Macroeconomics: Third Edition

Macroeconomics
Third Edition
Chapter 11
The Monetary System
Copyright © 2022, 2018, 2014 Pearson Education, Inc. All Rights Reserved
Key Ideas (1 of 3)
1. Money has three key roles: serving as a medium of
exchange, a store of value, and a unit of account.
2. The quantity theory of money describes the
relationships among the money supply, velocity, prices,
and real GDP.
Key Ideas (2 of 3)
3. The quantity theory of money predicts that over the
long-run, the inflation rate will equal the growth rate of
the money supply minus the growth rate of real GDP.
4. The Federal Reserve, the U.S. central bank, has a dual
mandate—low inflation and maximum employment.
Key Ideas (3 of 3)
5. The Federal Reserve holds the reserves of private
banks.
6. The Federal Reserve’s management of private bank
reserves enables the Fed to do three things: (1) set a
key short-term interest rate; (2) influence the money
supply and the inflation rate, and (3) influence long-term
real interest rates.
Money (2 of 11)
Money is an asset that people use to make and receive
payments when buying and selling goods and services.
Money (3 of 11)
Money serves three functions in a modern economy:
1. It is a medium of exchange.
2. It is a store of value.
3. It is a unit of account (measure of worth).
Money (4 of 11)
A medium of exchange is an asset that can be traded for
goods and services.
Money (5 of 11)
A store of value is an asset that enables people to transfer
purchasing power into the future.
Money (6 of 11)
A unit of account is a universal yardstick that is used to
express relative prices of goods and services.
Money (8 of 11)
Answer:
Function
Function Function
Item Medium of
Store of Value Unit of Account
Exchange
Sea shell Yes No Yes
Gold coin Yes Yes Yes
Cow Yes Yes No
U.S. dollar Yes Yes Yes
Bitcoin Yes Yes Yes
Money (9 of 11)
The U.S. dollar and other national currencies are examples
of fiat money.
Fiat money
An asset that is used as legal tender by government decree
and is not backed by a physical commodity like gold.
Money (10 of 11)
The money supply (M2) is the sum of currency in
circulation, checking accounts, savings accounts, and most
other types of bank accounts.
Money, Prices, and GDP (1 of 12)
Let’s remember a few definitions from Chapter 5:
• Nominal GDP is the total value of production (final goods
and services), using the prices from the same year the
output was produced.
• Real GDP is the total value of production (final goods and
services), using fixed prices taken from a particular base
year (which may or may not be the year the output was
produced).
Consider the Island of Dr. Jay, which produces only
basketballs.
Calculate nominal and real GDP for the base year of 2019:
Basketballs Basketballs
Year Number Price Nominal GDP Real GDP
Blank Blank
2019 10 $80
Blank Blank Blank Blank
2020
Suppose that nominal GDP increases to $1,000 in 2020,
but the source of the increase is unknown:
We will consider two possible scenarios.
2019 10 $80 $800 $800
2020 ? ? $1,000 ?
Scenario A:
2019 10 $40 $800 $800
blank
2020 25 $40 $1,000
Calculate the level of real GDP in 2020.

Calculate the growth rate of real GDP.
Calculate the growth rate of prices.
Scenario A:
2019 20 $40 $800 $800
2020 25 $40 $1,000 $1,000
$1000  $800
The growth rate of real GDP is  0.25
$800
$0
The growth rate of prices is  0.00
$40
Scenario B:
2019 20 $40 $800 $800
Blank
2020 20 $40 $1,000
Calculate the level of real GDP in 2020.

Calculate the growth rate of real GDP.
Calculate the growth rate of prices.
Scenario B:
2019 20 $40 $800 $800
2020 20 $50 $1,000 $800
$800  $800
The growth rate of real GDP is  0.00
$800
$50  $40
The growth rate of prices is  0.25
$40
Here is a summary of our results:
Growth Rate of Growth Rate of Real Growth Rate of Prices
Scenario Nominal GDP GDP
A 25% 25% 0%
B 25% 0% 25%
Under each scenario, we found that:
Growth rate of nominal GDP = Growth rate of real GDP +
Growth rate of prices
We can now define the nominal GDP growth equation as:
Growth rate of nominal GDP = Growth rate of real GDP +
Inflation rate
The quantity theory of money predicts a simple relationship
between the money supply and nominal GDP.
It predicts that over the long run:
Growth rate of money supply = Growth rate of nominal GDP
• From the nominal GDP growth equation:
– Growth rate of nominal GDP = Growth rate of real
GDP + Inflation rate
• From the quantity theory of money:
– Growth rate of money supply = Growth rate of
nominal GDP
• It follows that the inflation equation can be written as:
– Inflation rate  growth rate of money supply 

growth rate of real GDP
Inflation (1 of 7)
• What Causes Inflation?
– The quantity theory of money implies that inflation
occurs when the growth rate of money supply exceeds
the growth rate of real GDP. This relationship is
illustrated by the inflation equation.
– The exhibit on the next slide demonstrates the inflation
equation by using data from 110 countries during the
period 1960-1990.
Inflation (2 of 7)
Some distinctions:
• Inflation
– A situation of rising prices.
• Deflation
– A situation of falling prices (negative inflation).
• Hyperinflation
– A situation of extreme inflation where prices double
within three years.
Inflation (3 of 7)
Under inflation, all prices and all wages do not always
move together.
Under inflation, some relative prices, including the real
wage and real interest rate, can change.
This creates winners who benefit from unexpected gains
and losers who suffer from unexpected losses.
Inflation (4 of 7)
Who wins and who loses from unexpected inflation?
Winners:
1. A homeowner paying a mortgage at a fixed rate of
interest
2. The owners of a firm (shareholders) paying a pension
that is not indexed for inflation
Inflation (5 of 7)
Losers:
1. A bank receiving payments on a mortgage at a fixed
rate of interest
2. A retiree receiving a pension that is not indexed for
inflation
3. Workers who are unable to change their nominal wages
Inflation (6 of 7)
Inflation imposes social costs
such as:
1. Raising logistical cost.
2. Inflation can lead to
counterproductive policies
such as price controls.
Inflation (7 of 7)
Inflation generates social benefits such as:
1. Generating government revenue from printing currency
(seigniorage)
2. Sometimes stimulating economic activity

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Macroeconomics

Gold coin Yes Yes Yes

Cow Yes Yes No

U.S. dollar Yes Yes Yes

Bitcoin Yes Yes Yes

2020 25 $40 $1,000

Calculate the level of real GDP in 2020.

2020 25 $40 $1,000 $1,000

2020 20 $40 $1,000

Calculate the level of real GDP in 2020.

2020 20 $50 $1,000 $800

– Inflation rate  growth rate of money supply 

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