If there's no money in the economy, we just have to barter and trade.
But what if someone doesn't want what you offer to trade?
It 'lubricates' the economy.
Store of value
You can put your wealth in cash. It will be worth roughly the same amount.
Example:
Prison, cigarettes.
Not a great store of value, but can be used as a medium of exchange.
Unit of account
Standardizes 'value' and 'prices' between different products and services.
If you have only 3 goods in an economy, you just need 3 prices to compare the value of those goods.
If you have 4, then you need 6.
is the number of relative prices you need to compare goods.
Evolution of Money
You used to have bulk gold.
Needed to be weighed and assessed per transaction.
Gold coins
Standardized weight and purity.
But now you need to assess it (if you don't trust it).
Otherwise you can trust the goldsmith.
Problem:
Clipped coins.
Shave or trim the edges of the coin and keep the gold for yourself.
Milling.
Milling the edges of the coin to prevent clipping.
Makes it obvious if it was clipped.
Have the edges milled with a pattern.
Indivisible.
Can't be divided into smaller units.
Can't buy something worth less than the coin.
Bi metal / Tri metal
Gold silver and copper coins.
Establish a par between gold and silver, etc.
British got newton to see how many pounds of silver for 1 pound of gold.
He overvalued silver.
So silver was driven out of circulation.
Gresham's Law says 'bad money drives out good money'.
Example:
USD chases out Cuban dollars in Cuba.
Paper Money
Issued by the goldsmith.
Backed by gold reserves.
Convertible on demand.
Eventually people didn't come back to convert.
So issue more money than gold available.
Fiat
Not backed by anything.
Value is based on trust in the government.
'In God we Trust', that's the backing.
It's backed by law.
Debit.
Credit is not money, it's a promise to pay money.
Properties of Commodity Money
Homogeneous
Gold is gold. Simple.
If you have a bar of gold, it's worth the same as any other bar of gold of the same weight and purity.
Durable
Gold is durable. It doesn't corrode or degrade over time.
Portable
Need to be able to take your money anywhere.
Divisible
Good for day to day transactions.
Fixed in supply
If the supply of money can be easily increased, then it loses its value.
This is the problem with fiat money.
Which of these properites were improved when they intoduced coins and paper money?:
Portable with coins
Money Supply
1
5 responsibilities of central banks.
Liabilities and equities
First, issue currency.
Commercial Bank Deposits
Bank for the banks.
Overnight Rates
Example:
TD has an account with BOC
BOC the interest rate. Now TD must pay more to borrow money from BOC. So TD will increase the interest rates they charge to their customers, which will decrease the demand for loans and decrease the money supply in the economy.
Set at predictable intervals, so that banks can plan for it.
There's not moving of money between commercial banks.
It's just a clearing house, where the BOC keeps track of how much money each bank has.
Assets
Foreign Currency
Exchange rates. By buying and selling foreign.
Increasing supply of canadian dollars by buying foreign currency, which decreases the value of the canadian dollar.
If Canada sells US dollars, they'll take CAD out of circulation, increasing value.
One is sustainable the other isn't.
Example:
Trump criticizes China. Say they're manipulating exchange rate, keeping it low. So exports are cheap. So they buy US dollars to keep the value of their currency low. But if they stop buying US dollars, then the value of their currency will go up, which will make their exports more expensive and less competitive.
Maybe they're keeping it artificially low, so that the US has a deficit with China always.
To keep the rate low, People Bank of China buy US dollars with yuan.
They print their own money to buy money from the US, which increases the supply of yuan and decreases its value.
Accumulating US assets.
If they want to keep their value high, they sell US dollars. Eventually, you run out though.
So there's an asymmetry in this process.
Government Bonds
Example:
If govt has surplus, they put it into the Bank of Canada.
Otherwise, they issue Bonds to raise money.
Other assets
Central bank needs to maintain stability in the financial system.
'Bank run'
If everyone tries to withdraw their money at the same time, the bank will run out of cash and go bankrupt.
Because they operate at fractional reserve banking, they only keep a fraction of their deposits in cash, and lend out the rest.
In a crisis, they have toxic assets, and potentially a bank run.
The BOC buys those toxic assets to stabilize the financial system.
It's now , used to be more.
BOC can't go bankrupt, because their only customers are Banks.
