INFLATIONARY DEMAND SHOCKS AND INFLATION
-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.
IF THE GOVERNMENT DOES NOT VALIDATE INFLATION CAUSED BY AN ISOLATED DEMAND SHOCK
Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.
IF THE GOVERNMENT DOES VALIDATE INFLATION CAUSED BY ISOLATED DEMAND SHOCKS
Aggregate demand will shift to the right as a result of this supply shock. In response to this, SRAS shifts to the left due to wage adjustment. However, if the government tries to validate this change in supply by increasing the money supply (which lowers interest rates, and ultimately shifts AD to the right), this puts NEW INFLATIONARY PRESSURES on an economy: basically, the natural chain and anchor mechanism is fighting against government policy here, and the result is sustained inflation within an inflationary gap. The SRAS want to return output to Y*, but the government continues to artificially increase AD through monetary policy. As both AD and SRAS continue to shift right and left, respectively, the price level will continuously climb. =(
------------------------------------------------------------------------------
WHAT ABOUT ACCELERATING INFLATION?
-We know that in most cases, demand shocks cause wage adjustment, and that if governments are not crafty, they may follow this up with monetary validation. If we look at this graphically, we can say that the inflation rate (the change in the price level divided by the original price level) could be graphically represented by the vertical distance between the original price point and the new price point.
-When AD and AS both shift up, the inflationary gap will persist.
-Graphically, we know that inflation is accelerating if the arrow between the price points gets longer and longer.
SO... two questions we need to answer are:
1) What creates persistent inflation (what causes inflation to hang around, instead of being a one-off)?
The answer: Validation
and
2) When is the inflation at a constant rate, and when is it at an accelerating rate (what causes inflation to get worse and worse)?
The answer: Expectations
ACCELERATION HYPOTHESIS
-If the economy is running an inflationary gap caused by either increased aggregate demand (for an example, demand resulting from China's increased demand for raw materials) or increased aggregate supply (for an example, increase supply due to lower world prices of raw materials)...
-AND if the central bank wants to maintain the "good time" (aka: it uses monetary policy to validate this inflationary gap, and tries to keep the gap from being closed)...
-THEN, inflation will persist, and be accelerating.
In summary, if the BoC maintains a constant inflationary gap, then the actual inflation rate will persist and accelerate (the economy will continue to inflate at progressively larger rates over time).
WHY?
1) EXPECTATION EFFECTS (remember, actual inflation is a combined result of gap inflation, expectation inflation, and supply shock inflation)
-An increase in aggregate demand causes an inflationary gap, and as we know, this ultimately causes prices to rise due to the wage change mechanism
-As a result, expectations are formed: workers demand that their wages rise at a similar rate over the next year to account for predicted inflation (for an example, let's say that they expect inflation to be 2%, then they will demand a 2% wage increase).
-If the BoC adds inflationary pressures by maintaining the gap, then this will create extra gap inflation of 2%, which stacks on top of the expectation inflation for a combined actual 4% rate of inflation.
-This overall 4% rate of inflation informs new expectations for the next year: workers will demand 4% wage increases, and those new expectation pressures stack onto persistent gap inflation for a total of 6% total inflation over the next year
-This continues on for quite a while, generating an inflationary spiral.
AS LONG AS THE BoC VALIDATES THE GAP, EXPECTATIONS ARE ALWAYS BEING REVISED UPWARDS (worker expect higher and higher inflation, and demand higher and higher wage increases). People come to expect this inflation, and build it into their wage demands.
2) MORE RAPID MONETARY VALIDATION IS REQUIRED
-If the BoC wants to maintain output above Y*, it has to increase the rate of growth in the money supply.
-This is because the inflation rate is accelerating, and therefore, to accommodate for increase transaction demands due to higher prices, the BoC must accelerate the growth of money (basically, it must print a larger and larger quantity of money each year)
-This validation becomes more and more dramatic as time goes on
Let's summarize what we know!
We have an isolated shock ---> There will be no gap in the long run
We have have a repeated AS shock ---> There will be a persistent gap
We have a repeated AD shock ---> There will be a persistent gap
At Y*, persistent inflation will consist of only expectation inflation
With a Gap, there will be accelerating inflation, due to the gap inflation on top of expectation inflation
Cost push inflation from Y* lead to a recessionary gap
Demand pull inflation from Y* leads to an inflationary gap
AGAIN: Is monetary validation a good idea?
Yes, because monetary validation can eliminate recessions more quickly than simply letting "nature take its course"
No, because it causes inflation
Additionally, as we now know, monetary validation can create expected inflation to increase over time, creating a wage-price spiral. Some economists argue that the disadvantages of these increased expectations could be avoided if the BoC never validated gaps in the first place!
Saturday, March 27, 2010
The Gap Effect, and the Expectation Effect
THE WONDERFUL WORLD OF INFLATION:
People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.
