Explain the effect of each of the following on the AD curve for Country A:

1. A decrease in consumer optimism
2. An increase in real GDP in the countries that buy Country A exports
3. An increase in the price level
4. An increase in government spending on highways

 

4. The multiplier is the number by which we multiply an initial change in AD to obtain the amount by which the AD curve shifts at each price level as a result of the initial change.

Multiplier = Δ real GDP / initial Δ (component of AD)

Example: An increase in foreign incomes → X_n of this country increases

• D_for for P_Dom increases → Firms increase L

• As a result, incomes increase → C increases

• AD curve shifts → → → because of initial shift of X_n

5. Inflationary or recessionary gaps: Using the scenario of the Great Depression of the 1930s, explain what kind of gap the U.S. economy faced in 1933, assuming the economy had been at potential output in 1929. 1) Do you think the unemployment rate was above or below the natural rate of unemployment? 2) How could the economy have been brought back to its potential output?

Numerical task with a solution: The Multiplier effect

Suppose that the initial increase in net exports is $100 billion and that the initial $100-billion increase generates additional consumption of $100 billion at each price level. In Panel (a) of Figure The Multiplier, the AD curve shifts to the right by $200 billion – the amount of the initial increase in net exports times the multiplier of 2. We obtained the value for the multiplier in this example by plugging $200 billion (the initial $100-billion increase in net exports plus the $100-billion increase that it generated in consumption) into the numerator of and $100 billion into the denominator. Similarly, a decrease in net exports of $100 billion leads to a decrease in aggregate demand of $200 billion at each price level, as shown in Panel (b).

Figure The Multiplier effect

A change in one component of aggregate demand shifts the AD curve by more than the initial change. In Panel (a), an initial increase of $100 billion of net exports shifts the AD curve to the right by $200 billion at each price level. In Panel (b), a decrease of net exports of $100 billion shifts the AD curve to the left by $200 billion. In this example, the multiplier equals 2.

 

Chapter 4. The Nature and Creation of Money

Unit 4.1 Functions and Types of Money

Learning objectives

1. Define money and discuss its three basic functions.

2. Distinguish between commodity money and fiat money, giving examples of each.

3. Define what is meant by the money supply and tell what is included in two definitions of it (M1 and M2)

Money is anything that serves as a medium of exchange. A medium of exchange is anything that is widely accepted as a means of payment. Money, ultimately, is defined by people and what they do. When people use something as a medium of exchange, it becomes money.

The Functions of Money

Money serves three basic functions. By definition, it is a medium of exchange. It also serves as a unit of account and as a store of value.

A Medium of Exchange

The exchange of goods and services in markets is among the most universal activities of human life. To facilitate these exchanges, people settle on something that will serve as a medium of exchange – they select something to be money.

We can understand the significance of a medium of exchange by considering its absence. Barter occurs when goods are exchanged directly for other goods. A barter economy is an economy that has no medium of exchange. Goods are swapped for other goods. To see the advantages of a medium of exchange, imagine a barter economy, i.e. an economy which has no medium of exchange. Goods are directly swapped for other goods. The seller and the buyer each must want something the other has to offer. Trading is very expensive in a barter economy. People spend a lot of time and effort finding others with whom they can make swaps. The use of money makes trading simpler and more efficient. Nowadays, there are no purely barter economies, but economies nearer to or farther from the barter type. The closer is the economy to the barter type, the more wasteful it is.

Money is used as one part of almost every exchange. Workers exchange labour services for money. People buy or sell goods for money. People do not accept money to consume it directly but because it can subsequently be used to buy things they wish to consume.

A Unit of Account

Money is the unit in which prices are quoted and accounts are kept. In the USA, for instance, prices are quoted in US dollars, in Japan, in yens. It is usually convenient to use the same unit for the medium of exchange and unit of account. However, there are exceptions. During the German hyperinflation of 1922-23 prices in German marks changed very quickly. German shopkeepers found it more convenient to use dollars as the unit of account. Prices were quoted in dollars but payment was made in marks. Similarly, Russia used the US dollar as a unit of account keeping rubles as means of payment in the 1990s when inflation rate was high. The higher is the inflation rate, the greater is the probability of introducing a temporary unit of account using the national currency as the medium of exchange. Inflation is not the only reason of using two money units in the country. During 2000-2001 many European shopkeepers quoted prices in euros and in a local currency, even though the euro did not become their medium of exchange until 2002.

A Store of Value

To be accepted in exchange, money has to store value. Nobody will accept money in payment for goods supplied today if the money is worthless when they try to buy goods with it later. But money is neither the only nor necessarily the best store of value. Because of inflation, there are better ways to store value. Houses, arts collections, and interest-bearing bank accounts all serve as stores of value. Money differs from these other stores of value by being readily exchangeable for other commodities. Its role as a medium of exchange makes it a convenient store of value.

