Unit 4

Unit 4

3/3

Money is any asset that can be used to purchase goods and services

3 Uses of Money

1) Medium of Exchange - using money to determine value 

2) Unit of Account - used to compare prices

3) Store of Value - bank vs box

3 Types of Money

1) Commodity Money - it has value within itself (salt, olive oil, gold)

2) Representative Money - represents something of value (IOU)

3) Fiat Money - it is money because the government says so (paper currency and coins)

6 Characteristics of Money

1) Durability 

2) Portability

3) Divisibility

4) Uniformity

5) Limited Supply

6) Acceptability

Money Supply: the total value of financial assets available in the US economy

- M1 Money: 

   - Liquid Assets (easily to convert to cash) 

       - Coins

       - Currency (Paper)

       - Checkable deposits or demand deposits (checks)

       - Travelers Checks

- M2 Money: not as liquid as M1 Money

   - M1 Money + Savings Account + Money Market Account

3 Purposes of Financial Institutions

1) Store Money

2) Save Money

3) Loan Money

    1) Credit Cards

    2) Mortgages

4 Ways to Save

1) Savings Account

2) Checking Account

3) Money Market Account

4) Certificate of Deposit (CD)   

Loans

- Banks operate on a fractional reserve system; they keep a fraction of the funds and they loan out the rest. 

Interest Rates:

- Principal: the amount of money borrowed

- Interest: the price paid for the use of borrowed money 

   - Simple Interest: paid on the principal

   - Compound Interest: paid on the 

 principal plus accumulated interest

I = PRT/100

T= Ix100/PR

P = Ix100/RT

R = Ix100/PT

I = Simple Interest

P = Principal

R = Interest Rate

T = Time

Types of Financial Institutions 

1) Commercial Bank

2) Savings and Loans Institutions 

3) Mutual Savings Banks

4) Credit Unions

5) Finance Companies

Investment: redirecting resources you would consume now for the future 

Financial Assets: claims on property and income of borrower 

Financial Intemediaries: institutions that channel funds from savers to borrowers 

   1) Share risk through diversification - spreading out investments to reduce risk

   2) Provide information

   3) Liquidity (returns) - the money an investor receives above and beyond the sum of money that was initially invested

Bonds you loan

Stocks you own

Bonds: loans or IOUs that represent debt that the government or a corporation must repay to an investor. Generally low risk investments. 

3 Components of a Bond

- Coupon Rate: the interest rate that a bond issuer will pay to a bond holder

- Maturity: the time at which payment to a bond holder is due

- Par Value: the amount that an investor pays to purchase a bond (Principal)

Yield: the annual rate of return on a bond if the bond were held to maturity 

3/4

Time Value of Money

- Is a dollar today worth more than a dollar tomorrow? Yes. 

- Why? Opportunity cost & inflation. This is the reason for charging and paying interest. 

- Let v = future value of $

p = present value of $

r = real interest rate (nominal rate - inflation rate), expressed as a decimal

n = years

k = number of times interest is credited per year 

The simple Interest Formula:

v = (1+r)^n x p

The Compound Interest Formula

v = (1 + r/k)^(nk) x p

The Monetary Equation of Exchange

MV = PQ

M = money supply (M1 or M2)

V = money's velocity (M1 or M2)

P = price level (PL on the AS/AD diagram)

Q = real GDP (sometimes labeled y on the AS/AD diagram)

7 Functions of the Fed

1) It issues paper currency

2) Sets reserve requirements and holds reserves of banks

3) It lends money to banks and charges them interest

4) They are a check clearing service for banks

5) It acts as personal bank for the government

6) Supervises member banks

7) Controls the money supply in the economy

3/5

The Three Types of Multiple Deposit Expansion Question

- 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. 

The amount of new deposits of new depots - required reserve = the i risk change in excess reserves. 

3/6

Reserve Ratio = (Commercial Bank's Required Reserves) / (Commercial Bank's Checkable-Deposit Liabilities)

Excess Reserves = Actual (Total) Reserves - Required Reserves

Required Reserves = Checkable Deposits x Reserve Ratio

Assets:
- Reserves
   - Required reserves: % reuquired by Fed to keep on hand to meet demand.
   - Excess Reserves: % reserves over and aboce the amount needed to satisfy the minimum reserve ratio set by the Fed.
- Loans to firms, consumers, and other banks (earns interest)
- Loans to government = treasury secutities
- Bank Property - if bank fails, you could liquidate the building.