For the rest of us, lets reiterate:
Inflation is any rise in the general price level (P)
Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)
In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.
On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)
HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)
Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%
Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)
---------------------------------------
One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.
We're going to look at why NAIRU is called NAIRU in this chapter
--------------------------------------------------
INFLATION AND WAGE CHANGES:
Okay... why do people's wages change?
There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect
THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).
The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.
Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).
Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...
They were entirely correct... there is also...
THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!
Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.
The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.
People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.
For the rest of us, lets reiterate:
Inflation is any rise in the general price level (P)
Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)
In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.
On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)
HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)
Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%
Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)
---------------------------------------
One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.
We're going to look at why NAIRU is called NAIRU in this chapter
--------------------------------------------------
INFLATION AND WAGE CHANGES:
Okay... why do people's wages change?
There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect
THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).
The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.
Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).
Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...
They were entirely correct... there is also...
THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!
Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.
The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.
Wednesday, March 17, 2010
The Demand & Supply for Money
The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)
-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest
3 REASONS WHY PEOPLE HOLD MONEY
1: TRANSACTION DEMANDS FOR MONEY
-People hold money so that they can make transactions
2: PRECAUTIONARY DEMAND FOR MONEY:
-People hold money in case they experience an emergency where money would is required
-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"
3: SPECULATIVE DEMAND FOR MONEY:
-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)
The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)
The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)
Income, Prices, and The Nominal Interest Rate Affect Demand for Money!
The higher income is, the more transactions there are within an economy, so the higher demand for money will be
+ Positive Relation
The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost
- Negative Relation
The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.
+ Positive Relation
Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)
THE SUPPLY OF MONEY
-The money multiplier is relatively constant
-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)
-The money supply is independent from the interest rate (although it affects the interest rate)
-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph
-The real money supply is M/P: this describes money's purchasing power in terms of goods and services
PUTTING SUPPLY AND DEMAND TOGETHER: MONETARY EQUILIBRIUM
(This is also called liquidity preference theory of interest, or the portfolio balance theory)
-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier
Okay: So..
-The supply of money is perfectly inelastic (a vertical line)
-The demand for money varies inversely with the interest rate (it is a downward sloping curve)
Equilibrium occurs when demand and supply for money intersect: M = L
Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates
Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.
That's all for now!
-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest
3 REASONS WHY PEOPLE HOLD MONEY
1: TRANSACTION DEMANDS FOR MONEY
-People hold money so that they can make transactions
2: PRECAUTIONARY DEMAND FOR MONEY:
-People hold money in case they experience an emergency where money would is required
-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"
3: SPECULATIVE DEMAND FOR MONEY:
-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)
The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)
The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)
Income, Prices, and The Nominal Interest Rate Affect Demand for Money!
The higher income is, the more transactions there are within an economy, so the higher demand for money will be
+ Positive Relation
The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost
- Negative Relation
The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.
+ Positive Relation
Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)
THE SUPPLY OF MONEY
-The money multiplier is relatively constant
-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)
-The money supply is independent from the interest rate (although it affects the interest rate)
-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph
-The real money supply is M/P: this describes money's purchasing power in terms of goods and services
PUTTING SUPPLY AND DEMAND TOGETHER: MONETARY EQUILIBRIUM
(This is also called liquidity preference theory of interest, or the portfolio balance theory)
-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier
Okay: So..
-The supply of money is perfectly inelastic (a vertical line)
-The demand for money varies inversely with the interest rate (it is a downward sloping curve)
Equilibrium occurs when demand and supply for money intersect: M = L
Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates
Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.
That's all for now!
Thursday, March 4, 2010
MONEY MONEY MONEY
Money Money Money!
THE NATURE OF MONEY
-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.
-The REAL SECTOR describes the allocation of resources to produce different goods
-Resource allocation (use of factors) is dependent on relative prices
-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses
-The MONETARY SECTOR encompasses changes in the money supply (how much money is circulating in an economy)
-Most economists believe that a change in the money supply would just change the absolute price level in the long run
-If relative prices do not change (ie: the price of both wood and brick rises proportionately), then this will not change the allocation resources
-This shows the NEUTRALITY OF MONEY (A change in the money supply can change the macroeconomic price level, but it will not change relative prices, or GDP)
-The amount of money circulating in an economy affects ABSOLUTE prices, but not relative prices (so while the price of wood will go up, so will the price of bricks, and consequently, the price of houses)
-In modern economic theories, money supply has no long run effect on GDP (it only affects the price level)
-In the short run, however, money supply can affect both price level and GDP
This is the exchange identity: MV = PY : The velocity of money (the size of the money supply multiplied by the amount of times money is used in an economy) is equal to the general price level multiplied by real output. In other words, what you give up (the amount of many people spend to get things) is equal to what you get (the value of the real goods produced by an economy)
THE DEFINITION OF MONEY: 3 ESSENTIAL CHARACTERISTICS
1: Money is a medium of exchange
-Barter requires the "double coincidence of wants" (you have to want what I have, and I have to want what you have)
-Because such situations rarely occur, money is an excellent "in-between" medium-of-exchange for facilitating trade
There are stipulations, however!
