In these notes:
I.    Introduction to Money and Banking
II.  Real vs. nominal magnitudes
III. Prices and inflation

I.  INTRODUCTION TO MONEY AND BANKING

Money and Banking, as I teach it, is basically an applied macroeconomics course, with an emphasis on real-world institutions and policy. Monetary policy, as carried out by the nation's central bank, the Federal Reserve System (the "Fed"), is the main component of economic policy today.  The Fed is a non-governmental (yet not quite fully private) institution that exerts great influence on the economy by regulating the money supply and interest rates. If you want to understand the U.S. economy today, you need to understand monetary policy.

That's the money side of the course -- namely, knowing what money is, how the money supply is measured and how it affects the economy, and how the Federal Reserve controls the money supply in order to influence the economy, especially the rate of GDP growth and the rate of inflation.

Now, what is money? First, here's what is isn't. In the context of this course:
MONEY is not the same thing as INCOME or WEALTH

While in ordinary conversation we commonly use the word money to mean income ("he makes a lot of money") or wealth ("she has a lot of money"), in macroeconomics courses like this one money means something quite different, namely:

money = anything that is generally accepted as payment

Q: What is money? That is, what counts as money?
A:  Obviously, cash -- dollar bills, coins -- is a form of money.

Q:  Is there anything else that counts as money?
A: Checks.  (And the broader measures of the money supply include all other types of bank accounts as well.)

Q: Are credit cards money?
A: No. They're not legal tender. What a credit-card purchases really represents is just an extremely convenient, pre-approved loan. It's only part of the transaction, since the merchant then goes to the bank that issued the credit card to get money, and the bank sends you a bill which must be paid with money.

When economists talk about the "money supply," we mean something very different from national income (~GDP) or national wealth.  The money supply is a lot smaller than national income or national wealth.  Generally speaking,
money supply = cash in circulation + bank account deposits
-- There are several standard measures of the money supply.  The narrowest, and simplest, is "M1," or "transactions money," which corresponds closely to the definition of money as things that are generally accepted as payment:
---- M1 = cash in circulation + checking deposits (+ travelers' checks + money orders)
------ (The last two items are in parentheses because they are so small as to be just about negligible.)
------ M1 is about one trillion dollars, or about one-tenth of GDP, right now.

The other two measures of the money supply are M2 (which used to be called "broad money") and M3 (the largest).
---- M2 = cash + checking deposits (+ travelers checks and money orders) + savings & money-market deposits + small CD's (under $100,000) + MONEY-MARKET fund shares(held by individuals)
---- M3 includes everything in M2, as well as CD's and money-market funds that are large and/or held by institutions, plus several items that are basically sources of funds for banks.  (More on M3 in a later chapter.)

Q:  Why should we care about the money supply?
A:  The money supply (M^s) matters because it affects three very important things:  economic recessions, the price level, and inflation:

(1) Recessions may be caused by steep declines in the M^s growth rate
-- In the past 50 years, there have been eight recessions, and every single one of them was preceded by a notable decline in the money (M2) growth rate. Then again, not every decline in the M2 growth rate was followed by a recession -- thus the old joke that "economists have predicted twelve of the last eight recessions."
---- [Refer to Mishkin's Chapter 1, Figure 4 (p. 9).]

(3) Inflation: faster M^s growth rates tend to cause higher rates of inflation
-- From international comparisons we see a tight relationship between money (M2) growth rates and inflation rates. A hyperinflation (explosive growth of prices, inflation rates of over 50% per month, or well over 1000% per year) is impossible without extremely rapid money-supply growth.
---- [Refer to Mishkin's Chapter 1, Figure 6 (p. 11), which shows a cross-country comparison for the 1990s.]
------> Q: Since money supply growth is inflationary, and perfect price stability (0% inflation) seems like an ideal, wouldn't we be better off keeping the money supply perfectly stable, and not increasing it at all?
 ------ A: No. Money demand (people's demand for money for their transactions and savings) increases virtually every year as the volume of transactions (real GDP) increases, and if the money supply did not keep pace with money demand, then the economy would run into serious problems -- cash shortages, sky-high interest rates, and probably recession.

