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Chapter 10

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Western University
Economics 2152A/B
Desmond Mc Keon

Lecture 9 Chapter 10 (1, 2) Everybody likes money but they don’t actually adore “money”. What they are thinking about is what they can do with the money... - The transactions they can get from it - Sense of security you get from it  utility o Secure retirement, housing, education, etc. o All those are intertemporal consumption, and we need a vehicle to do that; to finance that - Sometimes, those vehicles get too complicated that the people buying and selling don’t even know what they are buying/selling o Unfortunate, because hard then to regulate the whole system We have real economy here already built, and now we need some kind of money market to surround us—this economy, just like the money market surrounds the one in the real world. This is the last chapter of our model, and then we do growth - Recall: in the beginning we said, there are two forks in the road for macroeconomics o (1) business cycle; medium term stuff o (2) one big growth path for the economy  what everything is really all about  So that the next generation (and the world) is “richer” (higher standard of living)  I.e., environmental conditions (usually only affordable by the really wealthy... to be concerned about the environment) - Idea here is that we need to surround our model with some sense of money market o Supply of money o Demand for money - Our model will then be called the Intertemporal Monetary Market o I.e., if in the exam they ask about the price level We are going to go through our four cases and see what happens to this market in them... - Note: You only need to know what we cover in class on the slides because we are skipping over a lot of content from the textbook (3) Review: Money in economics has these three criteria - Medium of exchange o We don’t want to go through a double coincidence of wants (someone else has to want what I have to offer, or else no transaction occurs)  Waste of time because time would be wasted on doing trades, and not doing work o Gold and silver popular, but could be anything - Store of value o Consumption can be saved  savings in units of i.e., gold, or whatever - Unit of account Backed by commodity: as much bills printed as was backed by i.e., gold - Private citizens were not allowed to own gold - All gov’t money was backed by gold - After WWII, countries dissipated this because things were pieces o They pegged their currency to US dollars  therefore US became reserve currency - NOW: money backed by nothing! Gov’t has fiat o But because US has rich economy, everyone trusts it o Nothing backs bank accounts either, very little paper NOW: - China trying to buy real assets instead of investing/lending to US - Note: difference between commodity backed currency and “fiat” currency o We are definitely in “fiat” currency period (4) Definitions: - Monetary Base (outside money  because we don’t have access to it) consists of o (1) Currency of country in circulation (in the banks, in the bank machines, in our pockets, in businesses) o (2) Bank Reserves (deposits (very special ***) of the banking/financial system with the Central Bank/BOC)  Due to this, central bank can easily fool around with these and get money - M1: currency in circulation plus transactions deposits at some financial institutions - M2: M1 + savings deposits at some financial institutions Monetary system - You make something from nothing - Ex. A person purchasing a car can consume/use the car just by showing [credibility] that he can contribute to the financial system o Our economy depends on this kind of transaction - Monetary system to the economy is like an electricity grid to our life o If electricity grid shuts down, nothing can run (5) Inflation and Fisher equation - Interest rate: the price of borrowing and lending over time o Price of money is the amount of goods it can buy - When money gets inflated (i.e., each piece of money goes up in relation to goods)  each piece of money is worth less o Inflation P'P 1 R i  1r  P 1i - Gross real rate of interest = Gross nominal interest rate ÷ Gross inflation rate o Refer to text o Approximation: Nominal interest rate = real interest rate + the rate of inflation - 1 + r  When you have a 1 in front, it is called the gross rate of return o Gross rate of return is a more accurate way of talking about return of something - Ex. Someone wants t
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