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ECON 4100 Monetary Economics William D. Lastrapes Fall 2008 ECON 4100 Monetary Economics William D. Lastrapes Fall 2008

Money Specialization is necessary for high productivity, high standards of living. Trade and exchange Money Specialization is necessary for high productivity, high standards of living. Trade and exchange are necessary for specialization. Money reduces costs of and facilitates exchange. So without money, low standard of living for all.

Money The study of money is the study of how people trade, the mechanics Money The study of money is the study of how people trade, the mechanics of the payments system. Such mechanics are typically ignored in micro models of voluntary exchange and efficient allocation of resources.

Voluntary exchange without money Barter: exchange of goods for direct consumption. (Double) coincidence of Voluntary exchange without money Barter: exchange of goods for direct consumption. (Double) coincidence of wants: for mutually beneficial trade to occur under barter, a seller must find a buyer who wants what he or she has, and has what he or she wants.

Voluntary exchange without money “The butcher has more meat in his shop than he Voluntary exchange without money “The butcher has more meat in his shop than he himself can consume, and the brewer and the baker would each of them be willing to purchase a part of it. But they have nothing to offer in exchange, except the different productions of their respective trades, and the butcher is already provided with all the bread and beer which he has immediate occasion for. No exchange can, in this case be made between them. ” -- Adam Smith

Solutions to the coincidence of wants • Central market (with trading posts). The key Solutions to the coincidence of wants • Central market (with trading posts). The key here is providing information.

Solutions to the coincidence of wants • Indirect barter: accept some goods for trade, Solutions to the coincidence of wants • Indirect barter: accept some goods for trade, not consumption. A stylized example:

Solutions to the coincidence of wants Preference Endowment First trade Final trade Butcher Beer Solutions to the coincidence of wants Preference Endowment First trade Final trade Butcher Beer Meat Beer (from brewer) Brewer Bread Beer Baker Meat Bread (from baker) Bread (from butcher) Meat (from butcher)

Solutions to the coincidence of wants • Money will evolve from indirect barter as Solutions to the coincidence of wants • Money will evolve from indirect barter as a single good becomes most ‘saleable. ’ “In order to avoid the inconveniency of such situations [no possible exchange], every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry. ” -- Smith

Claim on labor Claim on labor

To Kill a Mockingbird • • Good morning, Mr. Finch. I didn't want to To Kill a Mockingbird • • Good morning, Mr. Finch. I didn't want to bother you none. I brung you these here hickory nuts as part of my entailment. Well, I thank you. The collards we had last week were delicious. Scout, I think maybe, uh, next time Mr. Cunningham comes, you better not call me. I think it embarrasses him to be thanked. Why does he bring you all this stuff? He's paying me for some legal work I did for him. Why does he pay you like this? That's the only way he can. He has no money.

Modern barter Modern day barter systems: the internet can be used to provide information Modern barter Modern day barter systems: the internet can be used to provide information about exchange, which can promote direct (i. e. barter) exchange. An example: http: //www. merchantsbarter. com/

Functions of money Money is an asset or store of value that facilitates exchange. Functions of money Money is an asset or store of value that facilitates exchange. Money is neither income, nor wealth. Two basic functions of money: • medium of exchange – generally accepted means of payment • medium or unit of account, or a standard of value.

Functions of money Relative prices With n goods: n(n-1)/2 relative prices. n= 5 → Functions of money Relative prices With n goods: n(n-1)/2 relative prices. n= 5 → 10; n = 100 → 4950 relative prices. Under barter, must keep track of all. With unit of account, only keep track of n-1 prices, and easily compute relative prices. Example: relative price of apples in terms of oranges is the unit of account price of apples divided by unit of account price of oranges.

Functions of money Logically, the medium of exchange function and unit of account function Functions of money Logically, the medium of exchange function and unit of account function need not be served by the same commodity. For example, gold might be medium of exchange, ‘dollars’ might be unit of account.