M1 is the narrowest measure of the money supply, including only cash, checking account deposits, and travelers checks. M2 includes everything that is in M1 and also includes savings and money-market deposit accounts, small-denomination certificates of deposit (CD's or time deposits), and money-market mutual fund shares held by individuals. M3 is broader still, as it includes everything in M1 and M2 and also larger, institutional holdings of CD's and money-market funds, plus two key sources of borrowed funds for banks, term repurchase agreements (repos) and term Eurodollars.

("Small" time deposits, incidentally, are defined as those of less than $100,000, perhaps because $100,000 is the amount up to which deposits are insured by the Federal Deposit Insurance Corporation, or FDIC.)

Both the Money component and the Banking component of this course will be prominent in every lecture and in every chapter. One important place where money and banking intersect is in the determination of interest rates. In fact, if this course could be summed up in two words, we'd say:

The first several weeks of this course will revolve around interest rates -- understanding the different types of interest rates, seeing how they relate to bond prices, what causes them to change, how long-term rates relate to short-term rates, etc. Then, later in the course, we'll see how interest rates are affected by changes in the money supply and money demand, and how they exert enormous influence over the economy.

We say that money and banking intersect in the determination of interest rates because the interest rate is the "price" of money, and interest rates are usually posted by banks.   A BANK is defined as a financial institution that accepts deposits and makes loans.  Both deposits and loans involve interest.

II.   REAL VS. NOMINAL MAGNITUDES

Two important definitions:

NOMINAL: pertaining to an absolute measure of some economic variable (income, wealth, price, e.g.), without regard to its actual purchasing power or value relative to other things

REAL: inflation-adjusted; relative to the general price level

-- Exs.:
 

NOMINAL	REAL
Nominal GDP was $120 billion larger in 1982 than in 1981.	Real GDP (as measured in constant, 1981dollars) was $59 billion lower in 1982 than in 1981.(The economy was in a severe recession in 1982.)
The current price of a gallon of gas is a lot higher than when I was a kid in the 1970s. I remember when it was only about 75 cents a gallon.	Relative to other prices (in the consumer price index), gasoline is cheaper today than it ever was in the 1970s. That is, adjusted for inflation, gas is much cheaper today then it was then.

Real magnitudes, not nominal magnitudes, are what's most relevant economically.
-- When economists say "Get real" (and we say it a lot), we mean "adjust for inflation."

III. PRICES AND INFLATION

Aggregate price level: an index of the average prices of goods and services in the economy
-- Exs.: Consumer price index, Wholesale price index, GDP deflator
- The price level -- in this case, the Consumer Price Index (CPI) -- is an index, which has been set equal to 100 for a chosen base year, which we use as a basis for comparisons. Currently the base year is the average of three years, 1982-84. If the CPI was 160 in 1995, then average prices were 160% as high, or 60% higher, in 1995 than they were in 1982-84.

Inflation: a continual increase in the price level
Deflation:        "        decrease           "

Inflation rate: the yearly percent change in the price level

Aside: How to calculate a percent change in general:

                                 (New value) - (Old value)
   Percent change = ---------------------------------   ( * 100%)
                                           (Old value)

   or, a bit more compactly,

                                     (New value)
    Percent change  = { -----------------  - 1  }  (* 100%)
                                 (Old value)

To calculate the inflation rate for a given year, from price-level figures for consecutive years (or monthly figures that are twelve months apart):

                          (Price level in that year) - (Price level in the previous year)
Inflation rate = -----------------------------------------------------------------------------   (* 100%)
                                                 (Price level in the previous year)

                                  (Price level in that year)
OR                       { ------------------------------------------- - 1 } * 100%
                             (Price level in the previous year)

Ex.:
Q: Suppose the Consumer Price Index was 160 in 1995, and 164 in 1996. What was the inflation rate in 1996?
A: Inflation rate = (164-160)/160 = 4/160 = 1/40 = 1/4 * 1/10 = .25 * .10 = .025 = 2.5%