1: Money only works as a medium of exchange if people expect that others will accept their money as a legitimate form of payment
2: Money should have a generally high value relative to its weight (or else it will be awkward to exchange: can you imagine if sand or dirt were money, for instance!)
3: It must be divisible (you can divide a dollar in half. You cannot divide a live cow in half)
4: It must not be counterfeit-able (which explains the elaborate construction of dollar-bills)
2: Money is a method of storing wealth
-Earning and spending are not synchronized (ie: you may work on a Monday, but not wish to buy anything until a Saturday)
-Money has stable value which does not diminish over time
-It is a method of deferred payment (this is sometimes cited as the 4th role of money)
3: Money is a unit of account, or financial measurement
-We use money as a unit of measurement: we measure different transactions using dollars, thus it is a sort of accounting unit which facilitates accounting.
NOTE* Demand deposits (aka: deposits into an easily-accessible checking account) count as money, as they satisfy all of these conditions!
THE ORIGINS OF MONEY
1: Commodity Money
-Money was originally precious metals, such as gold
-These were generally recognized as valuable and accepted as payment in most places- they did not wear away or lose value over time, and they had a stable value
Problems:
-Originally, these metals were carried in bulk, so they would have to be weighed, and then stamped by a ruler, guaranteeing the weight of "face value"
-Clipping and shaving
-debasement led to inflation and Quantity Theory of Money
Gresham's Law:
-Bad money forces good money out of the system
-People will hang on to money with high intrinsic value (because it is a very good method for storing wealth)
2: Token Money
-To overcome the problems associated with commodity money, would was deposited at a goldsmith's vault for safekeeping. The goldsmith would give owners a receipt, and this receipt of ownership of the gold was exchanged, rather than the gold itself. Eventually, banks replaced goldsmiths, performing a similar function
-Bank notes were paper money, which were FULLY BACKED by gold (ie: convertible on demand)
-A country whose money is fully backed by gold is on the gold standard
3: Fractionally Backed Money
-Banks discovered that while some customers withdraw gold, and some customers deposit gold, most of their customers are simply trading indirectly using bank notes
-Thus, banks could issue more notes convertible to gold than they actually have gold in their vaults as reserves, and then charge interest on this lent money to generate profits.
-The fraction of money held in reserve affects the money supply: the higher the amount held in reserve, the lower the money supply (because money held in banks cannot be in circulation)
4: Fiat Money: Legal Tender
-Here, the state promises that a certain form of paper or coin currency is legally money, so it becomes money
-Over time, central banks took control of the note issuance: while it was originally backed by gold, it is now only fractionally backed
-Ultimately most of the money we deal with on a day to day basis is not backed by gold at all (for instance, if we went to the neighborhood bank, deposited a cheque, and asked for gold, the teller would probably think we were very strange)
-Most countries abandoned the gold standard by 1940 (WW2)
Legal Tender: The law requires that this be accepted to repay debts- refusal discharges debt.
-Fiat money is backed by the productive capacity of an economy
-Fiat money is valuable because it can purchase goods and pay debts (today's money is fiat money)
5: Bank Deposits (Modern Money)
-Money held by the public in the form of deposits withdrawn on demand from banks (no notice is required)
-(Checks and debit cards, however, are not considered money)
-Bank deposits function on a fractional reserve system: banks create money by granting more loans than deposits to cover them (so if a run on the banks were to occur, the banks would not actually have enough money on hand to pay everyone back.
THE CANADIAN BANKING SYSTEM:
Canada (and many other countries) has a central bank which controls the money supply (the bank of Canada, which a run by a "governor" of the bank of Canada)
-Although the Bank is owned and operated by the government, it operates separately from the cabinet on a day to day basis: it is ultimately held responsible the cabinet, however.
