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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 Portable Divisible Uniform Durable
Money Supply
M1 Currency: coins & bills (25%) Demand Deposits: checking account deposits (75%) M2 M1 Time Deposits: savings account deposits less than $100,000
Money Supply
M3 M2 Time Deposits: savings account deposits more than $100,000 L M3 Liquid assets (e.g., T-Bills)
(M/P)s 10 5 80
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
10 5
(M/P)d 80
100
Quantity of Money
(M/P)s 5
(M/P)d 80
Quantity of Money
(M1/P)s (M2/P)s
5 4 (M/P)d 80 85
Quantity of Money
Historical Data
International Data
Inflation
A continuous rise of the general price level
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
%M * %V = %P * %Y
V = 1/k and Y at full employment are constant
%M = %P : a 1% increase in the money supply causes a 1% increase in the general price level
Public Debt
Seigniorage or printing money: operates like an inflation tax on money holding as money loses real value
Fisher Effect
Define
i = nominal rate of interest r = real rate of interest = inflation rate
i=r+ r=i-
Historical Data
International Data
i = r + * r = i *
Changes in money demand and supply determine the price level Changes in the price level determine the inflation rate The inflation rate affects the interest rate The nominal interest rate affects the money demand
Money Supply
Price Level
Inflation Rate
Money Demand
> * <
Hyperinflation
When > 50% per month All unexpected costs get larger Delay in tax collection Inflation psychology Caused by excessive printing press Cure required fiscal reform
Hyperinflation in Germany