UNIT IV: The Components and Uses of Money

 

• Uses of Money
• Medium of exchange - bartering/trading
• Unit of account - establishes economic worth
• Store of value - money holds value over a period of time
• Types of Money
• Fiat money - money because the government says so
• Commodity money - goods; gets its value from the type of material from which it is made
• Representative money - IOU; paper money that is backed by something tangible
• Characteristics of Money
• Durability - even if you wash money, it doesn't disintegrate; money is durable
• Portability - you can take it in bill or coin form; money is very portable
• Divisibility - you can divide money
• Uniformity - no matter where you go in U.S., our money is the same
• Scarcity - 2 dollar bill, Susan B. Anthony coin
• Acceptability - our money is accepted anywhere, even though value may be different
• Money Supply
• M1 money - consists of currency (coins and paper money) in circulation, checkable deposits (demand deposits, checks), and traveler's checks
• M2 money - consists of M1 money plus savings accounts plus money market accounts plus deposits held by banks outside the U.S.
• Fractional Reserve Banking - the process by banks of holding a small portion of their deposits in reserves and loaning out the excess
• Banks keep cash on hand (required reserves) to meet depositor's needs
• Banks must keep reserved deposits in their vaults or at the Federal Reserve Bank
• Total reserves (total funds held by a bank) = required reserves + excess reserves
• TR = RR +ER
• excess reserves: reserves beyond those that are required
• Banks can legally lend only to the extent of their excess reserves
• Reserve ratio that is different from required reserves
• Reserve ratio = 1/RR
• Significance of a Fractional Reserve System
• Banks can create money buy lending more than their reserves
• Required reserves do not prevent bank panics, because banks must keep their required reserves
• FDIC is how they insure your money
• Reserved requirement gives the FED control over how much money banks can create
• Functions of the FED (Federal Reserve Bank)
• To control the money supply through monetary policy (circulation of currency and adjusting the interest rate)
• To issue paper money
• To serve as a clearing house for checks
• Regulate banking activities
• Serve as a ban for banks
• Balance Sheet: a statement of assets and claims summarizing the financial position of a firm or bank at some point in time
• Must balance at all times
• Assets
• What you own
• Must be equal to liabilities plus owner's equity/net worth
• Liabilities and Owner's Equity
• What you owe
• Claims of non-owners
• How Banks Work
• Assets
• Reserves
• Required reserves (rr) - %
• Required by FED to keep on hand to meet a demand
• Excess Reserves (er) - %
• Reserves over and above the amount needed to satisfy the minimum reserve ratio set by FED
• Loans to firms, consumers, and other banks (earns interest)
• Loans to government = treasury securities
• Bank property - if bank fails, you could liquidate the building (property)
• Liabilities
• Demand deposits (money put into the bank)
• Timed Deposits (CD's)
• Loans from: Federal Reserve and other banks
• Shareholders Equity - to set up a bank, you must invest your own money in it to have a stake in the banks success or failure
• Reserve Requirement
• Typically the required reserve ratio = 10%
• It is set by the FED
• The FED requires bank to always have some money readily available to meet consumers' demand for cash
• The required reserve ratio is the % of demand deposits (checking account balances) that must not be loaned out
• In a fractional reserve banking system, banks create money
• For a better understanding of fractional reserve banking, I recommend you to take your time out and watch this video:
• The Required Reserve Ratio
• The % of demand deposits that must be stored as vault cash or kept on reserve as federal funds in the bank's account with the Federal Reserve
• The required reserve ratio determines the money multiplier (1/reserve ratio)
• Decreasing the reserve ratio increases the rate of money creation in the banking system and is expansionary
• Increasing the reserve ratio decreases the rate of money creation in the banking system and is contractionary
• Changing the required reserve ratio is the least used tool of monetary policy and is usually held constant at 10%
• The Money Multiplier
• The money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply
• The money multiplier indicates the total number of dollars created in the banking system by each $1 addition to the monetary base (bank reserves and currency in circulation)
• To calculate the money multiplier, divide 1 by the required reserve ratio
• The Three Types of Multiple Deposit Expansion Questions
• Type 1: Calculate the initial change in excess reserves
• Aka the amount a single bank can loan from the initial deposit
• Type 2: Calculate the change in loans in the banking system
• Type 3: Calculate the change in the money supply
• Sometimes Type 2 and Type 3 will  have the same result (i.e. no FED involvement)
• Type 4: Calculate the change in demand deposits
• Max change in loans = initial change in ER x the money multiplier
• Max change in loans + $ amount of FED reserve action = max change in the money supply
• Change in loans = money multiplier x initial change in ER
• Max change in DD = max change in loans + $ amount of initial deposit
• REVIEW
• Required reserves = amount of deposit x required reserve ratio
• Excess reserves = total reserves - required reserves
• Maximum amount a single bank can loan = the change in excess reserves caused by a deposit
• The money multiplier = 1/required reserve ratio
• Total change in loans = amount single bank can lend x money multiplier
• Total change in the money supply = total change in loans + $ amount of FED action
• Total change in demand deposits = total change in loans + any cash deposited
• Fiscal Policy
• Congress
• Tax or Spend
• Monetary Policy
• FED
• Open Market Operations (OMO)
• Reserve Requirement
• Discount Rate
• Federal Funds Rate
• OMO - it is a preferred monetary tool because it is flexible
• The FED can buy or sell bonds
• Discount Rate - the interest rate charged by the FED for overnight loans to commercial banks
• It doesn't change money supply directly
• Federal Fund Rate - the interest rate charged by one commercial bank for overnight loans to another commercial bank
• The rates are negotiated between banks themselves
• The FED has several tools to manage the money supply by manipulating the excess reserves held by banks, a practice known as monetary policy
• Monetary Policy
• Expansionary ("easy" money): increase the money supply
• OMO - buy back bonds from the public
• Required Reserves - decrease reserve ratio
• Discount Rate - decrease discount rate
• Federal Fund Rate - decrease federal fund rate
• Contractionary ("tight" money): decrease the money supply
• OMO - sell bonds to the public
• Required Reserves - increase reserve ratio
• Discount Rate - increase discount rate
• Federal Fund Rate - increase federal fund rate
• Loanable Funds Market
• The market where savers and borrowers exchange funds (QLF) at the real rate of interest (r%)
• The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds
• The supply of loanable funds, or savings, comes from households, firms, government, and the foreign sector. The supply of loanable funds is also the demand for bonds
• Loanable Funds Market in Equilibrium
• 
• Changes in the Demand for Loanable Funds
• Remember that demand for loanable funds = borrowing (i.e. supplying bonds)
• More borrowing = more demand for loanable funds (increase)
• Less borrowing  = less demand for loanable funds (decrease)
• Examples
• Government deficit spending = more borrowing = more demand for loanable funds so DLF increase, r% increase
• Less investment demand = less borrowing = less demand for loanable funds so DLF decrease, r% decrease
• Example of Increase graph for DLF
• 
• Changes in the Supply of Loanable Funds
• Remember that supply of loanable funds = saving (i.e. demand for bonds)
• More saving = more supply of loanable funds (increase)
• Less saving = less supply of loanable funds (decrease)
• Examples
• Government budget surplus = more saving = more supply of loanable funds so SLF increase, r% decrease
• Decrease in consumer's MPS = less saving = less supply of loanable funds so SLF decrease, r% increase
• Example of Decrease Graph for SLF
• 
• Prime Rate - the interest rate that banks charge their most creditworthy customers