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Unformatted text preview: Money Demand and Velocity Pamela Labadie Fall 2010 Money is defined as anything accepted as a means of payment for goods and services or repayment of a debt. Money is an old invention that has three basic functions: 1. Store of Value- purchasing power can be stored over time. 2. Unit of Account- even if we evolve into a cashless society, we will still use the $ as a unit of account to measure value. 3. Medium of exchange : avoids the double coincidence of wants and decreases search and transactions costs, promoting efficiency. A key characteristic of money is that it is liquid. Definition : Liquidity is the relative ease with which an asset can be converted into a medium of ex- change. This is a subtle concept. It includes the property that the sale of an asset doesnt change its price. Money has taken many forms - well discuss 2 basic categories: 1. Commodity money A commodity money system is one in which the good circulating as money actually has direct value in consumption. The usual examples are precious metals such as gold or silver. The gold or silver may circulate or else paper currency that is convertible or redeemable into a fixed amount of gold or silver may circulate. If paper currency is convertible into a fixed amount of a commodity that has intrinsic value, we say the currency is backed . 2. Fiat money The other currency system is fiat money. Fiat money is unbacked and intrinsically worthless. The U.S. dollar is a fiat money system. There is no fixed amount of gold backing the dollar and the dollar has value only because it can be used as a medium of exchange. Essentially there is an element of trust in 1 a fiat money system. Governments like fiat money systems because it is low cost and creates revenue for a government. If a 10 dollar bill costs 25 cents to print, then by printing the bill the government creates revenue of $9.75. Revenue generated by printing fiat currency is called seignorage . Money Demand There are many forms of the money demand function. Heres a partial list of some things that affect money demand: 1. Wealth: If wealth rises, then money demand rises. 2. Risk: If interest-bearing assets become riskier, people wealth to safer assets like money, and hence money demand rises. 3. Liquidity of alternative assets: If interest-bearing assets become more liquid, then people shift away from holding money towards interest bearing assets. Money demand falls. 4. Efficiency of payments systems: If it is easy to transfer funds, pay bills and carry out transactions, then people will hold less money. Example: ATMs vs standing in line at the bank - if there were no ATMs and bank lines are long, your average cash withdrawal each visit would be larger and less frequent. Hence improvements in the efficiency of payments systems lowers money demand....
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This note was uploaded on 02/01/2011 for the course ECON 121 taught by Professor Labadie during the Fall '10 term at GWU.
- Fall '10