All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Answers for the Day
1970s: Money Supply Process

1. Let's talk about money. More specifically, let's talk about the history of money.

• When and where did we first see coins used as money? Why was this such an important development?
• When and where did we see first see paper money used?
• What is debasement of currency and what problem did it cause Nero, a Roman emperor in the first Century AD?

You will find this in the on-line history of money.  The first coins would appear to have been circulated in Lydia in approximately 690BC.  This allowed for a substantial expansion in the use of money by reducing the costs associated with determining the weight and purity of the gold used as money.   The first paper money appeared in China in the 806-821 period due to a severe shortage of metal for minting.  The debasement of currency was a VERY big problem in history.  The problem is simple - the supply of money was dependent on the supply of metals that were used to mint the coins.  You could get more coins if you watered down the metal content by mixing it with other metals or reducing the size of the coin.  One technique was to shave the edges off a coin which is why they do not have smooth edges. The problem with debasement was inflation, a relationship we will explore a bit later.

2. The island economy of Tundrania produces five goods using its only resource: labor. Below, these five goods are listed along with the amount of labor time embodied in the goods. Assume that any individual could produce each item if they so desired.

Auto	Food	Clothing	Shelter	Recreation
1,000	10	15	4,000	5

• a. What is the price of an auto in this economy? Tell me all the information I need to know for transactions purposes (how many different trades are there)?
• The price would be 100 Food or 1/4 shelter. For each good I would need to know four separate prices.
• b. Develop a commodity money and describe the prices of all the goods produced in the economy.
• Let's let food be the commodity money and then the prices would be auto = 100, clothing = 1.5, shelter = 400, and recreation = .5
• c. Develop a fiat money and describe all the prices in the economy.
• Let's decide that the 'real (R)' is money and that it takes 5 reals to buy a unit of food. The other prices are:
  • Auto = 500R
  • Food = 5R
  • Clothing = 7.5R
  • shelter = 2,000R
  • Recreation = 2.4R

3. During financial crises people tend to prefer cash to checks so they often attempt to take cash out of banks. This is what happened during the Great Depression as banks collapsed and people withdrew their money and put it into their mattresses.  If they convert their checking accounts into cash, what will happen to the money supply?

Let's start with the assumption that the money supply consists of coins and currency in circulation (outside the banks) and demand deposits. If people take money out of the bank, then the banks will have fewer reserves. But from the money multiplier we know that every dollar in reserves generates even more demand deposits. The result is households move $1 from a checking account to cash, the $1 comes out of the banking system where it could have generated $5 in demand deposits. The net effect on the money supply would be -$4. There would be one more dollar in cash in the money supply, but the demand deposits would be down by 5.

4. Assume that your forecaster, a fairly reliable source, has informed you that the economy is expected to emerge from a long recession. Please use S&D to develop a forecast for interest rates.

As you can see in the diagram below, with the expanding economy we will see increase income and this will shift out the money demand curve. The result is an increase in the interest rate (r*) and an increase in the money supply (M*).

5. What if we found ourselves in a situation where the FED did not want to see interest rates rise. Please describe to me how the FED could reverse the expected rise in rates and describe the three major tools that the FED could use to alter the money supply to achieve this goal.

The FED, if it is intent upon returning interest rates to their original level, will have to respond to the increase in money demand with an increase in money supply. We demonstrate the increase in the money supply with the outward shift in the supply curve. The money supply (M*) increases even more, but interest rates return to their original level.

How could the Fed increase the money supply?  It has three tools.  The money supply could be increased by the Fed's lowering of the discount rate, lowering the required reserve rate, or open market purchases of securities.

6. Explain, in words, what happens when the Federal Reserve conducts an open-market sale of $100 million in bonds. What is the ultimate effect on high-powered money, the money supply and interest rates?

When the FED buys government securities from the private sector, it pays for them with checks drawn on the FED. This would be an increase in high powered money or the monetary base. These checks, which eventually work their way back into the banking sector, can be used as reserves in the banks. The banks would then attempt to lower their excess reserves by making loans and 'creating' demand deposits. The result is that the money supply would increase. In the money market, this increase in supply could be expected to lower interest rates.

7. Determine with the aid of the MS-MD diagram the impact of the following on interest rates and the money supply.

a. an expansion in the economy

The expansion in the economy increases income (GDP) which results in an outward shift in the money demand curve. This will push interest rates upward.

b. the public's desire to hold a greater share of money as currency

The money supply decreases - shifting the supply curve inward. The decrease happens because the cash is moved out of the banks where there can be a creation of demand deposits. The result is higher interest rates and lower money supply.

c. the Fed's open-market purchases of government securities

The money supply increases - shifting the supply curve outward. The result is lower interest rates and higher money supply.

d. a decision on the part of banks to lower their excess reserves

The money supply increase - shifting the curve outward.   The level of reserves that sits idle in the banks will decrease and once these reserves are "activated", they will be financing higher balances in deposit accounts which are part of the money supply. The result is lower interest rates and higher money supply.

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