144 ❯ Step 4. Review the Knowledge You Need to Score High
What does this all mean? It means that your friend, as a borrower, must pay you $21 to
compensate you for the fact that he has your $100 for a period of two years. It also says that
had you, as a saver, put the $100 in the bank today, two years from now, you would have
$121 to spend on goods and services. This implies that you would be completely indifferent
to having $100 in your hand today or $121 two years from today. The differing sums are
equivalent units of purchasing power, just measured at two different points in time, and it
is the interest rate that equates the two.
So, to summarize:
• Money today is more valuable than the same amount of money in the future.
• The present value of $1 received one year from now is $1/(1 + r).
• The future value of $1 invested today, for a period of one year, is $1 × (1 + r).
• Interest paid on savings and interest charged on borrowing is designed to equate the
value of dollars today with the value of future dollars.Supply of Money
At the core of monetary policy is regulation of the supply of money. Because our paper
money is not backed by precious metals or crown jewels, we trust the government to
keep the value of our money as stable as possible. This value is guaranteed by stabiliz-
ing the money supply, which is measured by the central bank as M 1 and M 2 ; the
latter being more broadly defined and less liquid than the former. Liquidity refers to
how easily an asset can be converted to cash. A five-dollar bill, already being cash, is as
liquid as it gets. A Van Gogh painting hidden in your attic is also an asset but not a
very liquid one.
We can say that:
• M 1 = Cash + Coins + Checking deposits + Traveler’s checks. M1 is the most liquid of
money definitions.
• M 2 = M 1 + Savings deposits + Small (i.e., under $100,000 certificates of deposit) time
deposits + Money market deposits + Money market mutual funds. M2 is slightly less
liquid because the holders of these assets would likely incur a penalty if they wished to
immediately convert the asset to cash.
At any given point in time, the supply of money is a constant. This implies that the
current money supply curve is vertical. Because other measures of money supply are based
upon the most liquid M1, when we discuss the money supply, we focus on M1. Insight
gained from studying the expansion and contraction of M1 can be applied to M2.Demand for Money
People demand goods like cheese because cheese helps satisfy wants. People demand money
because it facilitates the purchase of cheese and other goods. In addition to this transaction
demand for money, people also demand money as an asset, just as a government bond or a
share of Intel stock is an asset. We quickly look at demand for money as the sum of money
demand for transactions and money demand as an asset.
Transaction Demand. As nominal GDP increases, consumers demand more money
to buy goods and services. For a given price level, if output increases, more money is
demanded. Or for a given level of output, if the price level rises, more money is demanded.
If nominal GDP is $1,000 and each dollar is spent an average of four times each year,
money demand for transactions would be $1,000/4 = $250. If nominal GDP increases to
$1,200, money demand for transactions increases to $1,200/4 = $300. We assume that the
nominal rate of interest does not affect transaction demand for money, so when plotted on
a graph with the nominal interest rate on the y-axis, it is a constant.TIPKEY IDEA“There are a
couple of ques-
tions on this.
Know what
is included in
each category.”
—Kristy,
AP Student