Money and Banking (EC 352), Gonzaga University

1. Money and Inflation
Ryan Herzog, Ph.D.
Associate Professor Economics

2. Key Questions
• What is money?
• How do we measure money?
• What is the link between inflation and
money?
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3. Readings
• The Plodding Dollar (FRED Blog)
• What Does Money Velocity Tell Us about Low
Inflation in the U.S.?
• The Disconnect Between Inflation and
Employment
• The New Normal and What it Means for
Monetary Policy
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4. The Use of Money
• Money is an asset that is generally accepted as payment for goods and
services or repayment of debt.
• Income is a flow of earnings over time, where wealth is the value of
assets minus liabilities.
• Functions of money:
– Medium of exchange: Money must serve as a medium of exchange. It needs
to be commonly accepted for the purchase of goods and services.
– Unit of account: Money must be able to measure the value of a good or
service. It serves as a yardstick for comparison.
– Store of value: Money must be able to hold value over time.
• Liquidity: is a measure of the ease with which an asset can be turned into
a means of payment.
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5. Credit and Debit Cards
• Are credit/debit cards money?
• A debit card works like a check only faster.
Funds are immediately removed from your
account.
• A credit card makes a deferred payment.
– If not paid on time, there is a late fee.
– If not paid fully, there is interest on the debt.
– It is an interest free loan for a period of time.
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6. Evolution of the Payments
System
• Commodity Money:
– valuable, easily standardized and divisible
commodities (e.g. precious metals, cigarettes)
• Fiat Money:
– paper money decreed by governments as legal
tender

7. Evolution of the Payments
System
• Checks:
– an instruction to your bank to transfer money
from your account
• Electronic Payment (e.g. online bill pay).
• E-Money (electronic money):
– Debit card
– Stored-value card (smart card)
– E-cash

8. Are We Headed for a Cashless
Society?
• Predictions of a cashless society have been
around for decades, but they have not come to
fruition.
• Although e-money might be more convenient and
efficient than a payments system based on paper,
several factors work against the disappearance of
the paper system.
• However, the use of e-money will likely still
increase in the future.

9. Will Bitcoin Become the
Money of the Future?
• Bitcoin is type of electronic money created in
2009.
• By “mining,” Bitcoin is created by decentralized
users when they use their computing power to
verify and process transactions.
• Although Bitcoin functions as a medium of
exchange it is unlikely to become the money of
the future because it performs less well as a unit
of account and a store of value.

10. Bitcoin
• Bitcoin is “a decentralized peer-to-peer
network that allows for the proof and transfer
of ownership with the need for a trusted third
party.”
– The technology used to record Bitcoin ownership
is the block chain
• The block chain is an ever-growing public
ledger of transactions that is encrypted and
distributed over a network of computers.
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11. Bitcoin
• Advocates view Bitcoin as a new form of digital
money with two advantages
– 1. Its value cannot be undermined by government
fiat
– 2. Its users can remain anonymous
• Bitcoin lacks the key characteristics of money
• Can private currency—digital or otherwise—do a
job better as money than what we currently
have?
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12. Commodity and Fiat Monies
• Commodity monies are things with intrinsic
value.
– Usable by most people
• Able to be made into standardized quantities, durable,
easily transportable, and divisible into smaller units.
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13. History of Commodity and
Fiat Money
• Gold has been the most common as it meets these requirements.
• In 1656, Stockholm Banco issued Europe’s first paper money King
of Sweden printed too many to try to finance a war and the bank
failed.
• In 1775, the Continental Congress of the United States of America
issues continentals to finance the Revolutionary War.
• Because of huge quantities issued, people became suspicious of
government-issued paper money.
• In 1862, the Confederate and the Union governments printed
money with no backing. After the Civil War, the US reverted to
using gold as money.
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14. Fiat Money
• Gold coins and notes, backed by gold, were used
into the 20th century.
• Todays paper money is called fiat money, because
its value comes from government decree, or
fiat.
• We are willing to accept these bills as payment
because the US government stands behind its
paper money.
• In the end, money is about trust. (Discuss more in
monetary policy goals and objectives)
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15. Money and Inflation
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16. Monetary Aggregates
• M0 or Monetary Base includes currency and
bank reserves
• M1 includes currency, checkable deposits and
travelers checks.
• M2 includes M1 plus savings accounts, money
market accounts, short term time deposits,
other stuff.
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17. Monetary Aggregates
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Value (billions)
M1 = Currency $1,598.6
(+) Traveler’s checks $.....
(+) Demand deposits $1,433.9
(+) Other checkable deposits $621.8
Equals Total M1 $3,656.1
M2 = M1
(+) Small-denomination time deposits $491.3
(+) Savings deposits and money market deposit accounts $9,275.4
(+) Money market mutual fund shares (retail) $767.9
Equals: Total M2 $14,190.6

18. Components of M1
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19. Components of M2
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20. Money, Inflation, and Interest
• With inflation, you need more money to buy
the same basket of goods.
– The primary cause of inflation is too much money.
– How do we define money?
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21. Growth of M1 and M2
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22. Money and Inflation
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23. Q-Theory of Money
• The quantity theory of money states that the
price level is proportional to the level of money:
– Mt x Vt P t x Yt
– where M is the supply of money, V is the velocity of
money which equals the average number of times per
period that each unit of money is spent, P is the price
index of the items traded, and Y is real GDP.
• The right hand side is nominal GDP
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24. Q-Theory of Money
• Two key assumptions:
– The velocity (V) of money is constant in the short
run
– Changes to P do not affect Y, Y is considered
constant in the short run.
• These assumptions imply:
• 𝑀 × 𝑉 = 𝑃 × 𝑌
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25. Velocity of Money
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26. Velocity of Money
• We can also use the equation of exchange to show the
relationship between money and inflation:
• %∆M + %∆V = %∆P + %∆Y
• Subtract %∆Y from both sides then:
• π = %∆P = %∆M + %∆V − %∆Y
• If we assume velocity is held constant then:
• π = %∆M − %∆Y
• Inflation will increase as money growth exceeds output
growth.
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27. Predicting Velocity
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28. Predicting Velocity
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29. Money and Inflation
• How robust is the relationship between money and
inflation?
• The relationship between money growth and inflation does
hold in the long run but not in the short run.
• This suggests that money is not neutral in the short run. We
can use money to change output.
• Since money is not neutral we can use monetary policy in
the short run (and perhaps long run).
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