Money and Financial Assets Review for AP Economics (page 3)
Review questions for this study guide can be found at:
Main Topics: Financial Assets, Functions of Money, Money Supply, Money Demand, The Money Market, Changes in Money Supply
In general, money is anything that is used to facilitate exchange of goods between buyers and sellers. Human history has seen many things used as money, from shells and tobacco to gold and spices. These different forms of money have all performed certain functions.
We have already discussed investment in physical (or capital) assets like machinery or new construction as components of GDP. The firm invests in a physical asset if the expected rate of return is at least as high as the real interest rate. Sometimes firms and households seek other forms of assets as a place for their money. Financial investments also yield a rate of return. We spend much more time discussing money as a short-term financial asset, but quickly address other financial assets like stocks and bonds.
A share of stock represents a claim on the ownership of the firm and is exchanged in a stock market. Firms that wish to raise money for capital investment can issue, and sell, these partial shares of ownership. This form of equity financing avoids debt, but relinquishes a small degree of control over the management, and profits, of the firm.
A bond is a certificate of indebtedness. When a firm wants to raise money by borrowing, they can issue corporate bonds that promise the bondholders the principle amount, plus a specified rate of interest, with repayment on a specific maturity date. This form of debt financing commits the corporation to interest payments, but does not relinquish shares of ownership. Like stocks, bonds can be bought and sold in a secondary market. We shall see how the central bank can intervene in this market in a way that has profound effects on the economy.
Functions of Money
Today's paper and coin money is called fiat money because it has no intrinsic value (like gold) and no value as a commodity (like tobacco). It serves as money because the government declares it to be legal tender, and in doing so, the government assures us that it performs three general functions.
- Medium of Exchange. Your employer exchanges dollars for an hour of your labor. You exchange those dollars for a grocer's pound of apples. The grocer exchanges those dollars for an orchard's apple crop, and on and on. If it weren't for money, we would still be engaging in the barter system, an extremely inconvenient way to exchange goods and services. If I were a cheese maker and I wanted apples, I would need to find an orchard that also needed cheese, and this would be a supremely difficult way to do my shopping.
- Unit of Account. Units of currency (dollars, euro, yen, etc.) measure the relative worth of goods and services just as inches and meters measure relative distance between two points. Again, this is an improvement over the barter system where all goods are measured in terms of many other goods. The value of a pound of cheese in a barter economy is measured in a dozen eggs, or a half pound of sausage, or three pints of ale. With money, the value of cheese, and all other goods and services, is measured in terms of a monetary unit like dollars.
- Store of Value. So long as prices are not rapidly increasing, money is a decent way to store value. You can put money under your mattress or in a checking account and it is still useful, with essentially the same value, a week or a month later. If I were the town cheese maker, I must quickly find merchants with whom to exchange my cheese, because if I wait too long, moldy cheese loses its value.
Time Value of Money
Money may serve as a store of value, but money does lose its value over time. Most of us prefer to receive money income as early as possible (the sooner we can begin to consume stuff ) and pay our debts as late as possible. If you lend your best friend $100, would you rather be paid back tomorrow, or five years from tomorrow? If you are not going to charge your best friend any interest on this loan, then you probably prefer your money as soon as possible. If your best friend paid you back in five years without interest, your $100 would have certainly lost value over time. After all, not having $100 for such a long period of time means that you were unable to consume $100 worth of goods! Delaying your consumption of goods that would give you utility must surely come at a cost. The idea of a time value of money is perhaps the most important reason for paying interest on savings and charging interest on borrowing.
Present Value and Future Value
Many decisions in life involve paying upfront costs today with the promise of a payoff tomorrow or even years from now. Many of you are familiar with this trade-off because you were told by a parent that, "If you finish eating your vegetables, you can watch TV before bedtime"; or "If you wash the car, you can go to the movie with your friends." As you consider attending college, the same principle applies. The costs (tuition, books, etc.) are paid today; but the payoffs (marketable skills, useful knowledge, etc.) are received years from today. As the previous section illustrates, dollars today are worth more than future dollars; so there must be a way to convert present and future dollars to the same time period so that wise decisions can be made. The interest rate is the key.
