Money

Terms
Bartering - The trading of one good for another. This requires the double Coincidence of wants, a condition met when two individuals each have different goods that they other wants. Commodity Money - Money that has an intrinsic value, that is, value beyond any value given to it because it is money. An example of this would be a gold coin that has value because it is a precious metal. Compound Interest - Interest that is paid on a sum of money where the interest paid is added to the principal for the future calculation of interest. Click here to see the Formula. Consumption - The purchase and use of goods and services by consumers. Currency - The form of money used in a country. Defaulting on the Loan - When a borrower fails to repay a loan leaving the lender without the money loaned. Demand for Money - The amount of currency that consumers use for the purchase of goods and services. This varies depending mainly upon the price level. Equilibrium - The state in a market when supply equals demand. Fiat Money - Money that has no intrinsic value, that is, its only value comes from the fact that a governing body backs and regulates the currency. Fischer Effect - The point for point relationship between changes in the money supply and changes in the inflation rate. Inflation - The increase of the price level over time. Interest - Money paid by a borrower to a lender for the use of a sum of money. Interest Rates - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money. Liquidity - The ease with which something of value can be exchanged for the currency of an economy. Medium of Exchange - An item used commonly to trade for goods and services. Money Supply - The quantity of money in an economy. In the US this is controlled through policy by the Fed. Nominal GDP - The total value of all goods and services produced in a country valued at current prices. Nominal Interest - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money not taking inflation into account. Nominal Value - The value of something in current dollars without taking into account the effects of inflation. Output - The amount of goods and services produced within an economy. Price Level - The overall level of prices of goods and services in an economy. This is used in the calculation of inflation rates. Purchasing Power - The real value of a dollar. This describes the quantity of goods and services that can be purchased for a dollar, taking into account the effects of inflation. Quantity Theory of Money - The theory that says that the value of money is based on the amount of money in circulation, that is, the money supply.

Real Interest - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money adjusted for inflation. Real Value - The value of something in taking into account the effects of inflation. Store of Value - A good that holds a value in such a way that its price is fairly insensitive inflation. Unit of Account - Something that is used universally in the description of money matters such as prices. The unit of account most commonly used in the US is the dollar. Value of Money - The purchasing power of the dollar. The amount of goods and services that can be purchased for a fixed amount of money. Velocity - The speed with which a dollar bill changes hands. The higher the velocity of money, the quicker that a given piece of currency will be traded for goods and services. Wage - The amount of money paid to workers by employers valued in current dollars. M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can be rearranged as V = (nominal GDP) / M. It can also be converted into a percentage change formula as (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). First, calculate the value of the loan, by adding one to the interest rate, raising it to the number of years for the loan, and multiplying it by the loan amount. Then, to calculate the amount of interest, simply subtract the original loan amount from the total due. The real interest rate is equal to the nominal interest rate minus the inflation rate.

Velocity of Money

Compound Interest

Real Interest Rate

Money

Functions of Money
Try to imagine an economy without money. Without money, it would be almost impossible to carry out the usual day to day business of life. For instance, if you wanted to buy a hamburger without cash, you would have to give the restaurant something else in return. Perhaps you could wash the dishes, or sweep the floor. Either way, the ability to pay for goods and services with money greatly simplifies consumer life and eliminates the necessity of bartering goods and services for other goods and services. What exactly does money do? Sure, you can buy things with it and save it, but how does it function within the economy? There are four basic functions of money:

The first is as a medium of exchange. The second is as a unit of account. The third is as a store of value. The fourth is as liquidity.

