Circuitism: A macroeconomic explanation of how banks create money for production activities, how firms direct production, how workers contribute to production and consumption and how money from. Real (inflation-adjusted) GDP, a key measure of economic growth, is expected to increase 3.3% in 2018 and 2.4% in 2019, versus 2.6% in 2017. It is projected to average 1.7% from 2020 to 2026 and 1.8% in 2027–2028. Over 2017–2027, real GDP is expected to grow 2.0% on average under the April 2018 baseline, versus 1.9% under the June 2017.

• Fed Vs Real Money Trade
• Fed Vs Real Money Trading
• Fed Vs Real Money Market
• Fed Vs Real Money
• Fed Vs Real Money Vs

Last updated: February 2, 2000

Note: These notes are preliminary and incomplete and they are not guaranteed to be free of errors. Please let me know if you find typos or other errors.

The Asset Market

Up to now we have covered (1) the labor market and the production function, where real wages, employment and potential output is determined, and (2) the market for goods and services, where the real interest rate and investment and saving are determined. Now we consider the market for financial assets (money and 'bonds') by focusing on the demand and supply of money in the economy. This will give us insights into other forces on interest rates - particularly those created by the Fed - and also on the ultimate determinants of inflation.

What is Money?

• Medium of exchange - barter is inefficient.
• Unit of account - money is the basic unit for measuring economic value.
• Store of value - money can be used to hold wealth.
• Low return (interest rate) - money pays no interest
• Low risk - money is a 'safe' asset in low inflation times
• High liquidity - money is the most liquid asset (money is accepted immediately for almost all transactions)

Definitions of monetary aggregates

In this class, when we talk about the nominal money supply we will generally be referring to the monetary aggregate M1. Hereafter, the symbol 'M' will denote M1.

Fed Vs Real Money Trade

The supply of money

The Federal Reserve Bank (Fed)

The Federal Reserve Bank (Fed) ultimately controls the supply of money in the economy. (How it does this and how the banking system works is detailed in the lectures on the Fed and Monetary Policy.) The Fed is the central bank for the U.S. and is a quasi-private entity (technically owned by private banks) created by the Federal Reserve Act in 1913. There are twelve regional Federal Reserve Banks across the country and the leadership of the system is conducted by the Board of Governors of the Federal Reserve System (Federal Reserve Board ). The Board consists of seven governors, appointed by the President to staggered fourteen-year terms. The President appoints one Board member as chairman - currently Allen Greenspan - for a term of four years. It is important to keep in mind that the Fed operates independently of the federal government. Congress and the President do not have direct control over the operations of the Fed.

How the Fed Controls the Money Supply

The Fed primarily controls the supply of money (M1) in the economy through what are called open market operations. These are the purchase and sale of government bonds by the Fed. The Fed operates the printing presses for the creation of currency. The Fed also owns a substantial amount of U.S. government bonds. When the Fed wants to increase the supply of money it performs an open market purchase of government bonds. That is, the Fed buys (by printing money) outstanding government bonds from the public or new government bonds from the Treasury (to finance the current deficit). This operations injects new cash into the economy. Conversely, when the Fed wants to decease the amount of money in the economy it performs an open market sale of government bonds. Here, the Fed sells some of its holdings of government bonds to the public in exchange for cash. This operation takes cash out of the economy.

Portfolio Allocation and the Demand for Assets

Portfolio theory tells us how individuals allocate their wealth among a number of financial assets (e.g. stocks, bonds, real estate, money). In general an individual's demand for assets is based on comparing the benefits of costs of holding different kinds of assets. These costs and benefits are functions of the following assets characteristics:

• Expected return - expected gain (or loss) from holding an asset over a particular investment horizon
• Risk - the degree of uncertainty in an asset's return
• Liquidity - the ease and quickness that an asset can be traded

An individual's demand for money is then based on the costs and benefits of holding money. As an asset, money has a very low expected return (it pays no interest), is very safe (the gov't guarantees its nominal value) and is the most liquid asset.

Simplifying assumptions

Since the general asset allocation problem involves many different kinds of assets with different risk and return characteristics we simplify this decision by assuming that there are only two kinds of financial assets in the economy.

• Money assets - low return, high liquidity and low risk. i_m = nominal interest rate on money assets (very low).
• Non-money assets (bonds) - higher return than on money assets and less liquidity. We assume that the risk associated with investing in bonds is not too high (think of government bonds as the generic non-money asset). Let i denote the nominal interest rate on non-money assets. Note that, by assumption, i > i_m. Also, recall that i = r +p^e, where r denotes the real return on non-money assets and p^e denotes expected inflation.

