EON 1132 Principles of Economics-Macro Economics-Macro
Harold Petersen February 17, 2015
It is time to turn to money, interest rates, banking, and monetary policy as pursued through a central bank, in this country country The Fed. First, what what do we mean by money? money? We all have a sense of this--dollar this--dollar bills in the U.S., U.S., or Euros in France, or yen in Japan--but Japan--but let's be a bit more more precise. By money, in economics, economics, we mean anything readily accepted as a means of payment. It may be some commodity, such as gold or silver, or paper, or even an accounting entry. Historically its most common form has been gold and silver, but olive oil, wampum, and cigarettes have also served as money. Money serves three purposes: 1) --a means by which I can trade what I have (economics lectures) for what I want (tennis balls and chocolate donuts) much more easily than through barter, or direct exchange. 2) Money also serves as --a means of preserving purchasing power for future needs or wants. wants. (I give my lectures now but want an airline ticket next next summer. I hold money money in the meantime.) meantime.) 3) Finally, Finally, money serves as --a basis for comparing apples and oranges--for keeping records as in total sales for a firm--for recording debts and collecting taxes--for measuring GDP and charitable giving. To serve these purposes well, money should be 1) 2) 3)
(gold is durable but ice cream or fish are not) (to facilitate small purchases as well as large--thus wheat might work but tractors would not) (so as to have high value per weight or volume measure and thus not be cumbersome in use--thus sand would not work well, even though it is durable and divisible).
Gold and silver worked worked quite well well for years. They met all all three of the the criteria above. But what do you suppose happened when when vast amounts of gold and silver were brought in to Europe from the New Word in the sixteenth century. As money was suddenly much more abundant, prices rose rapidly. At different times and places, tobacco, cigarettes, and wampum have all served as money. In colonial Virginia the the currency unit was pound of tobacco tobacco and tobacco was readily readily accepted as as a means of payment. payment. And then warehouse warehouse receipts that provided an ownership claim to tobacco became accepted as a means of payment. This was in effect paper money backed by tobacco.
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Cigarettes were used in a P.O.W. camp in World War II. Think of that great movie, Stalag 17, with William Holden. Shipments of goods would come in to the prisoners, including soap, shoelaces, cans of peaches, cigarettes, candy bars. Somehow they would be divided but then the prisoners would trade them among themselves. And cigarettes become the medium of exchange. I would accept ten cigarettes in exchange for a bar of soap, even if I didn’t smoke, and then exchange four cigarettes for a tube of toothpaste. And wampum was used by the American Colonists. Wampum were colored shells, or beads, which were produced by Native Americans. They were prized for their beauty and also had ceremonial value. They were pierced and strung for wearing. But were they limited in supply? Weren’t they shells, and couldn’t anyone pick them up on the beach. But they were pierced. And the art of piercing was a delicate one--to pierce them without breaking them. So they were limited in supply. Were they durable? Yes, so long as you didn’t step on them too hard. The colonists began to trade goods with the Native Americans for wampum and then trade the wampum amongst themselves for other goods. Wampum became a means of payment in all of the original 13 colonies. Today paper money is dominant--paper money printed and circulated by government. It is accepted and retains value based on a faith that government will exercise restraint in printing money. The U.S. money supply as measured in December 2014 consisted of
+ = + =
Currency (outside banks) Checking Account Deposits M1 (transactions money) Savings and Money Market Deposits M2 (broader measure of money)
1255 bill. 1651 bill. 2907 bill. 8719 bill. 11626 bill.
Why do we include checking accounts in our measure of money? Because they are spendable cash. Because so many payments are made by check, or by debit cards, and because checks are readily accepted as a means of payment. So we measure money as currency plus checking account deposits, and we call this measure M1. We think of this as spendable cash. But then what about money market mutual funds, from which we can write checks directly, or deposits in savings accounts, which can be moved to a checking account by an easy electronic transaction? Aren't these spendable cash as well. So we define a broader measure, including these, and we call it M2.
