The Uses of Money
- Medium
of Exchange : Money's most important function used to facilitate
transactions such as bartering or trading.
- Unit
of Account : Establishes worth. Providing a common measure of the value of
goods and services being exchanged
- Store of Value : Money holding value over a period of time
- Commodity Money : Money that would have value even if it were not being used as money. No physical money is exchanged
- Representative Money : Backed up by something tangible
- Fiat Money : Money because the government says so
Characteristics of Money
- Durability : Money is durable
- Divisibility : There are combinations to make the same amount
- Uniformity : It is the same in every state
- Portability : It is easy to carry around
- Scarcity : Not everyone has money, or at least a lot of money
- Acceptability : Money is acceptable everywhere
Money Supply
- M1 Money : it includes currency in circulation, checkable deposits (demand deposits), physical dollars and coins, traveler's checks
- M2 Money - it includes M1 Money, Savings accounts, Money market accounts and deposits held by banks outside the United States
Fractional Reserve System
- A process by banks of holding a small portion of their deposits in reserve and loaning out the excess
- Banks keep cash on hand (required reserves to meet depositor needs)
- Banks must keep reserve deposits in their vault or at the federal reserve bank
Total Reserves
- Total funds held by the bank
- Total Reserve = Required Reserve + Excess Reserve
Excess Reserves
- Reserves beyond those that are required
- Banks can legally lend only to the extent of their excess reserves
Reserve Ratio
- Reserve Ratio = Required reserve/ total reserve
Significance of a Fractional Reserve System
- Banks can create money by lending more than their reserves
- Required Reserves do not prevent bank panics because banks must keep their required reserves
- Reserve requirements gives the FED control over how much money banks can create
Functions of the FED
- Control the nation's money supply through monetary policy
- Issue paper currency
- Serves as a clearing house for checks
- Regulates banking activities
- Serves as a bank for banks
Balance Sheet
- A statement of assets and claims summarizing the financial position of a firm or a bank at some point in time
- Must balance at all times
- Assets (own) = Liabilities + Net Worth (owe)
Assets
- Reserves:
-Required Reserves (rr) - % required by Fed. to keep on
hand to meet 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 govt. = treasury securities
- Bank property - (if bank fails, you could liquidate the building/property)
Liabilities and Equity
- Demand Deposits (money that is put into 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)
- The percent of demand deposits that must be stored as vault cash or kept on reserve as federal funds in the banks accounts with the FED
- The RR ratio determines the money multiplier (1/RR)
- Decreasing the RR ratio increases the rate of money creation in the banking system and is contractionary
- Changing the RR ratio is the least used tool of monetary policy and is usually held constant at 10%
The Money Multiplier
- Money multiplier shoes us the impact of a change in demand deposits on loans and eventually the money supply
- The money multiplier indicates the total number of dollar 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
Required Reserve = Amount of deposit * Required Reserve
Ratio
Excess Reserve = Total Reserves - Required Reserves
Maximum amount a single bank can loan = The change in
excess reserves caused by a deposit
Total change in loans = Amount single bank can lend * money multiplier
Total change in money supply = Total change in loans and
amount of money of FED action
Total change in demand deposits = Total change in loans + cash deposited
Fiscal Policy
- Congress
- Tax or
- Spend
Monetary Policy
- FED
2. Reserve Requirement : bank's mass requirement
- Expansionary - Buy bonds from the public
- Contractionary - Sell bonds to the public
3. Discount Rate : interest rate charged by the Fed for overnight loans to commercial
- Expansionary - Decrease the reserve ratio
- Contractionary - Increase the reserve ratio
banks
4. Federal Fund Rate : interest rate charged one commercial bank for overnight loans
- Expansionary - Decrease discount rate
- Contractionary - Increase discount rate
to another commercial bank
- Expansionary - Decrease FFR
- Contractionary - Increase FFR
Prime Rate : The interest rate bank charges to their credit worthy
customers
Loanable Funds Market
- 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
Changes in Demand for Loanable Funds
- Demand for loanable funds = borrowing (supplying bond)
- More borrowing = more demand for loanable funds ->
- Less borrowing = more demand for loanable funds <-
- Government deficit spending = more borrowing = more demand for loanable funds
- Less investment demand = less borrowing = less demand for loanable funds
Changes in Supply of Loanable Funds
- Supply of loanable funds = saving
- More saving = more supply of loanable funds
- Less saving = less supply of loanable funds
- Government budget surplus = more saving = more supply of LF
- Decrease in consumers' MPS = less saving = less supply of LF
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