By understanding each of these functions, it is possible to see how important money is to the economy. The most obvious function of money is as a medium of exchange. When you hand the waiter a five-dollar bill in exchange for your hamburger, you are using money as a medium of exchange. You might have a hard time paying for your hamburger with five dollars worth of apples, but if you did, the apples would serve as a medium of exchange as well. To simplify, a medium of exchange is something that buyers give to sellers in exchange for goods and services. Perhaps money's most compelling advantage is that it is a commonly recognized and universally accepted medium of exchange. This allows anyone with money to walk into any restaurant with the confidence that the waiter or clerk will take your cash in exchange for goods or services. This would likely not be the case with a basket full of apples. The second function of money, as a unit of account, is rather obvious, but you may never have considered it before. When you walk into a restaurant, the menu tells you that a hamburger costs $5 and a steak costs $15. You know what this means and are able to compare these prices. If, on the other hand, apples and oranges were used as units of account, comparison between the costs of goods and services would be much more difficult. Imagine trying to determine what costs more, a hamburger costing 25 apples or a steak costing 30 oranges. As a unit of account, money serves as the common base of comparison that people use to present prices and record debts. Without a common unit of account, these tasks would be much more difficult. The third function of money, as a store of value, is one that we all know well. When you work, you are paid a wage. The portion of that wage that you do not spend gets saved. By saving money, you are able to spend some now and some later. In this way, money serves as a store of value, allowing you to trade current consumption for future consumption. Imagine if you were paid in bananas. Any bananas that you did not eat or trade immediately would rot, rendering you unable to enjoy the fruits of your labor at a later time. The fourth and final function of money, as a means of liquidity, is important for an economy to move beyond a simple system of bartering. Imagine that you have 30 apples, and you really want a steak. You walk to the local restaurant and ask the waiter if you can trade 30 apples for a steak. He informs you that they have plenty of apples, but could use some oranges. Frustrated and hungry, you walk out of the restaurant. In this example, apples lacked liquidity since they could not easily be traded for what you wanted. Liquidity describes the ease with which an item can be traded for something that you want, or into the common currency within an economy. Money is the most liquid asset because it is universally recognized and accepted as the common currency. In this way,

money gives consumers the freedom to trade goods and services easily without having to barter.

Types of Money
Money comes in a number of different forms. In the preceding section, we saw apples and oranges used as money. When something with intrinsic value, like precious metals, is used as money, it is called commodity money. It is interesting to think about the enormous variety of goods that can serve as commodity money. Basically, anything that can fulfill the four functions of money, to so some degree, can be used as commodity money. Barter economies depend on commodity money. When something lacking intrinsic value is used as money, it is called fiat money. This system only works if a government backs the fiat money and regulates its production. In most countries, the cash or currency is a form of fiat money. The advent of fiat money is great conveniences in many ways-imagine trying to carry a week's pay in apples and oranges.

Quantity theory of money

Value of money
What gives money value? We know that intrinsically, a dollar bill is just worthless paper and ink. However, the purchasing power of a dollar bill is much greater than that of another piece of paper of similar size. From where does this power originate? Like most things in economics, there is a market for money. The supply of money in the money market comes from the Fed. The Fed has the power to adjust the money supply by increasing or decreasing the number of bills in circulation. Nobody else can make this policy decision. The demand for money in the money market comes from consumers. The determinants of money demand are infinite. In general, consumers need money to purchase goods and services. If there is an ATM nearby or if credit cards are plentiful, consumers may demand less money at a given time than they would if cash were difficult to obtain. The most important variable in determining money demand is the average price level within the economy. If the average price level is high and goods and services tend to cost a significant amount of money, consumers will demand more money. If, on the other hand, the average price level is low and goods and services tend to cost little money, consumers will demand less money.

Figure %: Sample money market The value of money is ultimately determined by the intersection of the money supply, as controlled by the Fed, and money demand, as created by consumers. Figure 1 depicts the money market in a sample economy. The money supply curve is vertical because the Fed sets the amount of money available without consideration for the value of money. The money demand curve slopes downward because as the value of money decreases, consumers are forced to carry more money to make purchases because goods and services cost more money. Similarly, when the value of money is high, consumers demand little money because goods and services can be purchased for low prices. The intersection of the money supply curve and the money demand curve shows both the equilibrium value of money as well as the equilibrium price level.

