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Money Notes

Economics Notes > Macroeconomic Principles Notes

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Money Summary

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What is money?
Real and nominal interest rates Dynamic monetary model Neutrality of money Friedman rule

What is Money?

* Functions of money: a. Medium of exchange
? Money is accepted as payment in exchange for goods, and goods accepted in exchange for money b. Unit of account
? Labour contracts express wages in term of money, etc. c. Store of value
? Money can be stored and spent in the future (it does not physically depreciate, but value may change)

* Alternative forms of money:
* Commodity money
* Commodity-backed paper currency
* Circulating private bank notes
* Fiat money
* Transactions deposits at banks

Search Model of Money
* Barter exchange is difficult in highly developed, specialized economies
* Economic exchange requires search costs
? These costs are high when economic agents are specialised in consumption and production and can only trade a good or service for another good or service
* Search costs reduced dramatically if everyone accepts money in exchange for goods and services Simple search model of money
? 3 types of individuals
# Each produces one particular good
# Each individual only wants to consume one particular good
? Different from that it produces
# Each has a series of meetings with other individuals
? At random times
? Meeting only one person at a time
# Each meeting, the two individuals decide whether to trade or not
? Trade is difficult if there is an absence of the double coincidence of wants
# Absence of double coincidence of wants = One or more of the two individuals does not have something that the other would like Example of simple search model of money

* Individuals only accept as payment the goods that they want to consume themselves

* Absence of double coincidence

* [?] no trade takes place* Type II this time accepts good 1 even though they don't wish to consume it

* They then trade this with Type I to get good 2

* This makes good 1 a commodity money

Commodity money
? Allows exchange to take place
? Requirements:
# Storable
# Easy to verify quality
# Transportable
# Divisible
? e.g. precious metals have been the most common
? Tokens representing claims to the commodity can also be traded Private credit Example of private credit in the form of I.O.U.

* Trade the I.O.U.s? In principle, allows exchange to take place
? Requirements for issuer of I.O.U:
# Known to be able and willing to honour the I.O.U
# In addition, those who subsequently hold the I.O.U must also trust the issuer
? These are demanding requirements in all but the smallest communities Credit vs. Money I.O.U.s are not automatically media of exchange

Course Notes Page 27

? I.O.U.s are not automatically media of exchange
# [?] not automatically money
? How can I.O.U.s can become money?
# Issued by large, well-known and trusted financial intermediary
# Banknotes were claims to deposits at banks
? i.e. they were I.O.U.s
? Can private I.O.U.s be accepted as payment?
# Yes, if endorsed by a financial intermediary
# Financial intermediaries/credit reference agencies scrutinize the credit -worthiness of individuals
# e.g. credit cards
? Individuals can pay without holding any money
? Costly electronic payment system to verify transactions remotely
? Costly to collect information on credit histories Fiat money
? Intrinsically worthless object issued as money by a central bank or government
? Accepted by private agents as payment for goods on the belief that others will accept it in exchange for goods
? Like an I.O.U but now of the government
? Overcomes the absence of the double coincidence of wants problem Example of fiat money? It is an efficient system:
# Allows exchange easily to take place
# Low resource cost because money has no intrinsic value
? Risks:
# Use of money depends on belief that others will accept it given no intrinsic value
# Beliefs could be self-fulfilling
# Abuse of money issuing powers by governments (i.e. hyperinflation)

A Dynamic Monetary Model
* Extends the dynamic model to incorporate money
* A variant of a cash-in-advance model
* Assumes that consumers and firms require cash on hand to purchase goods or can use a system of credit (at some cost)
* There are 3 time periods
* Past
* Present
* Future

Money, prices and inflation
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Stock of money: M Price level: P Inflation rate (expected): i Current price level = P, expected future price level = P'

* Expected inflation =

Real and nominal interest rates
* Real interest rate = r
? Save one unit of goods today and receive 1 + r units of goods in the future
* Nominal interest rate = R
? Save one unit of money today and receive 1 + R units of money in the future

Fisher equation

* Tells us real return r given by nominal interest rate R Relationships between goods and money, today and in the future
? One unit of goods today buys P units of money today
? One unit of money invested today yields 1 + R units of money in the future
? One unit of money in the future buys 1 / P' units of goods in the future
* Exact fisher equation:
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* If we multiply both sides by
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* This is because if both r and i are small then ri is negligible
* [?] approximate fisher equation:

US real and nominal interest rates Graph of US real and nominal interest rates

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* Very high nominal interest rates when inflation is very high
* Nominal interest rates are not negative
* Real interest rates can be significantly negative

Agents in the model Course Notes Page 28

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