Behavorial Model for Money Demand

Our model for the demand for nominal money balances takes the following form

Fed Vs Real Money Trading

M^d = P·L^d(Y, i)

where

• M^d = demand for nominal money balances (demand for M1)
• L^d= demand for liquidity function
• P = aggregate price level (CPI or GDP deflator)
• Y = real income (real GDP)
• i = nominal interest rate on non-money assets

Discussion

• Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions.
• As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions. This is the liquidity demand for money.
• As the nominal interest rate on non-money assets (bonds), i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases.
• Since i = r + p^e, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).

The demand for real balances

Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P. This gives the liquidity demand function or the demand for real balances function:

MD = M^d/P = L^d(Y, i)

Fed Vs Real Money Market

The left-hand-side of the above equation is the demand for nominal balances divided by the aggregate price level or the demand for real balances (the real purchasing power of money). The right-hand side is the liquidity demand function. The demand for real balances is decomposed into a transactions demand for money (captured by Y) and a portfolio demand for money (captured by i).

The real money demand function is graphed below:

Whenever income or expected inflation change the real money demand curves shifts. For example, if Y increases the real money demand function shifts up and right; if expected inflation increases the real money demand function shifts down and left.

Equilibrium in the money market

Real money demand and the real money supply as functions of the real interest rate are illustrated in the above graph. Real money demand is graphed holding fixed real income and expected inflation. The real money supply is equal to the nominal amount of M1, denoted M₀, divided by the fixed aggregate price level, P₀. It is assumed that the Fed does not alter the money supply based on the valued of the real interest rate. Therefore, the real money supply function is a vertical line in the graph with the real interest rate on the vertical axis and real money balances on the horizontal axis.

Notice that real money demand and real money supply intersect when the real interest rate is r₀. This is the value of the real interest that equates money demand with the money supply and establishes equilibrium in the money market. When the money market is in equilibrium there are no economic forces acting on the economy to alter the real interest rate.

If the real interest rate were r₁ then the demand for real balances would be greater than the fixed supply of real balances (as illustrated above). In this case we say there is an excess supply of money in the money market. Practically, what this means is that individuals are holding more money than they would like given the high real interest rate. Accordingly, individuals will attempt to rebalance their portfolios; i.e. they will try to get rid of money by buying bonds (our generic non-money asset). In doing so the demand for bonds increases and so the price of bonds increases. Because bond prices are inversely related to the interest rate on bonds, the increased price of bonds lowers the real return on bonds (holding expected inflation fixed). Therefore, the excess supply of money at r₁ (dis-equilibrium in the money market) leads to economic forces that act to lower the real interest rate. These forces cease to operate when the real interest falls to r₀ where the demand for real balances is equal to the supply of real balances.

Comparative statics

Increase in the nominal money supply (M)

Consider the money market initially in equilibrium at r = 6% as illustrated in the above graph.. Suppose the Fed increases the nominal money supply by an open market purchase of government bonds. This increases the money supply from M₀ to M₁. Holding the price level fixed, this increases the supply of real balances from M₀/P₀to M₁/P₀. If the real interest rate stays at 6% then the supply of real balances will be greater than the demand for real balances: there will be an excess supply of money in the money market. Consequently, individuals will try to get rid of the excess money by buying bonds which puts downward pressure on the real interest rate (holding expected inflation fixed). As r drops we move along the liquidity demand curve toward the new equilibrium at r = 5%.

Increase in the aggregate price level (P)

Consider the money market initially in equilibrium at r = 6% described in the graph below. Now suppose that the aggregate price level increases from P₀ to P₁. Holding the nominal money supply fixed, this reduces the supply of real balances from M₀/P₀ to M₀/P₁. If the real interest rate stays at 6% the supply of real balances will be less than the demand for real balances: there will be an excess demand for money. The excess demand for money will prompt individuals to sell bonds (demand for bonds falls) and so the real interest rate on bonds will rise. As r rises, we move up along the liquidity demand curve toward the new equilibrium at r = 7%.

Consider the money market in equilibrium at r = 6% as illustrated above. Suppose that current income (Y), which is the same as current output (GDP),. Increases from Y₀ to Y₁. This increases the transactions demand for money as so the real money demand curve shifts up and to the right. If the real interest rate stays at 6% there will be an excess demand for money which puts upward pressure on the real interest rate. As r increases, we move along the money demand curve up towad the new equilibrium at r = 8%.

The Federal Reserve - Why US Currency is Not Real Money

Gold and silver are considered real money in most parts of the world. Even in the united states of America, legal tender was backed by gold or silver until 1968 when the Federal Reserve Bank, finally convinced the congress to allow the FRB to remove any kind of real money backing whatsoever.