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We measure money because we see a link between money, or spendable cash, and total spending. In the Keynesian model, spending drives the system, and the availability of money impacts spending. We build models to explain the link, and then we look to measurement to test the models. We look to measures that help explain how the system works. For a time we thought M1 was the better measure in that it provided the closer link to spending. And then it seemed that M2 worked better. And now we are not so sure. Your text suggests that M2 is the better measure. I tend to prefer M1, but in either case it is a close call. . Why do people hold money, as opposed to assets which earn interest, as do bonds, or dividends, as do stocks, or land or antiques, which might be expected to increase in value? Primarily for convenience in making transactions, but also as a store of wealth. 1) Transactions. Receipts and Expenditures are not perfectly synchronized in time. We may get paid once a month and then make expenditures over the course of the month. We are holding money on most days in anticipation of expenditures to be made, to bridge a gap between receipts and expenditures. 2) Precautionary. We hold money to meet anticipated near-term expenditures but also hold some in reserve for unanticipated needs. The car might break down or guests may arrive unexpectedly. 3) Store of Wealth. We may hold part of our wealth as money in order to be able to act immediately should an investment opportunity arise. The advantage of having money is the ability to act very fast. And some people hold money as a store of wealth because they do not want records kept of how much wealth they have. Or people abroad may hold U.S. currency as a store of wealth because they believe it is safer than other forms of wealth. In sum, the gain from holding money is the advantage of liquidity--we have the cash there in case we need it. By liquidity we mean nearness to cash. An asset is liquid if it is easily converted to cash, at low cost. The cost of holding money is the interest foregone--an opportunity cost for those of who know this term--what we could have earned on other investments. Let’s review that just a bit. What do we mean by ? What is the opportunity cost of going to college, in monetary terms? It is what you could be earning if you were working full time in the job market. And what is the opportunity cost of going to a movie tonight. It is the value to you of whatever else you could be doing with the time. In both cases there are direct costs, or explicit costs—for college the tuition and for the movie the price of the
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ticket, but there are also opportunity costs, or the value to us of the next best opportunity. So a cost of holding money is the interest we could be earning if we invested the money in treasury bills or an insured savings account. Currently, with interest rates so low, this is very small. In 1981, with short-term interest rates at about 14%, it was quite high. And we found then that people held very little cash. Portfolio Theory is concerned with how people weigh risk, return, and liquidity in their management of assets. A part of this is summarized in a demand for money function as follows: + Md = f(GDP, i), or Md = f(PQ, i) GDP captures the need for money to meet transactions, both on the part of households and business firms, whereas i, or the interest rate, is a measure of the cost of holding money. At higher GDP (nominal GDP) people need more money to make transactions, but at higher interest rates they find they can get along with less cash (for any given dollar amount of transactions). We express this in a graph showing Md sloping downward to the right. The money supply, Ms is shown as a vertical line. We assume the supply of money can be controlled by the central bank. By increasing the money supply, the Fed pushes down interest rates, which in turn will tend to increase spending, primarily on I but on C and G, and X as well. As spending increases, aggregate demand shifts to the right, and output increases. i
Ms
Ms' P
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Q* AS
io
i1
i1 AD'
I
Md(PQ)
AD(C+I+G+X) M
Io
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We will go on to see just how the Fed does this, through its control over the banking system. First, we need to look at how the banking system works. First, note that we have two types of banks--commercial banks and central banks.
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1. . A commercial bank is a business firm--as such it provides a service (or services) for which it expects to earn a profit. The commercial bank provides two primary services: a. First, it receives demand deposits and honors checks drawn against them, thereby providing a safe and convenient means of payment. b. Second, the bank provides credit, or loans, to households and business firms. The bank earns its revenue primarily from the interest it charges on loans. It also imposes charges on checking accounts with small balances, as most of you are aware, but on large accounts it will typically waive charges. How then does it earn anything on these accounts? From lending your money at interest. You do pay for a checking account, even where charges are waived, but you do it through the opportunity cost of your money. The bank is effectively lending your money to its customers. 2. . A central bank is a public institution, one with certain social responsibilities. The central bank has two primary responsibilities: a. Lender of last resort--to stand ready to pump liquidity into the system as needed in order to avert panic and runs. b. Stabilizer of the economy--to control money and credit so as to pursue stable growth and high employment without inflation. The first responsibility of the central bank, historically, was to be a lender of last resort. Remember that the commercial bank has accepted your money in a checking account with a promise to pay on demand, either to you to someone to whom you have written a check. But most of this money has been loaned out and cannot be recalled immediately. Ordinarily this is no problem. Money comes in every day and money goes out, but the balance in the vault remains about the same. But then something happens to make people afraid. They rush to the bank to demand their money, and the bank does not have it in cash. The bank may be sound in terms of its investments, but it is short of cash. It goes to its neighbor bank down the street and asks for a loan. And this may be fine. But once in a while we get widespread fear and all the banks find their customers demanding their money. This is where the central bank is supposed to step in, as
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a lender of last resort, to pump in whatever cash is needed to prevent a panic from developing. We will start next time with how commercial banking developed, largely through the goldsmiths in the Middle Ages, we will trace through creation of loans and deposits, and then will come back to central banking. We will of course look at how central bankers responded in the financial panic in 2008.