Comments • Menger (1871): money evolves spontaneously • Most saleable goods: scarce, durable, portable, Comments • Menger (1871): money evolves spontaneously • Most saleable goods: scarce, durable, portable, divisible, and homogeneous • Cattle one of the first media of exchange and media of account; but metals (gold and silver most common historically)

Modern money • Paper currency Modern money • Paper currency

Modern money • Paper currency • Checkable deposits at banks (checking accounts) • Stored-value Modern money • Paper currency • Checkable deposits at banks (checking accounts) • Stored-value cards • Local currencies http: //www. berkshares. org/ • Pay pal?

Alternatives to money • Credit • Liquid assets • Gold and silver? Alternatives to money • Credit • Liquid assets • Gold and silver?

Purchasing power of money and inflation • Purchasing power of money: value in exchange Purchasing power of money and inflation • Purchasing power of money: value in exchange for other goods: how much a monetary unit can buy. • Price level: the reciprocal of the purchasing power of money; the money price of the ‘average good. ’ • Inflation rate: rate of change of price level over time

US Price level (CPI) US Price level (CPI)

US Inflation (CPI) US Inflation (CPI)

Recent US inflation Recent US inflation

Purchasing power of money and inflation • Hyperinflation: extreme inflation (say greater than 50% Purchasing power of money and inflation • Hyperinflation: extreme inflation (say greater than 50% per month). At this rate, $1 item on Jan. 1 would cost $130 on Dec. 31. • German hyperinflation: inflation rate was 322% per month from August 1922 to November 1923.

German wholesale price index 12/1914 12/1921 12/1922 12/1923 Index 125 3, 490 147, 480 German wholesale price index 12/1914 12/1921 12/1922 12/1923 Index 125 3, 490 147, 480 126, 160, 000, 000 mon. rate 4. 3% 36. 6% 455%

Inflation occurs when the quantity of money grows faster than the demand to hold Inflation occurs when the quantity of money grows faster than the demand to hold it. If there is too much money, people try to spend it on goods and services, driving prices up. “Too much money chasing too few goods. ” “Inflation is always and everywhere a monetary phenomenon. ” Hyperinflations occur when money supply growth far exceeds money demand growth, as in Post World War I Germany. Such hyperinflation can only happen with fiat money when money is cheap to produce and there is no ‘anchor’ for its quantity.

Measuring the quantity of money • • • M 1 = Currency held outside Measuring the quantity of money • • • M 1 = Currency held outside of banks + checkable deposits issued by financial institutions + traveler’s checks M 2 = M 1 + plus savings deposits (including money market deposit accounts) and small-denomination (less than $100, 000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments of less than $50, 000), net of retirement accounts. MZM = M 2 + institutional money market mutual funds – small denomination time deposits.

M 1 money stock M 1 money stock

M 1 money stock M 1 money stock

 M 2 money stock M 2 money stock

Real money balances M = nominal stock of money (in unit of account) P Real money balances M = nominal stock of money (in unit of account) P = price level M/P = real money stock; the quantity of money in terms of its purchasing power, what it can buy. An example: the real value of $100, if bread is $2 a loaf, is 50 loaves of bread.

A ‘shopping time model’ of money • • Households consume leisure and other stuff A ‘shopping time model’ of money • • Households consume leisure and other stuff They can shop or consume leisure. Opportunity cost of shopping is leisure. Shopping time can be reduced by incurring transactions costs. • Optimal shopping time minimizes total costs of exchange.

A ‘shopping time model’ of money Costs Total costs Waiting costs Transactions costs Shopping A ‘shopping time model’ of money Costs Total costs Waiting costs Transactions costs Shopping Time

A ‘shopping time model’ of money Costs Waiting costs Transactions costs with barter Transactions A ‘shopping time model’ of money Costs Waiting costs Transactions costs with barter Transactions costs With money Shopping Time