BackMoney, Banking, and Inflation: Key Concepts in Macroeconomics
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A Brief History of Money: From Barter to Commodity to Fiat
Barter System
The barter system involves the direct exchange of goods or services without the use of money.
Double coincidence of wants: Both parties must want what the other offers, making transactions time-consuming and inefficient.
Example: A farmer wants shoes and must find a shoemaker who wants wheat.
Commodity Money
Commodity money uses items with intrinsic value (such as gold) as a medium of exchange.
Intrinsic value: The commodity itself has value outside its use as money.
Difficulty: Controlling the supply and portability of commodity money can be challenging.
Example: Gold coins used in trade.
Fiat Money
Fiat money is currency authorized by a central bank, not backed by a physical commodity.
Expectation-based value: Households and firms trust the currency's value due to government backing.
Example: Modern paper currency such as the US dollar.
The Functions of Money
Medium of Exchange
Money is accepted by buyers and sellers as payment for goods and services.
Legal tender: Money must be accepted for transactions within an economy.
Unit of Account
Money provides a standard measure for valuing goods and services.
Advantage: Standardized money increases efficiency by allowing easy price comparisons.
Example: Pricing goods in dollars rather than bartering.
Store of Value
Money can be saved and used for future purchases.
Example: Saving cash for future expenses.
Standard of Deferred Payment
Money facilitates borrowing and lending by serving as a means to settle debts in the future.
Disadvantage: Money may lose purchasing power over time due to inflation.
Advantage: Money is easily converted into a liquid medium for payment.
Money Supply and Banking
Money as a Stock
Money supply refers to the total value of currency and deposits in circulation.
Example: Cash and checking account balances.
Bank Money Creation
Banks create money by loaning out reserves in excess of required reserves.
Required reserves: The legally mandated minimum reserves a bank must hold, based on its deposits.
The Simple Deposit Multiplier
The deposit multiplier shows how much the money supply can increase based on new deposits.
Formula:
Total change in checking account deposits:
Overall change in money supply: Increase in deposits minus decline in currency.
Real-world multiplier: Usually lower than the simple deposit multiplier due to currency leakage and other factors.
Inflation and the Quantity Theory of Money
Long-Run Implications
The quantity theory of money explains the relationship between money supply growth and inflation.
Equation:
Velocity of money (V): The average number of times each dollar is used in a purchase.
Assuming constant velocity: In the long run, inflation rate equals the growth rate of money minus the growth rate of real GDP.
Implication: Inflation occurs when money supply grows faster than real GDP.
Short-Run Implications: The Phillips Curve
The Phillips curve illustrates the short-run trade-off between inflation and unemployment.
Ceteris paribus: The short-run Phillips curve shows a negative relationship between inflation and unemployment.
Policy movements: Changes in monetary or fiscal policy can shift the curve.
Expansionary policies: Lower unemployment but higher inflation (leftward movement).
Contractionary policies: Lower inflation but higher unemployment (rightward movement).