In Canada, our current governor of the Bank of Canada is Mike Carney (Monetary Policy) and our current minister of finance is Jim Flaherty (Fiscal Policy)
THE FUNCTIONS OF THE BANK OF CANDA
1: It is the Bankers' Bank
-It is a lender of last resort to Chartered Banks (they can lend money from the BoC if they have to)
-Chartered Banks have their checking accounts at the Bank of Canada (reserves)
-As of 2002, about $1.2 billion was actually held in asset form at the bank of Canada
2: It is the government's bank
-The government has a chequing account at the BoC
-The government replenishes this account from larger accounts at Chartered Banks
-The BoC's monetary tool is "switching" the location of government accounts (between the BoC and Chartered Banks)
3: It regulates the money supply
-It prints money (this is only done as a reaction in Canada)
4: It regulates financial markets
-It prevents panic and bank failures
-Financial intermediaries (chartered and commercial banks) borrow short term and loan long term from the BoC, so increases in the bank rate squeezes them, and makes the "overnight market" less attractive: basically the higher the BoC sets the bank rate, the higher Chartered Banks will set their prime rate in order to continue to profit, and the more money they will hold in reserve to avoid getting "dinged" with interest for borrowing from the government should a customer seek to withdraw money
-The BoC is concerned about the exchange rate
So, the money supply involves the government, central banks, and chartered banks
The Canadian System
Canada- few banks with many branches (the banking sector is much more like an oligopoly)
USA- many banks with fewer branches (the banking sector is much more like monopolistic competition)
The systems are a bit different, but they essentially function the same way
COMMERCIAL BANKS: Includes chartered banks (formed prior to 1980), smaller banks trusts and credit unions, and foreign banks
A commercial bank is a profit-maximizing private corporation
Chartered Banks
-They hold deposits (trust companies also do this)
-They transfer deposits by cheque (the post office also does this)
-They make loans (credit unions also do this)
-They invest in government securities (insurance companies also do this)
-The government used to require the chartered banks to old money on reserve, but this is no longer required after reforms to the Bank Act (1980)
Interbank Cooperation
-Several Banks can make pooled loans to large companies (which they all benefit from due to the interest paid)
-Charted Banks must now compete against credit card companies
-Debit Cards
-Cheque clearing distinguishes chartered banks (they will turn cheques into money!)
-A clearing house settles interbanks debts: the net difference is accomplished by change in deposits at the bank of Canada
Chartered Banks are Profit-Maximizing Private Corporations:
-Their main asset is securities and loans
-Their main liability is deposits
-They make profits by borrowing money for less than they lend it for
-Competition is strong among different banks, which leads to competitive rates, which is good for consumers
The Big 5:
Royal
Toronto Dominion
Scotia
CIBC
BMO
Note* Our prof usually refers to chartered and commercial banks interchangeably
RESERVES
-Their purpose is to meet demands on deposits for chartered banks
-A RUN ON THE BANKS is when more depositors wish to withdraw more deposits than there are reserves
WAYS TO AVOID A RUN ON THE BANKS:
1: Reserves- the BoC can induce an INCREASE in reserves and avert a run on the banks by
-Loaning money directly to chartered banks
or
-Open Market Operations: buying securities from Chartered Banks
2: The Canadian Deposit Insurance Coporation
-A Federal Crown Corporation
-Insures deposits in any one account up to $100,000
-A problem is that this insurance is an incentive for banks to pursue riskier investment options "if this investment makes us money, the depositor wins- if it loses us money, then the taxpayer loses"
TYPES OF RESERVES:
1: A Reserve Ratio is the chartered bank's fraction of deposit liability held in Cash of BoC deposits
Actual reserves = reserves the Chartered Bank actually holds
Target reserves = reserves a Chartered Bank wishes to hold
Excess reserves = reserves a Charted Bank holds above target
Secondary reserves = liquid assets convertible to cash (ie: T-bills, and government bonds)
The old bank act required banks to hold reserves for stability and confidence in the system, and to regulate the money supply
Competition from intermediaries and international banks who were not required to hold reserves lead to the elimination of required reserves. Now, the BoC uses the "overnight target rate" (how much interest it charges target rates on overnight loans) to regulate reserves and control the money supply
Presently, actual reserves are about 0.5% of total Chartered Banks liabilities (so we are using a fractional reserve system)
THE FRACTIONAL RESERVE SYSTEM
The reserve ratio is much much less than 1, at about 0.5% of total liabilities. Chartered banks only hold a small portion of deposits on reserve, and the BoC will bail them out if reserves are too low to meet demands on deposits.
The Cost for chartered Banks of borrowing from the BoC (the Bank rate, or the "overnight rate") determines how much reserves banks will hold. An increase in the cost of borrowing will induce the Chartered Banks to hold more reserves
BANK RATE INCREASES ---> BANKS HOLD MORE IN RESERVES
BANK RATE DECREASES ---> BANKS HOLD LESS IN RESERVES
Target reserve ratios are now determined independently by Chartered Banks, but there is incentive for them to still hold some reserves on hand, in order to avoid losing money: the Bank rate determines the opportunity cost of the risk of loaning out more than is on reserve for Chartered Banks.
The Creation of Money!
