Functions and measures of money
Money serves as a means of payment (i.e., a method of settling a debt), but it also has three additional functions:
it is a medium of exchange (allowing us to avoid an inefficient barter economy -- trading goods and services for other goods and services directly);
a unit of account (simplifying comparisons of the relative values of different goods and services); and
a store of value (because it can be held and exchanged later for goods and services). Note that persistent inflation reduces the utility of money as a store of value; cf., Zaire.
In a modern economy, money consists of currency and deposits at banks and other financial institutions. We use two principal measures of money: M1 and M2. M1 is the narrower measure of the two, and includes currency in circulation outside of banks (not held by the U.S. government), traveler's checks, and checking deposits of individuals and businesses. M2 consists of M1 plus savings deposits, time deposits (deposits with a fixed term to maturity), and money market mutual funds. These two monetary aggregates and their growth over time are closely watched, for reasons that we shall see soon.
As Parkin's Fig. 13.1 nicely shows, currency is a rather minor part of the total stock of money, representing just over 30 percent of M1 and not quite 10 percent of M2. Checking deposits represent 69 percent of M1 and 22 percent of M2, while savings deposits are the single largest component, accounting for nearly 35 percent of M2. Time deposits and money market funds represent the remaining 33 percent of M2.
(Financial intermediaries like banks play an important role in the economy, and as you will see later this week in recitations, they serve to create money in the form of deposits by virtue of their ability to make loans.)
Money, real GDP, and the price level
Now we turn to a consideration of the effects of a change in the quantity of money on the economy. As before, the aggregate supply-aggregate demand (AS-AD) model provides a framework for our analysis.
As we noted when we first introduced the AS-AD model, increases in the supply of money tend to increase aggregate demand both directly (more money available tends to increase demand for goods and services) and indirectly (an increased quantity of money means that banks have more to lend, and typically interest rates decline, thereby increasing invest-ment expenditures and expenditures on consumer durable goods).
In the short run, then, an increase in the quantity of money will ordinarily result in an increase both in real GDP and the price level. The mix of these two elements will depend on how steep or flat the SAS curve is, and on how large is the change in the quantity of money.
In the long run, by contrast, the effect of a change in the quantity of money will be entirely on the price level. That is, following an initial rise in GDP and the price level, there will eventually be a corresponding rise in wages causing a leftward shift of the SAS curve and yielding a new equilibrium as shown below.
The quantity theory of money underlies the long-run effect just described. More specifically, the quantity theory of money holds that in the long run, an increase in the quantity of money will bring an equal percentage increase in the price level.
Parkin provides an explanation of the quantity theory of money and its link to the AS-AD model. Without going into the details, I'll simply note the key aspects: in the long run the quantity theory and the AS-AD model have the same prediction (an increase in the quantity of money will bring an equal percentage increase in the price level), while in the short run there is a less precise link between the quantity of money and the price level.
Parkin presents an overview of both historical evidence on the quantity theory for the U.S. and international comparisons. He notes that in looking at historical evidence, one must take into consideration growth in potential GDP, so the quantity theory's prediction should be modified to the following: the inflation rate in the long run will equal the rate of growth of the money supply minus the growth rate of potential GDP. In brief, he finds evidence broadly consistent with the data.
Note the implication for policy: to achieve no inflation in the long run, the money supply should grow at the rate of growth of potential GDP.
Finally, note the natural experiment in Zaire that provides an excellent illustration of the quantity theory of money. (This will be discussed in lecture)