ECON332 Chapter Notes - Chapter 4: Federal Reserve System, Debit Card, Market Liquidity

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9 Aug 2016
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What is money?
Money is any commodity or token that is generally acceptable as a means of payment:
A medium of exchange
A unit of account
A store of value
 Different groups of assets may be classified as money. Money can be defined narrowly or
broadly.
Currency in circulation, checking deposits, and debit card accounts form a narrow
definition of money.
Deposits of currency are excluded from this narrow definition, although
they may act as a substitute for money in a broader definition.
checking deposits  cash
Money is a liquid asset: it can be easily used to pay for goods and services or to
repay debt without substantial transaction costs.  Monetary or liquid assets
earn little or no interest.
Illiquid assets require transaction costs in terms of time, effort, or fees to convert
them to funds for payment. They generally earn a higher interest rate or rate of
return than monetary assets.
 Let’s group assets into monetary assets (or liquid assets) and nonmonetary assets (or
illiquid assets).
The demarcation between the two is arbitrary:
 Currency in circulation, checking deposits, debit card accounts, savings deposits, and time
deposits are generally more liquid than bonds, loans, deposits of currency in the foreign
exchange markets, stocks, real estate, and other assets.
Money Supply
The central bank substantially controls the quantity of money that circulates in
an economy, the money supply.
In the U.S., the central banking system is the Federal Reserve System.
The Federal Reserve System directly regulates the amount of currency in circulation.
It indirectly influences the amount of checking deposits, debit card accounts, and
other monetary assets.
Money Demand
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Money demand represents the amount of monetary assets that people are willing
to hold (instead of illiquid assets).
 What influences willingness to hold monetary assets?
We consider individual demand of money and aggregate demand of money.
What Influences Demand of Money for Individuals and Institutions?
1. Interest rates (i.e. expected rates of return) on monetary assets relative to the expected
rates of returns on nonmonetary assets.
 Monetary assets pay little or no interest, so the interest rate on non-monetary assets like
bonds, loans, and deposits is the opportunity cost of holding monetary assets.
2. Risk: the risk of holding monetary assets principally comes from unexpected inflation,
which reduces the purchasing power of money.
 But many other assets have this risk too, so this risk is not very important in defining the
demand of monetary assets versus nonmonetary assets.
3. Liquidity: A need for greater liquidity occurs when the price of transactions increases or
the quantity of goods bought in transactions increases.
What Influences Aggregate Demand of Money?
1. Interest rates: A higher interest rate means a higher opportunity cost of holding
monetary assets  lower demand of money. Why? Because could just lend them out,
people don't want to hold on to them so lower demand.
2. Prices: the prices of goods and services bought in transactions will influence the
willingness to hold money to conduct those transactions.
 A higher level of average prices means a greater need for liquidity to buy the same
amount of goods and services  higher demand of money.
3. Real National Income: greater income implies more goods and services can be bought, so
that more money is needed to conduct transactions.
 A higher real GNP means more goods and services are being produced and bought in
transactions, increasing the need for liquidityhigher demand of money.
A Model of Aggregate Money Demand
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The aggregate demand of money can be expressed as:
Md = P x L(R,Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand of real monetary assets
Alternatively:
Md/P = L(R,Y)
Aggregate real money demand is a function of national income and interest rates.
Note: recall that for a given real income level Y, real money demand rises as the interest
rate falls  as interest gets lower the opportunity cost to hold onto my money is lower
(meaning if interest rate falls, I cant earn as much by lending my money so I want to
hold onto it)
On the other hand, an increase in real Income level (Y) will result in an increase in real
money demand at EVERY LEVEL of interest rate and causes the demand curve to shift
upward  increase in income people want to spend more need to hold more money
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