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Intermediate macroeconomics chapt04

Chapter 4:
Money and Inflation

Functions of Money
Medium of Exchange
Store of Value
Unit of Account
Standard of Deferred Payment

Types of Money
Commodity money: a commodity with some
intrinsic value used as a medium of exchange
(e.g., cigarettes in POW camps)
Fiat money: a commodity with no intrinsic value
established by a government decree as money
(e.g., coins & bills)

Characteristics of Money

Limited in supply
Widely accepted

Money Supply
– Currency: coins & bills (25%)
– Demand Deposits: checking account deposits (75%)
– M1
– Time Deposits: savings account deposits less than

Money Supply
– M2
– Time Deposits: savings account deposits more
than $100,000
– M3
– Liquid assets (e.g., T-Bills)

The Measures of Money

$434 billion in April 1998

Money Supply Line
The quantity of money in circulation is controlled
by the central bank in real value = M/P
Interest Rate (%)


Quantity of Money

Money Demand
The amount of money demanded for transaction
and speculation purposes depends on personal
income and interest rate
At any level of personal income, quantity
demanded of money is a negative function of
interest rate

Money Demand Line
M/P = f(Y, r)
Y = income
r = real interest rate

Interest Rate (%)




Quantity of Money

Money Market Equilibrium
Interest Rate (%)



Quantity of Money

Federal Reserve System, FED
The central bank of the U.S.
Independent decision making unit with regional
In charge of money supply management and
economic stabilization

Tools of Monetary Policy
Legal reserve ratio: ratio of cash reserves to
deposits that banks are required to maintain
By lowering the ratio, banks will have more
reserves to lend and invest, increasing the money

Tools of Monetary Policy
Discount rate: rate of interest the FED charges on
loans to banks
By lowering the rate, banks encourage borrowing
from the FED and lending to the public, increasing
the money supply

Tools of Monetary Policy
Open Market Operations: FED’s purchases and
sales of government bonds
By purchasing bonds and paying the sellers, the
FED increases the money supply

Expansionary Monetary Policy
Increase the money supply by any one or
combination of the above tools
Reduce the interest rate to encourage investment
Increase investment expenditures, thus creating
employment & income

Expansionary Monetary Policy
Interest Rate (%)

(M1/P)s (M2/P)s
80 85

Quantity of Money

Quantity Theory of Money
Equation of Exchange: MV = PY

– M = money supply
– V = income velocity of money: the rate of
turn over of money
– P = general price level
– Y = output of goods & services

Income Velocity of Money
(M/P)d = kY where k is the percentage of money balances
held for transactions
Equilibrium (M/P)s = (M/P)d
M/P = kY
M/k = PY
So, V = 1/k
If k = 0.10, then V = 10: a $1 changes hands 10 time a year

Money Supply Growth & Inflation
In 1960s, inflation was low and money supply
growth constant at about 7%
In the 1970s, inflation rose as the money supply
grew at an increasing rate to reach 10%
In the 1980s and 1990s, inflation fell as money
supply grew at a declining rate to reach about 6%

Historical Data

International Data

A continuous rise of the general price level
General price level is measured by the CPI or
GDP Deflator
Percentage change of the general price level over
the previous period

Inflationary Trend
Inflation stayed under 5% during the 1960s
It averaged 7.7% in the first half and 10.6% in the
second half of the 1970s
Since the early 1980s, inflation rate has declined
to as low as 3% in the late 1990s

Money and Inflation
Take percentage change from MV = PY
%ΔM * %ΔV = %ΔP * %ΔY

V = 1/k and Y at full employment are constant
%ΔM = %ΔP : a 1% increase in the money supply causes a
1% increase in the general price level

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