Liabilities + Equity:
- Demand Deposits ($ put in 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 bank's success of failure

 3/17

Factors that weaken the effectiveness of the deposit multiplier

1) If banks fail to loan out all of their excess reserves 

2) If bank customers take their loans in cash rather than in new checking account deposits, it creates a cash or currency drain. 

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded. 

MD or DM increases, interest rate decreases. 

MD or DM decreases, interest rate increases.

A single bank can create money through loans by the amount of excess reserves.
The banking system as a whole can create money by a multiple (deposition money multiplier) of the initial excess reserves.

Cash is existing money and increases bank reserves. there is no immediate change in MS, only composition of money changes.
When the Fed purchases a bond from the public, it is new money and increases bank reserves. There is an immediate change in MS coming from the Fed, it puts new money in circulation.
When the bank purchases a bond from the public, new money is made and bank reserves increase. There is an immediate change in MS because money is coming form the reserves, which puts new money in circulation.

3/19
The Fedearl Fund Rate is where FDIC member banks loan each other over night funds in order to balance accounts each day. Interest rate when banks borrow money from each other.
The Prime rate is the ineterst rate the banks chanrge to their most credit-worthy customers
The Discount Rate is the interest that the Fed charges commercial banks for borrowing money. Decrease during recession and increase during inflation.
The Reserve Requirement is the amoutn of money banks must keep in their reserves. Decrease during expansionary and increase during inflationary.
Open Market Operations, buying or selling securities/bonds - buy onds in expasionary, increase money supply. Sell bonds in contractionary, decrease money supply.

3/23

Loanable Funds Market: the market where savers and borrowers exchange funds (Qlf) at the real rate of interest (r%)

- The demand for likable 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 the Demands for Loanable Funds:

- Remember that demand for loanable funds = borrowing (ie supplying bonds)

- More borrowing = more demand for loanable funds (shift right)

- Less borrowing = less demand for loanable funds (shift left)

- Example: Government deficit spending = more borrowing = more demand for loanable funds (Dlf shift right, r% increases)

- Example: Less investment demand = less borrowing = less demand for loanable funds (Dlf shifts left, r% decreases)

Changes in the Supply of Loanable Funds:

- Remember that supply of loanable funds = saving (ie demand for bonds)

- More saving = more supply of loanable funds (shifts right)

- Less saving = less supply of loanable funds (shifts left)

- Example: Government budget surplus = more saving = more supply of loanable funds (Slf shifts right, r% decreases)

- Example: Decrease in consumers' MPS = less saving = less supply of loanable funds (Slf shifts left, r% increases)

Final thoughts on Loanable Funds:

- When government does fiscal policy, it will affect the loanable funds market. 

- Changes in the real interest rate (r%) will affect Gross Private Investment.

-       M1 Money: currency (coins and paper money) in the hands of the public & all checkable deposits in commercial banks or savings institutions

o   Coins/paper money are debts of government and government agencies

o   Checkable deposits are debts of commercial banks and savings institutions.

o   Coins are token money, and has intrinsic value (metal worth less than coin)

o   Paper money is in the form of Federal Rserve Notes issues by the U.S. central bank (Federal Reserve System)

o   Checkable deposits largest component of M1 Money

-       M2 Money: M1 Money + Near-monies (may be converted into currency or checkable deposits

o   Savings account, money market deposit account, time deposits, money market mutual funds

-       With a constant demand for money, the supply of money will determine the value or purchasing power of the monetary unit.

-       Acceptability is more important than legal tender

-       Higher prices lower value of the dollar because more dollars are needed to buy something

o   If the price level doubles, the value of the dollar declines by one half

o   D = 1/P

-       Stabilization of money includes fiscal policy and monetary policy (regulation of money supply)

-       The main determinant of the amount of money demanded for transactions it the level of nominal GDP

-       When the interest rate or opportunity cost of holding money as an asset is low, the public will choose to hold a large amount of money as assets. When interest rate is high, people will hold less assets and buy more interest-bearing bonds.

-       Lower bond prices are associated with higher interest rates.

-       The collective attempt to buy more bonds due to a surplus in the money supply will increase the demand for bonds, push bond prices upward, and lower interest rates.

-       Higher bond prices are associated with lower interest rates.

-       When a commercial bank buys government bonds from the public, the effect is the same as lending. New money is created.

-       The selling of government bonds to the public by a commercial bank – like the repayment of loans – reduces the supply of money.

-       Reserves can be lost by individual banks, but there are no loss of reserves for the banking system as a whole.

-       Total Money Supply = Initial Checkable Deposits + Checkable Deposits Created Through Lending

-       When the Fed buys government bonds, the demand for them increases and their interest rates decline.