Because money acts as a store of value, it can be used as a standard for future payments. When you borrow money, for example, you typically sign a contract pledging to make a series of future payments to settle the debt. These payments will be made using money because money acts as a store of value.

Types of Money

Although money can take an extraordinary variety of forms, there are really only two types of money: money that has intrinsic value and money that does not have intrinsic value.

Commodity money is money that has value apart from its use as money. Gold and silver are the most widely used forms of commodity money. Gold and silver can be used as jewelry and for some industrial and medicinal purposes, so they have value apart from their use as money.

But something need not have intrinsic value to serve as money. Fiat money is money that some authority, generally a government, has ordered to be accepted as a medium of exchange. The currency – paper money and coins – used today is fiat money; it has no value other than its use as money.

Checkable deposits, which are balances in checking accounts, and traveler’s checks are other forms of money that have no intrinsic value. They can be converted to currency, but generally they are not; they simply serve as a medium of exchange. If you want to buy something, you can often pay with a check or a debit card. A check is a written order to a bank to transfer ownership of a checkable deposit. A debit card is the electronic equivalent of a check. Suppose, for example, that you have $100 in your checking account and you write a check to your campus bookstore for $30 or instruct the clerk to swipe your debit card and “charge” it $30. In either case, $30 will be transferred from your checking account to the bookstore’s checking account. Notice that it is the checkable deposit, not the check or debit card, that is money. The check or debit card just tells a bank to transfer money, in this case checkable deposits, from one account to another.

Measuring Money

The total quantity of money in the economy at any one time is called the money supply. Economists measure the money supply because it affects economic activity. What should be included in the money supply? We want to include as part of the money supply those things that serve as media of exchange. However, the items that provide this function have varied over time.

Before 1980, the basic money supply was measured as the sum of currency in circulation, traveler’s checks, and checkable deposits. Currency serves the medium-of-exchange function very nicely but denies people any interest earnings.

Over the last few decades, especially as a result of high interest rates and high inflation in the late 1970s, people sought and found ways of holding their financial assets in ways that earn interest and that can easily be converted to money. For example, it is now possible to transfer money from your savings account to your checking account using an automated teller machine (ATM) or the mobile banking facilities, and then to withdraw cash from your checking account. Thus, many types of savings accounts are easily converted into currency.

Economists refer to the ease with which an asset can be converted into currency as the asset’s liquidity. Currency itself is perfectly liquid; you can always change two $5 bills for a $10 bill. Checkable deposits are almost perfectly liquid; you can easily cash a check or visit an ATM. An office building, however, is highly illiquid. It can be converted to money only by selling it, a time-consuming and costly process.

As financial assets other than checkable deposits have become more liquid, economists have had to develop broader measures of money that would correspond to economic activity. Because it is difficult to determine what (and what not) to measure as money, central banks report several different measures of money, including M1 and M2.

Typically, M1 is the narrowest of the money supply definitions. It includes currency in circulation, checkable deposits, and traveler’s checks. M2 is a broader measure of the money supply than M1. It includes M1 and other deposits such as small savings accounts (less than $100,000 in the USA).

M2 is sometimes called the broadly defined money supply, while M1 is the narrowly defined money supply. The assets in M1 may be regarded as perfectly liquid; the assets in M2 are highly liquid, but somewhat less liquid than the assets in M1. Even broader measures of the money supply include large time-deposits, money market mutual funds held by institutions, and other assets that are somewhat less liquid than those in M2.

Note!

Credit cards are not money. A credit card identifies you as a person who has a special arrangement with the card issuer in which the issuer will lend you money and transfer the proceeds to another party whenever you want. With all the operational definitions of money available, which one should we use? Economists generally answer that question by asking another: Which measure of money is most closely related to real GDP and the price level? As that changes, so must the definition of money. The choice of what to measure as money remains the subject of continuing research and considerable debate.

Key concepts

· Money is anything that serves as a medium of exchange. Other functions of money are to serve as a unit of account and as a store of value.

· Money may or may not have intrinsic value. Commodity money has intrinsic value because it has other uses besides being a medium of exchange. Fiat money serves only as a medium of exchange, because its use as such is authorized by the government; it has no intrinsic value.

· Central banks report several different measures of money, including M1 and M2.

 

Unit 4.2 The Banking System

Learning objectives

1. Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system.

2. Describe the process of money creation (destruction), using the concept of the deposit multiplier.

3. Describe how and why banks are regulated and insured.

4. Explain the primary functions of central banks.