum of individual wealth for the economy

b. M^d+NM^d= Aaggregate demand for wealth

c. M+NM= Aggregates supply of wealth

d. (M^d-M)+(NM^d-NM)=0 The exceed demand for money plus the excess demand foe nonmonetary assets must equal zero.

f. If M^d=M then NM^d=NM

B. The asset market equilibrium condition

1. M/P=L(Y,r +π^e ) real money supply equals real money demand

M is fixed by the central bank

Fix inflation for now

Y is determined when the supply of labor is determined. (the amount of labor determines Y form the production function)

Given Y the goods market equilibrium determines r

2. With all the other variables determined in the asset market equilibrium the asset market determines the price level.

The price level will equal the ration of nominal money supply to real money demand

A. the inflation rate is closely related to the growth of money supply

1. rewrite the asset market equilibrium in growth terms

If the asset market is in equilibrium, The inflation rate equals the growth rate of the nominal money supply minus the growth rate of real money demand

To predict inflation we must forecast both money supply growth and real money demand

B. The expected inflation rate and the nominal interest rate

1, For a given real interest rate expected inflation will determine the nominal rate

2. What factors determine expected inflation?

If people expect an increase in money growth, they would then expect an increase in the inflation rate

The expected inflation rate would equal the current inflation rate if money growth and income growth are stable

Expectations are difficult to measure