Assume:
-There is a fixed reserve ratio
-There are no leakages or cash drains (this implies that a change in the money supply will manifest as a change in deposits)
2 Conditions are required for Banks to Make Money
1: The Public must be willing to use bank deposits as money
currency ratio = (public cash holdings/public bank deposits) or C/D
2: banks must be willing to use the fractional reserve system
reserve ratio = (reserve assets/deposit liabilities) or R/D
If the currency ratio is equal to 1, then there is no banking system
If the reserve ratio is equal to 1, there is no creation of money (there is just safety deposit boxes)
The Creation of Deposit Money
Assume:
-cr = 0 (all of the cash is deposited in banks)
-rr = 0.20 (banks loan out 80% of their deposits)
The creation of money is possible due to the fractional reserve system
Changes in the money supply are equal to deposits or withdrawals / The reserve ratio
The currency ratio acts as a cash drain, or leakage. The uncertainty of the banking system increases the currency ratio and decreases the multiple expansion of the money supply (the more cash people hold onto instead of converting into a bank deposit, the smaller the change in the money supply due to banks loaning out money)- we saw this sort of thing happen in 2008 with the US financial meltdown- people lost faith in the banks and wanted their money back, so the money supply in the United States suddenly decreased.
On the other hand, deposits are very convenient (thanks to debit cards), which decreases the currency ratio
High Powered Money (H) is "cash": a combination of cash held on reserve by banks, and cash in circulation within the public.
H = rr * D + cr * D
THE MONEY MULTIPLIER
Money Supply = M
M = D + C (bank deposits + money in circulation)
But, C = cr * D
so
M = (1 + cr)D
H = R + C
R = rr * D and C = cr * D
Therefore, H = (rr + cr)D
The money multiplier = Changes in M/Changes in H
= (1 + cr)/(rr + cr)
If the currency ratio = 0, then the money multiplier = 1/rr
If banks want to hold more money (the reserve ratio increases) or if the public wants to hold more cash (the currency ratio increases), then the money multiplier gets smaller: basically, the more loanable money which is held in banks, the higher the multiplier effect for money!
AN EXAMPLE OF THE MONEY MULTIPLIER
Assume:
-A constant reserve ration of 0.20
-cr = 0
Person 1 deposits $100 in the bank.
The bank loans out $80 to person 2
Person 2 deposits $80 in another bank
The bank loans out $64 to person 3
Etc...
With each transaction, the money supply increases by a decreasing amount (it works similarly to the expenditure multiplier effect)
So, let's do the math: 100 * the money multiplier = 100 *(1/0.20) = 500!
Monetary Base (H) = C + R - this is the amount of cash in an economy
Money Supply (M) = C + D - This is the amount of money in an economy (because not all money is cash!)
Variable reserve ratios make the the money multiplier equation complicated, but it still works
Cash Drains: Money creation is not automatic- it depends on public and bank behaviors
Public: Uncertainty causes the cr to increase, which makes it harder to create new money
Bank: Uncertainty causes the rr to increase, which makes it harder to create new money
TYPES OF DEPOSITS
Demand Deposit
-Can be withdrawn on demand (no notice required)
-Money can be transfered via cheque
Savings Deposit
-Notice of withdrawal required
-Non-transferable by cheque
Term Deposit
-Chequable savings accounts are now available, so the old distinction isn't as useful
-Today, "term deposit" distinguishes "notice accounts" from other accounts
-A deposit must be left in the account for a term: if withdrawn early, there is a reduced interest rate on that money (so the depositor gets less bang for their buck)
Definitions of the money supply
H = High Powered Money, or cash in public and cash in reserves
M1B = Cash in public + Demand Deposits (this emphasizes the exchange medium function of money)
M2 = M1B + savings deposits at chartered banks (emphasize money's wealth storage function)
M2+ = M2 + Deposits at other intermediaries, including credit unions, trust companies, insurance companies, and MMFs
M2++ = M2+ and all other mutual finds + Canada Savings Bonds
The BoC uses M2's to control inflation.
Near Money and Money Substitutes
There is debate over the definition of the money supply: if a medium of exchange is important, than M1B should define the money supply. If a storage of wealth is important, than deposits that pay higher returns but are not chequable (ie: the M2 series) should count as part of the money supply
Near Money is not a good medium of exchange, but it IS a good store of wealth (like Savings Bongs, Mutual Funds, and Money held in trust accounts)
Money Substitutes are good methods of exchange, but not good methods of storing wealth (like credit cards and debit cards)
Whew. That's all!
THE NATURE OF MONEY
-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.