Figure %: Sample shift in the money market The value of money, as revealed by the money market, is variable. A change in money demand or a change in the money supply will yield a change in the value of money and in the price level. Notice that the change in the value of money and the change in the price

level are of the same magnitude but in opposite directions. An increase in the money supply is depicted in Figure 2. Notice that the new intersection of the money supply curve and the money demand curve is at a lower value of money but a higher price level. This happens because more money is in circulation, so each bill becomes worth less. It takes more bills to purchase goods and services, and thus the price level increases accordingly. The quantity theory of money is based directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases. Based on this definition, the quantity theory of money also states that growth in the money supply is the primary cause of inflation.

Velocity
While the relationship between money supply, money demand, the price level, and the value of money presented above is accurate, it is a bit simplistic. In the real world economy, these factors are not connected as neatly as the quantity theory of money and the basic money market diagram present. Rather, a number of variables mediate the effects of changes in the money supply and money demand on the value of money and the price level. The most important variable that mediates the effects of changes in the money supply is the velocity of money. Imagine that you purchase a hamburger. The waiter then takes the money that you spent and uses it to pay for his dry cleaning. The dry cleaner then takes that money and pays to have his car washed. This process continues until the bill is eventually taken out of circulation. In many cases, bills are not removed from circulation until many decades of service. In the end, a single bill will have facilitated many times its face value in purchases. Velocity of money is defined simply as the rate at which money changes hands. If velocity is high, money is changing hands quickly, and a relatively small money supply can fund a relatively large amount of purchases. On the other hand, if velocity is low, then money is changing hands slowly, and it takes a much larger money supply to fund the same number of purchases. As you might expect, the velocity of money is not constant. Instead, velocity changes as consumers' preferences change. It also changes as the value of money and the price level change. If the value of money is low, then the price level is high, and a larger number of bills must be used to fund purchases. Given a constant money supply, the velocity of money must increase to fund all of these purchases. Similarly, when the money supply shifts due to Fed policy, velocity can change. This change makes the value of money and the price level remain constant. The relationship between velocity, the money supply, the price level, and output is represented by the equation M * V = P * Y where M is the money supply, V is the

velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can thus be rearranged as V = (nominal GDP) / M. Conceptually, this equation means that for a given level of nominal GDP, a smaller money supply will result in money needing to change hands more quickly to facilitate the total purchases, which causes increased velocity. The equation for the velocity of money, while useful in its original form, can be converted to a percentage change formula for easier calculations. In this case, the equation becomes (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). The percentage change formula aids calculations that involve this equation by ensuring that all variables are in common units. The velocity equation can be used to find the effects that changes in velocity, price level, or money supply have on each other. When making these calculations, remember that in the short run, output (Y), is fixed, as time is required for the quantity of output to change. Let's try an example. What is the effect of a 3% increase in the money supply on the price level, given that output and velocity remain relatively constant? The equation used to solve this problem is (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). Substituting in the values from the problem we get 3% + 0% = x% + 0%. In this case, a 3% increase in the money supple results in a 3% increase in the price level. Remember that a 3% increase in the price level means that inflation was 3%. In the long run, the equation for velocity becomes even more useful. In fact, the equation shows that increases in the money supply by the Fed tend to cause increases in the price level and therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is not affected by the actions of the Fed since it is based on the amount of production, not the value of the stuff produced. This means that the percent change in the money supply equals the percent change in the price level since the percent change in velocity and percent change in output are both equal to zero. Thus, we see how an increase in the money supply by the Fed causes inflation. Let's try another example. What is the effect of a 5% increase in the money supply on inflation? Again, we being by using the equation (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). Remember that in the long run, output not affected by the Fed's actions and velocity remains relatively constant. Thus, the equation becomes 5% + 0% = x% + 0%. In this case, a 5% increase in the money supply results in a 5% increase in inflation. The velocity of money equation represents the heart of the quantity theory of money. By understanding how velocity mitigates the actions of the Fed in the long run and in the short run, we can gain a thorough understanding of the value of money and inflation.

