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Monetary Policy

AP Economics
by

Daniel Kim

on 6 June 2016

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Transcript of Monetary Policy

Unit IV: Monetary Policy!
Stacks on stacks on stacks....
Who is on the...
$100 Bill
Benjamin Franklin
$50 Bill
Ulysses S. Grant
$20 Bill
Andrew Jackson
$10 Bill
Alexander Hamilton
$5 Bill
Abraham Lincoln
$2 Bill
Thomas Jefferson
50 Cent
John F. Kennedy
10 Cent
Franklin D. Roosevelt
$1000 Bill
Grover Cleveland
$100,000 Bill
Woodrow Wilson
Why Money?
Ok so as you may know the main reason economies worldwide have transitioned to using money is that Barter Systems are inefficient!
Barter System:
Before trade can occur, each trader had to have something the other wanted
Some goods cannot be split. If I John Florance is worth 5 goats, how do you exchange if you only want 1 goat?
And what do we do if some goat herders don't like John Florance and want a bunch of squirrels instead? I'd have to go get me some squirrels!
So what Exactly IS
money
?
Money is anything that is generally accepted in payment for goods and services. Money is NOT the same as
wealth
or
income
.
Wealth
Total value of accumulated assets
Income
Money earned for doing work or from investments
Ok so There are
two types
of money!
Commodity Money
Something that performs the function of money and has alternative uses...like gold, silver, cigarettes
Fiat Money
Something that serves as money but has no other important uses like...paper money and coins
3 Functions of Money
A Medium of Exchange
Money can easily be used to buy goods and services without the complications of the barter system
A Unit of Account
Money measures the value of all goods and services. It is a measurement of value
A Store of Value
Money allows you to store purchasing power for the future. Money doesn't die or spoil
Money can further be differentiated into three forms depending on how "liquid" it is.
m1
This is all of the money in the economy in the form of coins, cash, and checking-account deposits. It is the most liquid form of money.
m2
This includes M1 PLUS savings accounts and small time deposits (or money held at banks that cannot be drawn within a certain time period), and Mutual Funds
m3
This includes M1 PLUS M2 plus larger time deposits that are over $100,000.
Super Liquid
Illiquid
Liquidity
is just a measure of how quickly and easily an asset can be converted into cash!
Liquid Assets
can easily converted into cash while
illiquid assets
cannot be easily converted into cash without significant loss of time and value
Stocks
Bonds
Now to understand the differences and similarities between stocks and bonds, we'll have to think about a
lemonade stand
!
Now let's imagine you're all 10 years old again and you want to start a lemonade stand. In order to get started you
ask grandma to lend you $100
for your inputs to start the company!
In exchange you give her a piece of paper that says, "IOU $100 and I will pay you back in a year plus 5% interest"
What you just gave grandma is what we call
Bonds
!
Bonds are basically IOU's that
represent a company's or a country's debt
. It's a promise to investors that they will get their money back. So when you purchase a bond, you're literally buying debt!
(It's important to note that a bond holder has NO OWNERSHIP of a company)
Now that $100 was a good start but you're still short some money. So you decide to
sell half of your company
to your sister Amy. She gives you $50 bucks!
In exchange for her money, you give her a piece of paper that says, "
Our company has 100 shares of stock, and Amy now owns 50 shares for $1 a piece
"
The stocks that you have just given Amy represent
ownership of your company
. Stock owners are allowed to make decisions and make money off of company profits
Now Amy can
make money
as a shareowner in two ways:
Dividends:
Portions of a corporation's profits paid out to stockholders
Capital Gains:
Money earned when stockholders sells stock for more than he/she paid for it
* If you bought $1000 worth of Apple stock in 2005, it would be worth $47,000 today.
Ok so what backs the money supply?
Right so we're off the gold standard. What makes our money valuable?
This is just a fancy IOU from the government
1. Buyers and Sellers must have confidence that it
IS
legal tender
2. Money must not be
easily reproduced
or
copied
3. Money needs to be
easily transported
and
divided
Inflation
Decreases purchasing power
Rapid Inflation
Decreases acceptability
The Money Supply
Just like anything in economics there is a limited supply of money in the economy thus we can represent it the
Money Market
Demand (MD)
Nominal Interest Rate (ir)
Quantity of Money
D
Money
2%
5%
10%
15%
Notice the inverse relationship between interest rates and the quantity of money demanded
Money Demand
needs to be approached a bit differently than demand for other goods and services. It is the sum of:
Transaction Demand
is the demand for currency necessary to purchase goods and services
asset Demand
is the demand for money in liquid form as opposed to illiquid forms like stocks, bonds, a home, or jewelry.
Ok so for example, what would happen to the quantity demanded for money when
interest rates increase?

Why?
The quantity demanded would fall because individuals would rather have interest earning assets instead of liquid money.
Imagine Jane here has $100 in her pocket. She could keep it as liquid cash or invest it in some interest earning asset.
Liquid Form
Asset Form
Pros
Cons
Easily available to purchase goods and services
Pros
Cons
Safe from risky investments
Does not generate any interest
Easier to spend
Over time can generate profits from interest rates
Difficult to convert to liquid cash to spend
Less liquid funds in an emergency
what would happen to the quantity demanded for money when
interest rates Decrease?

Why?
The quantity demanded would rise because individuals would have less incentive to convert cash into interest earning assets.
Just shift it
Time to shift the curve. The Money Demand Curve can shift for three different reasons:
Price level
Technology
Income
If the general price level increases, individuals will require more money to purchase goods and services with thus shifting the money demand curve to the right (vice versa)
If there is a rise in incomes, there will be a higher demand for goods and services which would again increase the transaction demand for money (vice versa)
Technology like the use of credit cards, paypal, or online banking has decreased the need and use for money
Nominal Interest Rate (ir)
Quantity of Money
D
Money
2%
5%
10%
15%
S
Money
Supply (MS)
Notice that the supply is completely vertical. This means that the supply of money is completely independent of the interest rate
This is because a country's money supply is controlled by its central bank, or for us the Federal Reserve
Full transcript