2
Fractional Reserve Banking
Banks only keep a fraction of their deposits in cash, and lend out the rest.
This creates money in the economy, because when a bank lends out money, it creates a new deposit in the borrower's account, which increases the money supply.
Example:
If the reserve requirement is 10%, and someone deposits $1000, the bank keeps $100 in reserve and lends out $900. The borrower then deposits that $900 in another bank, which keeps $90 in reserve and lends out $810, and so on. This process continues until the total money created is $10,000.
Because of this, we have a money multiplier.
Example:
Commercial banking has reserve ratio of .
If the central bank issues . They will hold and create of loans.
The next company will take those and buy more stuff, etc.
Eventually that comes back into the bank.
In this case, the money multiplier is .
Cash Drain
If people withdraw cash from the bank, it reduces the amount of reserves the bank has, which reduces the amount of money they can lend out, which reduces the money supply in the economy.
Example:
If someone withdraws from the bank, the bank's reserves decrease by , and they can only lend out instead of , which reduces the money supply by .
Creates a leak in the system when people just keep the money in their pocket and don't consume.
Updated money multiplier.
with c is cash drain.
3
Friedman's Quantity Theory of Money
is the velocity of money.
How many times does a dollar change hands in a year?
is the price level.
is the real output of the economy.
is GDP/GDE
is the money supply.
M1, M2, etc. depending on how you define it.
Example:
So each dollar changes hands 20 times a year.
Second most influential equation in economics after Keynes.
Inflation is a monetary phenomenon.
He then rewrote the expression as:
Over last years, is roughly constant.
So inflation, is per year.
If a central bank wants to reduce inflation, they just reduce growth of money supply.
Increase interest rates and reduce money supply, which reduces inflation.
Trimmed CPI:
Exclude volatile prices: Oil, Gas.
Money Demand
Money
Cash + Debit vs Bonds
Wealth is allocated between money and bonds.
Theories
Transaction motive
to have money on hand for day to day transactions.
Money you hold is what you plan to spend.
Theory of Liquidity Preference
to have money on hand for day to day transactions, but also to have some money on hand for emergencies.
When you hold a bond, you'll get return per year. Cash + Debit has an opportunity cost of per year, because you could be earning that return if you held a bond instead.
Precautionary motive
to have some money on hand for emergencies.
People who carry lots of cash on hand. Might come from a place with a lot of political instability, or they might be in a situation where they need to have cash on hand for emergencies.
is interest rate
shifts the demand curve left and right
When interest rates go up, there is a decrease in quantity demanded.
When uncertainty increases, there's an increase in the demand curve.
Example:
Excess supply of money, means excess demand for bonds.
When there's an excess demand for anything prices goes up.
So price of bonds goes up.
yield on short term bond.
,
Par value and face value of the bond.
This is what takes us from point B to C.
What's gonna happen in the market during a war?
Uncertainty increases, so demand for money increases, which decreases the price of bonds, which increases the interest rate.
Exchange Rate IRP
Interest Rate Parity
Reflect interest rate differentials.
and
Then between US and Canada
If canada has then . Then money starts flowing into canada.
So . It's an appreciation of the canadian dollar, because you can buy more US dollars with 1 canadian dollar.
Example:
Bonds and Stocks
How does interest rate effect the stock market?
This is next week
Predict what happens to interest rates if the govt manipulates govt spending, tax rates, interest rates, etc.
if the dividends are constant and perpetual.
is the dividend in
is the interest rate
Example:
is the Present Discounted Value
as interest
dollars a year per life is worth today.
Suppose interest rates go up because the war. Then , so . So stock prices go down.
When there's uncertainty caused by a war, higher interest rates, etc. then stock prices go down.
Bonds
Suppose we have a year bond with and which is coupon.
With
PDV is
If , then we expect . So bond prices goes down.
two year bond
Prices of bonds go down, depending on interest rate no matter the length of the bond, but longer term bonds are more sensitive to interest rate changes.
IRP Model
This is a linear version of .
We know from IRP that
So increasing will decrease .
means
So
Put into
Sub this into .
Fake AE
We have basically removed influence on and . So it's just previous week's content now.
Since from we have a smaller multiplier because change in price.
If then we have that and , so which shifts to the right.
If that shifts to the right, so appreciates.
If in america, they need to spend more to import from us.
So our goes down. So our multiplier gets even smaller.