Before we get into how the Federal Reserve Bank operates, we should comprehend what money is. So let us take a look at the definition of 'money' from before the Federal Reserve Bank 'changed' it for most Americans. In Black's Law Dictionary, 4th edition, we find,

“MONEY. In usual and ordinary acceptation it means gold, silver, or paper money used as circulating medium of exchange, And does not embrace notes, bonds, evidences of debt, or other personal or real estate. Lane v. Railey, 280 Ky. 319, 133 S.W.2d 74, 79, 81.”

So now we are all clear that 'money' means gold or silver or a paper representation of gold or silver. We will take a look at one of the 'paper representations' below. We also know that it does not mean a promisory note or an I owe you.

An understanding of how the Federal Reserve Bank operates in conjunction with the federal government is important to understand why we would no longer have a gold standard for currency. The Federal Reserve Bank purchases, at cost, currency from the United States. The cost is about 2 ½ cents per bill. It matters not whether the bill is a 1 dollar bill or a 1,000 dollar bill. The cost is 2 ½ each. The federal reserve bank then loans the money back to the federal government at face value and is paid back with interest. The interest is in the form of funds collected through the voluntary 'income tax' system.

If the FRB was required to back money with gold, then it could not have so much money at the stroke of a keyboard. All they have to do is tell the federal government when to print more money, the federal government then applies ink to paper, and presto, money magically appears.

Fed Vs Real Money

One of the ways that the FRB has taken gold out of the standard is by, through the lending industry, not accepting gold or silver as a 'liquid asset'. What the lending industry is saying is 'We don't accept money as a liquid asset.' After wall, isn't that what gold and silver coins are? They are money. What some people do not realize, is the value of gold and silver has not risen in the last century. That is why the dollar amount imprinted on a one ounce gold coin is still $50. What has changed is the value of the currency that the federal government permits to be used. This currency is debt back by debt.

We used to back our money with gold or silver. US currency actually stated on the bill that it was redeemable for X amount of gold or silver or it was redeemable for X 'Dollars'. You won't find anything of the sort on a Federal Reserve Note.

The following is a ten dollar bill printed in 1934. Note the large print along the center bottom states, 'WILL PAY TO THE BEARER ON DEMAND TEN DOLLARS'. Obviously, that indicates that the bill itself is not in fact money at all, but guaranteed that the bearer would be paid money when he turned in the bill to the US Treasury or 'any Federal Reserve Bank'.

The fine print in view of Hamilton's gaze (Click on image for larger view) states, 'THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE, AND IS REDEEMABLE IN LAWFUL MONEY AT THE UNITED STATES TREASURY OR ANY FEDERAL RESERVE BANK.' (Empasis added) This serves as further evidence that this piece of paper is nothing more than a promissory note and is, in fact, not money. This piece of paper merely represent the guarantee of payment of money. So what has changed?

Now, we simply get the piece of paper. There is no money, just paper. It has no value other than what we give it. That is why the value of it continues to decline. There will come a day, as has happened in every country using a fiat money system, that the 'money' will be worthless and those who thought enough in advanced to take it upon themselves to collect real money, ie: gold and silver, will be the only people who will survive the fiat currency collapse. It is estimated that an once of gold will cost $1,000 by the year 2010. (As we can see from when this article was orignally posted on our old site, we have far surpassed the amount predicted. As a matter of fact, gold has just recently dipped back to $1,300 per ounce.) Have you purchased any gold coins yet? You better start.

I recommend purchasing both gold and silver coins. When the FRN system finally collapses, you will need some smaller coins to use in trade. One of the best places to trade for gold or silver coins is through Bullion Direct® in their Nucleo^™ Exchange. There you can buy and sell gold and silver with other individuals with Bullion Direct® serving as an intermediary. That way a 3rd party confirms what you are purchasing. You can then have them hold the gold in their safe or have them deliver it to you. Either way, you will own real money instead of fiat money.

You might find it hard to understand how the FRN system could collapse. For many decades the US dollar has been considered by the rest of the world as the most stable currency with which to trade. So even though a buyer and seller were neither located in the United States, they would still use the US dollar for the trade. For example, if Argentina sold oil to China, the US dollar is what China used to pay Argentina for the oil. When other countries stop using the US dollar for trading, the dollar will become more and more devalued making the cost of living soar. There are already numerous countries using other forms of curreny for trade due to the insecurity of the US dollar. The more others turn away from trading with the US dollar, the more likely this collapse. The day that no other country will take the US dollar in trade, will be the day that 49,000,000 (49 million) people on food stamps will be told by the US government, 'Sorry, we have no food stamps for you this month. We will notify you when we do.' What do you suppose will happen when 49,000,000 hungry people are told they will not receive their food benefit from the federal government?

How prepared are you?

Fed Vs Real Money Vs

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