MONETARY THEORY & POLICY

Introduction of Concepts (Cont.)

• Money
– “Lubricant that greases the wheels of economic
activity”
– Not just limited to currency (bills and coins)—also
includes demand deposits (checking accounts)
issued by banks
– Plays a key role in influencing the behavior of the
economy as a whole and the performance of
financial institutions and markets

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 Introduction of Concepts (Cont.)

• Money (Cont.)
– More broadly the monetary economy
• Facilitates transactions within the economy
• Principal mechanism through which central
banks attempt to influence aggregate economic
activity
– Economic Growth
– Employment
– Inflation

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The Role of Money in the Macro
economy
 Introduction
• Recurrent theme—What is the proper amount of
money for the economy?
• Sir William Petty (1623–87) wrote in 1651
“To which I say that there is a certain measure and
proportion of money requisite to drive the trade of a
nation, more or less than which would prejudice the
same”
– Too much money will lead to inflation
– Too little money will result in an inefficient economy

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 Introducing Money
• Uses of Money
 Standard of value: or unit of account for all the
goods and services we might wish to trade.
 Medium of exchange: it is the only financial
asset that virtually every business, household,
and unit of government will accept in payment of
goods and services.
 Store of value: reserve of future purchasing
power.
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 Introducing Money
• Liquid Asset
– Something that can be turned into a
generally acceptable medium of exchange,
without loss of value
– Currency and checking accounts are most
liquid assets

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Primary Definition of Money (M1)

• Currency outside banks plus checking

accounts (demand deposits)

• Other definitions of money (M2 and M3)

start with M1 and add progressively less
liquid financial assets
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 Composition of the Money Supply (Money
Aggregates)
M1 consists of coins and currency in circulation, checking accounts
(A checking account is a deposit account with a bank or other financial firm
that allows the holder to make deposits and withdrawals).

M2 is a more broad definition of money than M1. M2 = M1 + small savings

accounts, money market funds(money market funds include cash, cash
equivalent securities, and high-credit-rating, debt-based securities with a
short-term maturity. Money market funds are intended to offer investors high
liquidity with a very low level of risk. Money market funds are also called
money market mutual funds.) and small time deposits(Time deposits are an
extremely safe investment but they have a low rate of return).

M3 is even more broad and includes M2 + large time deposits, large money
market funds.
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 Who Determines Our Money Supply?

• Gold does not determine the money supply—

this link was abolished in 1968.

• Central Bank is responsible for execution of

national monetary policy
Who Determines Our Money Supply? (Cont.)

• Central Bank influences the total money

supply, but not the fraction of money
between currency and demand deposits
which is determined by public preferences
• Central Bank implements monetary policy
by altering the money supply and
influencing bank behavior

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 The Importance of Money:
Money Versus Barter

• Barter—direct exchange of goods/services for

other goods/services
– Very inefficient and limited economy
– No medium of exchange or unit of account
– Requires double coincidence of wants—”I have
something you want and you have something I
want”
– Items must have approximate equal value
– Need to determine the “exchange rate” between
different goods/services
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