Let's again assume that you are going to lend your friend $100, and that he is going to pay you back in one year. We'll also assume that there is no inflation, so a 10 percent nominal interest rate is equal to the real interest rate. The opportunity cost of lending your friend $100 is the interest you could have earned—$10, after a year had passed. So the interest rate measures the cost to you of forgoing the use of that $100. After all, you could have spent $100 on clothing right now that would have provided immediate benefit to you. To see the relationship between dollars today (present value, or PV) and dollars one year from now (future value, or FV), a simple equation is applied:
- FV = PV*(1 + r) or, using our example,
- FV = $100*(1.10) = $110
In other words, one year into the future, that $100 will be worth $110. We can also rearrange our equation and solve for the present value PV:
- PV = FV/(1 + r) and, using our example again,
- PV = $110/(1.10) = $100
This tells us that $110 a year from now is worth only $100 in today's dollars. If you were lending the money for a period of two years,
- FV = PV(1 + r)2 = $100(1.10)*(1.10) = $121
What does this all mean? It means that your friend, as a borrower, must pay you $21 to compensate you for the fact that he has your $100 for a period of two years. It also says that had you, as a saver, put the $100 in the bank today, two years from now you would have $121 to spend on goods and services. This implies that you would be completely indifferent to having $100 in your hand today or $121 two years from today. The differing sums are equivalent units of purchasing power, just measured at two different points in time; and it is the interest rate that equates the two.
- Money today is more valuable than the same amount of money in the future.
- The present value of $1 received one year from now is $1/(1 + r).
- The future value of $1 invested today is $1*(1+r).
- Interest paid on savings and interest charged on borrowing is designed to equate the value of dollars today with the value of future dollars.
Supply of Money
At the core of monetary policy is regulation of the supply of money. Because our paper money is not backed by precious metals or crown jewels, we trust the government to keep the value of our money as stable as possible. This value is guaranteed by stabilizing the money supply, which is measured by the central bank as M1, M2 and M3, each of which is more broadly defined and less liquid than the previous one. Liquidity refers to how easily an asset can be converted to cash. A five-dollar bill, already being cash, is as liquid as it gets. A Van Gogh hidden in your attic is also an asset, but not a very liquid one.
- M1 = cash + coins + checking deposits + traveler's checks. M1 is the most liquid of money definitions.
- M2 = M1 + savings deposits + small (i.e., under $100,000 certificates of deposit) time deposits + money market deposits + money market mutual funds. M2 is slightly less liquid because the holders of these assets would likely incur a penalty if they wished to immediately convert the asset to cash.
- M3 = M2 + large (over $100,000) time deposits. M3 is even less liquid than M2 because the asset holder would have to wait longer to liquidate a CD or pay a large penalty.
At any given point in time, the supply of money is a constant. This implies that the current money supply curve is vertical. Because other measures of money supply are based upon the most liquid M1, when we discuss the money supply, we focus on M1. Insight gained from studying the expansion and contraction of M1 can be applied to M2 and M3.
" There are a couple of questions on this. Know what is included in each category." —Kristy, AP Student
Demand for Money
People demand goods like cheese because cheese helps satisfy wants. People demand money because it facilitates the purchase of cheese and other goods. In addition to this transaction demand for money, people also demand money as an asset, just as a government bond or a share of Intel stock is an asset. We quickly look at demand for money as the sum of money demand for transactions and money demand as an asset.
Transaction Demand. As nominal GDP increases, consumers demand more money to buy goods and services. For a given price level, if output increases, more money is demanded. Or for a given level of output, if the price level rises, more money is demanded. If nominal GDP is $1000 and each dollar is spent an average of four times each year, money demand for transactions would be $1000/4 = $250. If nominal GDP increases to $1200, money demand for transactions increases to $1200/4 = $300. We assume that the nominal rate of interest does not affect transaction demand for money, so when plotted on a graph with the nominal interest rate on the y axis, it is a constant.
Asset Demand. Money can be held as an asset at very little risk. If you put money under your mattress, there is the advantage of knowing that a crashing stock market or real estate market does not diminish the value of this asset. The main disadvantage of putting this asset under your mattress is that it cannot earn you any interest. As the interest rate on bonds rises, the opportunity cost of holding money under your mattress begins to rise and so you are more likely to lessen your asset demand for money. At a lower interest rate on bonds, you are more likely to increase your asset demand for money.
Total Demand. Plotted against the nominal interest rate, the transaction demand for money is a constant MDt. Adding this constant amount of money needed to make transactions to a downward sloping asset demand for money (MDa) provides us with the total money demand curve. This is seen in Figure 16.1
The Money Market
The central bank, having established a given level of money supply circulating in the economy, allows us to incorporate a vertical money supply (MS) curve with a downward sloping money demand curve to complete the money market. John Maynard Keynes developed the theory of liquidity preference, which postulates that the equilibrium "price" of money is the interest rate where money supply intersects money demand. Just like any market, if the price is below equilibrium (a shortage) the price must rise, and if the price is above equilibrium (a surplus) the price must fall. Money demand can increase if more transactions are being made, but the real focus of the rest of this chapter is on changes in money supply. Equilibrium is shown in Figure 16.2.
