Understanding Money, Banking, and Financial Markets: Lecture Notes, Study notes of Health sciences

Download Understanding Money, Banking, and Financial Markets: Lecture Notes and more Study notes Health sciences in PDF only on Docsity! Lecture Notes on MONEY, BANKING, AND FINANCIAL MARKETS Peter N. Ireland Department of Economics Boston College irelandp@bc.edu http://www2.bc.edu/~irelandp/ec261.html Chapter 3: What Is Money? 1. Meaning of Money 2. Functions of Money Medium of Exchange Unit of Account Store of Value 3. Measuring Money Theoretical Measures Empirical Measures Federal Reserve’s Monetary Aggregates This chapter begins by defining money in basic terms. It then discusses the various functions of money in the economy as a whole. Finally, it considers how economists and the Federal Reserve measure money in the US economy. 1 Meaning of Money Money = anything that is generally accepted in payment for goods and services or in the repayment of debts. Objects that qualify as money under this definition: Currency (dollar bills and coins). Checking account deposits. Perhaps even savings deposits. 1 These economists suggest that the correct measure of money is one that is most closely linked to the behavior of inflation and output. The problem with this definition is that historically, measures of money that work well in predicting inflation and output in one period do not work as well during other periods. 3.3 Federal Reserve’s Monetary Aggregates Given the problems associated with both theoretical and empirical measures of money, the Federal Reserve provides data on several measures of money, called monetary aggregates. M1 = assets that are clearly used as a medium of exchange: Currency. Traveler’s checks. Demand deposits = checking accounts that pay no interest. Other checkable deposits = checking accounts that pay interest, including negotiable order of withdrawal (NOW) accounts. M2 = M1 + other assets that provide limited check-writing privileges or are extremely liquid: Small denomination (under $100,000) time deposits (CDs) and repurchase agreements (RPs). Savings deposits. Money market deposit accounts (MMDAs) = high-yielding bank deposits that offer limited check-writing privileges. Like money market mutual fund shares, but: Are issued by banks. Are insured by the Federal Deposit Insurance Corporation (FDIC). Retail or noninstitutional money market mutual fund (MMMF) shares owned by individuals. M3 = M2 + other liquid assets: Large denomination (over $100,000) time deposits (CDs). Institutional money market mutual fund (MMMF) shares owned by businesses. 4 Large denomination (over $100,000) repurchase agreements (RPs). Eurodollar deposits. Mishkin’s Table 1 shows the value of M1, M2, and M3 and their various components as of December 2002: M1 = Currency $626.5 billion + Traveler’s checks $7.7 + Demand deposits $290.7 + Other checkable deposits $281.2 Total M1 $1206.1 billion M2 = M1 + Small time deposits and RPs $1332.3 billion + Savings deposits and MMDAs $2340.4 + Noninstitutional MMMF shares $923.7 Total M2 $5802.5 billion M3 = M2 + Large time deposits $1105.2 billion + Institutional MMMF shares $767.7 + Large repurchase agreements $511.7 + Eurodollar deposits $341.1 Total M3 $8528.2 billion Observations: M3 is always bigger than M2, and M2 is always bigger than M1. These relationships must always hold, of course, because M3 includes everything in M2, and M2 includes everything in M1. In December 2002, the total US population, ages 16 and over, was about 220 million. Take $626.5 billion =$626,500 million in currency and divide by 220 million people to calculate Currency per capita = $626, 500 million in total currency 220 million people = $2, 847.73 A large fraction of this currency must be held by foreigners as a store of value and by people engaged in criminal activities! Mishkin’s Figure 1 (p.54) plots the growth rates of M1, M2, and M3 from 1960 through 2002: 5 The monetary aggregates show some tendency to move together, but often grow at different rates. This fact highlights the difficulty of using the monetary aggregates to forecast inflation and output. The figure on the next page plots 10-year averages of Core Consumer Price Inflation and M2 growth in the US, 1969-2003: M2 growth and inflation share similar long-run trends throughout most of the period. Both rise during the 1970s and fall during the 1980s and early-to-mid-1990s. Beginning in the late 1990s, however, the two series diverge: M2 growth begins to rise, but inflation continues to fall. Either M2 growth is no longer useful in explaining long-run movements in inflation, or inflation is due to rise. Again, these observations highlight the difficult in finding relationships between in- flation, output, and measures of money. 4 Conclusion This chapter has shown that it is fairly easy: To provide a basic definition of money. To identify the functions performed by money in the economy as a whole. But, this chapter has also shown that it is more difficult in practice to decide exactly which assets qualify as money and which do not. For this reason, the Federal Reserve provides several measures of money, or monetary aggregates. Often these measures of money move together, but sometimes they do not. Often these measures of money help predict movements in inflation and output, but sometimes they do not. Hence, Federal Reserve economists and financial market participants spend a lot of time and effort trying to determine what is going on with the money supply and what it means for the economy as a whole. 6