Interest Rates

Mechanics of Interest
When you deposit money into a bank, the bank uses your money to give loans to other customers. In return for the use of your money, the bank pays you interest. Similarly, when you purchase something with a credit card, you pay the credit card company interest for using the money that paid for your purchase. In general, interest is money that a borrower pays a lender for the right to use the money. The interest rate is the percent of the total due that is paid by the borrower to the lender. The calculation of compound interest is rather simple. To calculate the value of a loan, add one to the interest rate, raise it to the number of years for the loan, and multiply it by the loan amount. For example if you borrow $10,000 at 8% per year, in one year you would owe $10,000 * (1.08 ^ 1) = $800 in interest. To calculate the amount of interest, simply subtract the original loan amount from the total due. In this example, the interest due would be $10,800 - $10,000 = $800.

Reasons for Paying Interest

Why do people pay interest? Lenders demand that borrowers pay interest for several important reasons. First, when people lend money, they can no longer use this money to fund their own purchases. The payment of interest makes up for this inconvenience. Second, a borrower may default on the loan. In this case, the borrower fails to pay back the loan and the lender loses the money, less whatever can be recovered from the borrower. Interest helps to make the risk of default worth taking. In general, the more risk there is of default on the loan, the higher the interest rate demanded by the lender. Finally, and most importantly, lenders demand interest since while the borrower has the money; inflation tends to reduce the real value, or purchasing power, of the loan. In this case, interest allows the balance due to grow as inflation erodes the real value of the balance due.

Real vs. Nominal Interest Rates

We learned above that the third and most important reason why lenders demand interest is that inflation tends to decay the real value of loans over time. For example, let's say a loan is made for $10,000, inflation is 5%, and the loan is paid back after one year. When the loan is made, it can purchase $10,000 worth of goods, such as a compact car. After a year of inflation at 5%, the same compact car costs $10,500. At the same time, one year later, the $10,000 loan is repaid in full. Unfortunately, due to inflation, the real value, or purchasing power, of the money when the loan is repaid is $500 less than when it was made. By charging an interest rate at least equal to the rate of inflation, this problem is corrected. For example, say a loan is made for $10,000 at 5% interest, inflation is 5%, and the loan is paid back after one year. When the loan is made, it can purchase $10,000

worth of goods, such as a compact car (again). After a year of inflation at 5%, the same compact car costs $10,500. At the same time, one year later, the loan is repaid in full plus interest, totaling $10,500. In this case, the effects of inflation and the interest rate counteract each other so that the real value of the money stays the same even though the nominal value of the money increases by $500. Two different interest rates are used in the discussion of loans. The nominal interest rate is the interest rate reported when a loan is made. This rate does not take into account the effects of inflation. The real interest rate is not usually reported when a loan is made. This rate takes into account the effects of inflation on the purchasing power of money repaid from a loan. There is a relationship between the nominal interest rate, the real interest rate, and the rate of inflation. The real interest rate is equal to the nominal interest rate minus the inflation rate; the real interest rate, or the purchasing power of the loan, is equal to the interest earned less the effect of inflation. In the problem above, the nominal interest rate was 5%, the inflation rate was 5%, and thus, using the equation, the real interest rate was 0%. In this case, the lender received no protection from default or payment for the inconvenience of having the money unavailable. In general, lenders always charge a nominal interest rate greater than the expected inflation rate.

Fischer Effect
The nominal interest rate is what is paid on the balance due on a loan. If the equation presented above is rearranged, we see that the nominal interest rate is equal to the real interest rate plus the inflation rate. In the previous section on the quantity theory of money, we learned that when the Fed increases the money supply, the major effect is an increase in the inflation rate. From the equation just presented, we learn a second effect of an increase in the money supply. Because the nominal interest rate is equal to the real interest rate plus the inflation rate, an increase in the inflation rate due to an increase in the money supply by the Fed results in an increase in the nominal interest rate. This increase is affected by lenders to ensure that they receive the real interest rate they wanted on the loan, regardless of the effects of inflation. The point for point adjustment of the nominal interest rate to the real interest rate is called the Fischer effect.