-The REAL SECTOR describes the allocation of resources to produce different goods
-Resource allocation (use of factors) is dependent on relative prices
-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses
-The MONETARY SECTOR encompasses changes in the money supply (how much money is circulating in an economy)
-Most economists believe that a change in the money supply would just change the absolute price level in the long run
-If relative prices do not change (ie: the price of both wood and brick rises proportionately), then this will not change the allocation resources
-This shows the NEUTRALITY OF MONEY (A change in the money supply can change the macroeconomic price level, but it will not change relative prices, or GDP)
-The amount of money circulating in an economy affects ABSOLUTE prices, but not relative prices (so while the price of wood will go up, so will the price of bricks, and consequently, the price of houses)
-In modern economic theories, money supply has no long run effect on GDP (it only affects the price level)
-In the short run, however, money supply can affect both price level and GDP
This is the exchange identity: MV = PY : The velocity of money (the size of the money supply multiplied by the amount of times money is used in an economy) is equal to the general price level multiplied by real output. In other words, what you give up (the amount of many people spend to get things) is equal to what you get (the value of the real goods produced by an economy)
THE DEFINITION OF MONEY: 3 ESSENTIAL CHARACTERISTICS
1: Money is a medium of exchange
-Barter requires the "double coincidence of wants" (you have to want what I have, and I have to want what you have)
-Because such situations rarely occur, money is an excellent "in-between" medium-of-exchange for facilitating trade
There are stipulations, however!
1: Money only works as a medium of exchange if people expect that others will accept their money as a legitimate form of payment
2: Money should have a generally high value relative to its weight (or else it will be awkward to exchange: can you imagine if sand or dirt were money, for instance!)
3: It must be divisible (you can divide a dollar in half. You cannot divide a live cow in half)
4: It must not be counterfeit-able (which explains the elaborate construction of dollar-bills)
2: Money is a method of storing wealth
-Earning and spending are not synchronized (ie: you may work on a Monday, but not wish to buy anything until a Saturday)
-Money has stable value which does not diminish over time
-It is a method of deferred payment (this is sometimes cited as the 4th role of money)
3: Money is a unit of account, or financial measurement
-We use money as a unit of measurement: we measure different transactions using dollars, thus it is a sort of accounting unit which facilitates accounting.
NOTE* Demand deposits (aka: deposits into an easily-accessible checking account) count as money, as they satisfy all of these conditions!
THE ORIGINS OF MONEY
1: Commodity Money
-Money was originally precious metals, such as gold
-These were generally recognized as valuable and accepted as payment in most places- they did not wear away or lose value over time, and they had a stable value
Problems:
-Originally, these metals were carried in bulk, so they would have to be weighed, and then stamped by a ruler, guaranteeing the weight of "face value"
-Clipping and shaving
-debasement led to inflation and Quantity Theory of Money
Gresham's Law:
-Bad money forces good money out of the system
-People will hang on to money with high intrinsic value (because it is a very good method for storing wealth)
2: Token Money
-To overcome the problems associated with commodity money, would was deposited at a goldsmith's vault for safekeeping. The goldsmith would give owners a receipt, and this receipt of ownership of the gold was exchanged, rather than the gold itself. Eventually, banks replaced goldsmiths, performing a similar function
-Bank notes were paper money, which were FULLY BACKED by gold (ie: convertible on demand)
-A country whose money is fully backed by gold is on the gold standard
3: Fractionally Backed Money
-Banks discovered that while some customers withdraw gold, and some customers deposit gold, most of their customers are simply trading indirectly using bank notes
-Thus, banks could issue more notes convertible to gold than they actually have gold in their vaults as reserves, and then charge interest on this lent money to generate profits.
-The fraction of money held in reserve affects the money supply: the higher the amount held in reserve, the lower the money supply (because money held in banks cannot be in circulation)
4: Fiat Money: Legal Tender
-Here, the state promises that a certain form of paper or coin currency is legally money, so it becomes money
-Over time, central banks took control of the note issuance: while it was originally backed by gold, it is now only fractionally backed
-Ultimately most of the money we deal with on a day to day basis is not backed by gold at all (for instance, if we went to the neighborhood bank, deposited a cheque, and asked for gold, the teller would probably think we were very strange)
-Most countries abandoned the gold standard by 1940 (WW2)
Legal Tender: The law requires that this be accepted to repay debts- refusal discharges debt.
-Fiat money is backed by the productive capacity of an economy
-Fiat money is valuable because it can purchase goods and pay debts (today's money is fiat money)
5: Bank Deposits (Modern Money)
-Money held by the public in the form of deposits withdrawn on demand from banks (no notice is required)
-(Checks and debit cards, however, are not considered money)
-Bank deposits function on a fractional reserve system: banks create money by granting more loans than deposits to cover them (so if a run on the banks were to occur, the banks would not actually have enough money on hand to pay everyone back.
THE CANADIAN BANKING SYSTEM:
Canada (and many other countries) has a central bank which controls the money supply (the bank of Canada, which a run by a "governor" of the bank of Canada)
-Although the Bank is owned and operated by the government, it operates separately from the cabinet on a day to day basis: it is ultimately held responsible the cabinet, however.
