Hi, welcome to macroeconomics. This is Kate. This tutorial is on the money supply. We'll also be looking at the price level and inflation. As always, my key terms are in red and my examples are in green.
So in this tutorial we'll talk about what the money supply is. You'll see that the interest rate is actually the price of money. And we'll talk about how prices will rise whenever there is an increase in the money supply, and that's what we call inflation.
So here's a definition of the money supply for you. The sum of cash and deposits and savings and checking accounts at a given time. It's also defined as the capital stock within an economy at any given time.
Really, the money supply is, just what it sounds like, all of the money in the economy. And something to keep in mind is that there are different ways that people hold money. There's very liquid forms. Liquid means how easily can I access it? So the most liquid form of money is cash. Cash is certainly in the money supply.
But a lot of people don't hold a ton of cash anymore. They keep a lot of their money in checking accounts. That's also extremely liquid because we can draw from that any time with a debit card or write a check on it.
There's also less liquid forms of money that are included in our money supply. So when you hold money in your savings account you can certainly access that relatively easily today. But you have to go through another step to get it. And then there are other interest-bearing accounts that people have that are even less liquid, certainly, than savings accounts. All of these things are included in our money supply.
And this idea of interest-bearing accounts leads us to the key term, interest rate. The interest rate is the price an individual pays to borrow money. Or it can be looked at as the opportunity cost that an individual absorbs to hold a quantity of money.
And let's define price for a second. Price is the cost of a good or service, obviously. Remember, nominal prices reflect the current or prevailing price for an item. Whereas, real prices adjust for purchasing power variation over time. And I figured we would mention that here because we will be talking about inflation in this tutorial.
So since I defined for you interest rates and price, you can see that the interest rate really is the price of money. And I know that sounds weird to talk about the price of money itself, but that's what interest rates are. Because think about it, if I choose to hold my money as cash, or if I go out and buy something with cash right now, what did I sacrifice? What did I give up the opportunity to do with that money? I gave up the opportunity to earn interest on it. So that's why the interest rates are the price of money.
So when do prices tend to rise? Well, certainly we know that prices can go up whenever an item becomes more valuable. So as people demand it more, for example. So right around Valentine's Day the price of roses, we know, skyrockets. And that's because people are just placing more value on it. That is not inflation necessarily.
Prices, though, can also rise when there's an increase in the amount of money circulating in an economy. So here's an example to simplify this, to think about it. This is a very simple example. Let's say there's only two people in an economy and each one has $2. And there's only one thing that they can purchase with these dollars, they can purchase hamburgers. So there happened to be four hamburgers total in the economy.
All right. So we have $4 in the economy and for hamburgers. Which means that, basically, each hamburger will be priced at $1 right. Let's say, suddenly, someone drops four more dollars out of the sky into this little simplified economy. The money supply now doubles. It increases to $8.00. So someone has just increased this money supply. What's going to happen to the price of the four hamburgers? Well, there's only four hamburger still yet, $8.00. So the price increases to $2 per hamburger.
So you can see that when the money supply increases the price of goods and services in an economy will also increase. So as we have more dollars circulating in our economy things tend to get more expensive. And that's what we call inflation. And we know from year to year decade to decade we can see that things are more expensive. People also tend to make more money. So when we look at our purchasing power we're looking at how much better off, or worse off are we able to afford the things today as we were in the past.
So inflation is the general level of an increase in prices from one period to another. One last thing to note here is that an increase in the money supply will also affect the price of money or interest rates. Remember how we talked about interest rates being the price of money. But think about this, what happens to the price of something whenever there's a greater supply of it? Whenever there's more and more and more of something, what happens to the value of it? Doesn't it tend to lose value?
So we'll be looking later on in this course about how whenever there's an increase in the money supply how that will impact interest rates in the economy. And sometimes our Federal Reserve System will specifically try to increase the money supply in order to lower interest rates.
So in this tutorial we looked at what the money supply is. We talked about how the interest rate is the price of money. And we saw that prices will rise whenever there's an increase in the money supply and that's what we call inflation. Thank you so much for listening. Have a great day.