"How Is the Money Market Different from the Market for Loanable Funds?"
" This is an important question. Know the difference." —AP Teacher
Tough question, we'll take it in two and a half parts. I'm sure the first is much more helpful, the second much more esoteric and the half is going to earn you the graphing points.
- Breadth of scope
- Different philosophies
The supply of loanable funds, which varies directly with the interest rate, comes from national saving. The supply of money is more inclusive than just saving; it includes currency and checking deposits. A $100 bill in your wallet would fall into the money supply curve, but not into the supply of loanable funds. The demand for loanable funds comes from investment demand. The demand for money includes the money used for investment, but also for consumption (transaction demand) and for holding as an asset (asset demand). So basically the money market, both on the supply and the demand side, is broader, and more inclusive, than the market for loanable funds. The price (a.k.a. the interest rate) appears to be the same in both markets, and is the result of …
We don't want to delve too much into the Keynesian versus Classical philosophical debates because they are quite unlikely to appear on your AP Macroeconomics exam. It can seem a little confusing to show the interest rate as the "price" in both the market for loanable funds and the market for money. The reason that both markets are presented here, and in your textbook, is that they represent fundamental differences in macroeconomic philosophies.
- Classical economists believe that the price level is flexible and long-run GDP adjusts to the natural rate of employment. For any level of GDP, the interest rate adjusts to balance the supply and demand for loanable funds and the price level adjusts to keep the money market in equilibrium.
- Keynesian economists believe that the price level is sticky. For any price level, the interest rate adjusts to balance the supply and demand for money and this interest rate influences aggregate demand and thus the short-run level of GDP.
- Bottom line here: the two different ways of looking at the interest rate are the result of two different ways of looking at the overall economy and the difference in the longrun (Classical) and short-run (Keynesian) views of the economy…. and 1/2. Graphing
While it appears that the same interest rate is graphed on the vertical axis of both the loanable funds and money market graphs, they are not in fact the same. It is correct to label the vertical axis of the money market with a nominal interest rate and the vertical axis of the loanable funds market with the real interest rate. Changes in the money market can be viewed as short-term changes and therefore the role of expected inflation is negligible. For long-term decisions like investment and saving, the price of investment, or return on saving, does depend upon expected inflation and so it makes sense to focus on the real rate of interest when making long-term plans. Here's a way to keep it straight: "Loanable funds are REAL-ly fun."
Changes in Money Supply
When we talk about monetary policy, we are really talking about money supply policy. The tools used to expand or contract the money supply are discussed later in this chapter, but it's useful to see what is happening in the money market when the money supply increases or decreases.
An Increase in the Money Supply
Like the market for any commodity, when the supply increases, there exists a temporary surplus at the original equilibrium price. The money market is no different. At the original interest rate of 10 percent, the supply of money is $1000. Now the Fed increases the money supply to $1500. In Figure 16.3, you can see that at 10 percent, there is now a surplus of money.
With surplus money on their hands, people find other assets, like bonds, as places to put the extra money. As more people increase the demand for bonds, the bond price rises, and this lowers the effective interest rate paid on the bonds.
How does this work?
A bond is selling at a price of $100 and promises to pay $10 in interest. The interest rate = $10/$100 = 10 percent. But if the price of the bond is driven up to $125, the same $10 of interest actually yields only $10/$125 = 8.0 percent. With lower interest rates available in the bond market, the opportunity cost of holding cash falls and the quantity of money demanded increases until MD = $1500. An increase in the money supply therefore decreases the interest rate.
A Decrease in the Money Supply
If the Fed decides to decrease the supply of money from $1000 to $500, there is a shortage of money at the 10 percent interest rate. A shortage of money sends some bondholders to sell their bonds so that they have money for transactions. An increase in the supply of bonds in the bond market decreases the price and increases the rate of interest earned on those assets.
How does this work?
If the original price of the bond is $100, promising to pay $10 in interest, the interest rate is 10 percent. If the price falls to $90, the same $10 of interest now yields $10/$90 = 11.1 percent. Higher interest rates on bonds increase the opportunity cost of holding cash and so the quantity of money demanded falls until the interest rate rises to the point where MD = $500. This adjustment is seen in Figure 16.4.
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