In Canada, our current governor of the Bank of Canada is Mike Carney (Monetary Policy) and our current minister of finance is Jim Flaherty (Fiscal Policy)
THE FUNCTIONS OF THE BANK OF CANDA
1: It is the Bankers' Bank
-It is a lender of last resort to Chartered Banks (they can lend money from the BoC if they have to)
-Chartered Banks have their checking accounts at the Bank of Canada (reserves)
-As of 2002, about $1.2 billion was actually held in asset form at the bank of Canada
2: It is the government's bank
-The government has a chequing account at the BoC
-The government replenishes this account from larger accounts at Chartered Banks
-The BoC's monetary tool is "switching" the location of government accounts (between the BoC and Chartered Banks)
3: It regulates the money supply
-It prints money (this is only done as a reaction in Canada)
4: It regulates financial markets
-It prevents panic and bank failures
-Financial intermediaries (chartered and commercial banks) borrow short term and loan long term from the BoC, so increases in the bank rate squeezes them, and makes the "overnight market" less attractive: basically the higher the BoC sets the bank rate, the higher Chartered Banks will set their prime rate in order to continue to profit, and the more money they will hold in reserve to avoid getting "dinged" with interest for borrowing from the government should a customer seek to withdraw money
-The BoC is concerned about the exchange rate
So, the money supply involves the government, central banks, and chartered banks
The Canadian System
Canada- few banks with many branches (the banking sector is much more like an oligopoly)
USA- many banks with fewer branches (the banking sector is much more like monopolistic competition)
The systems are a bit different, but they essentially function the same way
COMMERCIAL BANKS: Includes chartered banks (formed prior to 1980), smaller banks trusts and credit unions, and foreign banks
A commercial bank is a profit-maximizing private corporation
Chartered Banks
-They hold deposits (trust companies also do this)
-They transfer deposits by cheque (the post office also does this)
-They make loans (credit unions also do this)
-They invest in government securities (insurance companies also do this)
-The government used to require the chartered banks to old money on reserve, but this is no longer required after reforms to the Bank Act (1980)
Interbank Cooperation
-Several Banks can make pooled loans to large companies (which they all benefit from due to the interest paid)
-Charted Banks must now compete against credit card companies
-Debit Cards
-Cheque clearing distinguishes chartered banks (they will turn cheques into money!)
-A clearing house settles interbanks debts: the net difference is accomplished by change in deposits at the bank of Canada
Chartered Banks are Profit-Maximizing Private Corporations:
-Their main asset is securities and loans
-Their main liability is deposits
-They make profits by borrowing money for less than they lend it for
-Competition is strong among different banks, which leads to competitive rates, which is good for consumers
The Big 5:
Royal
Toronto Dominion
Scotia
CIBC
BMO
Note* Our prof usually refers to chartered and commercial banks interchangeably
RESERVES
-Their purpose is to meet demands on deposits for chartered banks
-A RUN ON THE BANKS is when more depositors wish to withdraw more deposits than there are reserves
WAYS TO AVOID A RUN ON THE BANKS:
1: Reserves- the BoC can induce an INCREASE in reserves and avert a run on the banks by
-Loaning money directly to chartered banks
or
-Open Market Operations: buying securities from Chartered Banks
2: The Canadian Deposit Insurance Coporation
-A Federal Crown Corporation
-Insures deposits in any one account up to $100,000
-A problem is that this insurance is an incentive for banks to pursue riskier investment options "if this investment makes us money, the depositor wins- if it loses us money, then the taxpayer loses"
TYPES OF RESERVES:
1: A Reserve Ratio is the chartered bank's fraction of deposit liability held in Cash of BoC deposits
Actual reserves = reserves the Chartered Bank actually holds
Target reserves = reserves a Chartered Bank wishes to hold
Excess reserves = reserves a Charted Bank holds above target
Secondary reserves = liquid assets convertible to cash (ie: T-bills, and government bonds)
The old bank act required banks to hold reserves for stability and confidence in the system, and to regulate the money supply
Competition from intermediaries and international banks who were not required to hold reserves lead to the elimination of required reserves. Now, the BoC uses the "overnight target rate" (how much interest it charges target rates on overnight loans) to regulate reserves and control the money supply
Presently, actual reserves are about 0.5% of total Chartered Banks liabilities (so we are using a fractional reserve system)
THE FRACTIONAL RESERVE SYSTEM
The reserve ratio is much much less than 1, at about 0.5% of total liabilities. Chartered banks only hold a small portion of deposits on reserve, and the BoC will bail them out if reserves are too low to meet demands on deposits.
The Cost for chartered Banks of borrowing from the BoC (the Bank rate, or the "overnight rate") determines how much reserves banks will hold. An increase in the cost of borrowing will induce the Chartered Banks to hold more reserves
BANK RATE INCREASES ---> BANKS HOLD MORE IN RESERVES
BANK RATE DECREASES ---> BANKS HOLD LESS IN RESERVES
Target reserve ratios are now determined independently by Chartered Banks, but there is incentive for them to still hold some reserves on hand, in order to avoid losing money: the Bank rate determines the opportunity cost of the risk of loaning out more than is on reserve for Chartered Banks.
The Creation of Money!
Assume:
-There is a fixed reserve ratio
-There are no leakages or cash drains (this implies that a change in the money supply will manifest as a change in deposits)
2 Conditions are required for Banks to Make Money
1: The Public must be willing to use bank deposits as money
currency ratio = (public cash holdings/public bank deposits) or C/D
2: banks must be willing to use the fractional reserve system
reserve ratio = (reserve assets/deposit liabilities) or R/D
If the currency ratio is equal to 1, then there is no banking system
If the reserve ratio is equal to 1, there is no creation of money (there is just safety deposit boxes)
The Creation of Deposit Money
Assume:
-cr = 0 (all of the cash is deposited in banks)
-rr = 0.20 (banks loan out 80% of their deposits)
The creation of money is possible due to the fractional reserve system
Changes in the money supply are equal to deposits or withdrawals / The reserve ratio
The currency ratio acts as a cash drain, or leakage. The uncertainty of the banking system increases the currency ratio and decreases the multiple expansion of the money supply (the more cash people hold onto instead of converting into a bank deposit, the smaller the change in the money supply due to banks loaning out money)- we saw this sort of thing happen in 2008 with the US financial meltdown- people lost faith in the banks and wanted their money back, so the money supply in the United States suddenly decreased.
On the other hand, deposits are very convenient (thanks to debit cards), which decreases the currency ratio
High Powered Money (H) is "cash": a combination of cash held on reserve by banks, and cash in circulation within the public.
H = rr * D + cr * D
THE MONEY MULTIPLIER
Money Supply = M
M = D + C (bank deposits + money in circulation)
But, C = cr * D
so
M = (1 + cr)D
H = R + C
R = rr * D and C = cr * D
Therefore, H = (rr + cr)D
The money multiplier = Changes in M/Changes in H
= (1 + cr)/(rr + cr)
If the currency ratio = 0, then the money multiplier = 1/rr
If banks want to hold more money (the reserve ratio increases) or if the public wants to hold more cash (the currency ratio increases), then the money multiplier gets smaller: basically, the more loanable money which is held in banks, the higher the multiplier effect for money!
AN EXAMPLE OF THE MONEY MULTIPLIER
Assume:
-A constant reserve ration of 0.20
-cr = 0
Person 1 deposits $100 in the bank.
The bank loans out $80 to person 2
Person 2 deposits $80 in another bank
The bank loans out $64 to person 3
Etc...
With each transaction, the money supply increases by a decreasing amount (it works similarly to the expenditure multiplier effect)
So, let's do the math: 100 * the money multiplier = 100 *(1/0.20) = 500!
Monetary Base (H) = C + R - this is the amount of cash in an economy
Money Supply (M) = C + D - This is the amount of money in an economy (because not all money is cash!)
Variable reserve ratios make the the money multiplier equation complicated, but it still works
Cash Drains: Money creation is not automatic- it depends on public and bank behaviors
Public: Uncertainty causes the cr to increase, which makes it harder to create new money
Bank: Uncertainty causes the rr to increase, which makes it harder to create new money
TYPES OF DEPOSITS
Demand Deposit
-Can be withdrawn on demand (no notice required)
-Money can be transfered via cheque
Savings Deposit
-Notice of withdrawal required
-Non-transferable by cheque
Term Deposit
-Chequable savings accounts are now available, so the old distinction isn't as useful
-Today, "term deposit" distinguishes "notice accounts" from other accounts
-A deposit must be left in the account for a term: if withdrawn early, there is a reduced interest rate on that money (so the depositor gets less bang for their buck)
Definitions of the money supply
H = High Powered Money, or cash in public and cash in reserves
M1B = Cash in public + Demand Deposits (this emphasizes the exchange medium function of money)
M2 = M1B + savings deposits at chartered banks (emphasize money's wealth storage function)
M2+ = M2 + Deposits at other intermediaries, including credit unions, trust companies, insurance companies, and MMFs
M2++ = M2+ and all other mutual finds + Canada Savings Bonds
The BoC uses M2's to control inflation.
Near Money and Money Substitutes
There is debate over the definition of the money supply: if a medium of exchange is important, than M1B should define the money supply. If a storage of wealth is important, than deposits that pay higher returns but are not chequable (ie: the M2 series) should count as part of the money supply
Near Money is not a good medium of exchange, but it IS a good store of wealth (like Savings Bongs, Mutual Funds, and Money held in trust accounts)
Money Substitutes are good methods of exchange, but not good methods of storing wealth (like credit cards and debit cards)
Whew. That's all!
Subscribe to:
Posts (Atom)