Unit 4

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

3 uses of money:

1st use - medium of exchange. It is used to determine value

2nd use - unit of account. Used to compare prices.

3rd use - store a value. Keep in mind that some people choose to hide their money. 

3 types of money:

Commodity money - has value within itself. 3 examples: salt, olive oil, and gold

Representative money - represents something of value. Ex. IOU

Fiat - money because the government says so. Consists of paper currency and coins 

Currency is not the same thing as money.

6 characteristics of money:

1. Durability

2. Portability

3. Divisibility

4. Uniformity

5. Limited supply

6. Acceptability

Money supply - total value of financial assets available in the US economy

M1 Money 

- liquid assets (easily to convert to cash). Coins, currency, checkable deposits/demand deposits, travelers checks

M2 Money 

Not as liquid as M1 money

- saving account 

- money market account

3 purposes of financial institutions

1. Store money

2. Save money

3. Loan money. 2 reasons to loan money: credit cards and 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 which means they keep a fraction of the funds and loan out the rest

Interest Rates:

-principle: amount of money borrowed

-interest: price payed for the use of borrowed money

• simple interest: paid on the principle

I = (P x R x T)/100

I; simple interest 

P; principal

R; interest rate

T; time

• compound interest: paid on the principle plus the accumulative interest. 

5 types of financial institutions

1. Commercial bank

2. Savings and loan institutions

3. Mutual savings bank

4. Credit unions

5. Finance companies

Investment - redirecting resources; consume now for the future. 

Financial assets - claims on property and income of borrower

Financial intermediaries - institution that channels funds from savers to borrowers. 3 purposes

1. Share risks through diversification. It is spreading out investment to reduce risk.

2. Provide information 

3. Liquidity (returns) - money investor receives above and beyond the sum of money that was initially invested. The higher the risk; the higher the returns

Bonds you loan

Stocks you own 

Bonds are loans, IOU, that represent debt that the government or a corporation must repay to an investor. They are generally low risk investment. There are 3 components

1. Coupon rate (interest rate that a bond issuer will pay to a bond holder)

2. Maturity (time at which payment to a bond holder is due)

3. PAR value (principle; amount an investor pays to purchase a bond)

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

Time Value of Money

Is a dollar today worth more than a dollar tomorrow?

Why? 

Opportunity cost and inflation

This is the reason for charging and paying interest

v = future value of money

p = present value of money 

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 * p

The compound interest formula 

v = (1+ (r/k))^nk * 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)

Functions of FED

It issues paper currency

Sets reserve requirements and holds reserves of banks

It lends money to banks and charges them interest

They are a check clearing service banks

It acts as personal bank for the government

Supervises member banks

Controls the money supply in the economy

How do banks create money?

By lending out deposits that are used multiple times

Where do the loans come from?

From depositors who take cash and place it in their banks

How are the amounts of potential loans calculated?

Using their bank balance sheet, or T-accounts that consists of assets and liabilities for banks

Right side of the T-account sheet

1= demand deposits (DD) or checkable deposits

• cash deposits from the public

• they are liabilities because they belong to depositors

2= owners equity (stock shares)

• there are values of stocks held by the public ownership of bank shares

• if demand deposits come from someone's cash holdings, then DD is already part of money supply

• if the demand deposit comes in from the purchase of bonds (by the FED) then this creates new cash and therefore creates new Money Supply (M-1)

Bank Assets (left side of the T account sheet)

#1= required reserves (RR)

• these are the percentages of demand deposits that must be held in the vault so that some depositors have access to their money. Requirement can vary, but AP usually uses 5%, 10%, or 20% for easy calculations

#2= excess reserves (ER)

• these are the source of new loans. These amune are applied to the monetary multiplier/reserve Multiploer (DD=RR plus ER)

#3= bank property holdings (building and fixtures)

#4 = securities (federal bonds)

• these are bonds purchases by the bank, or new bonds sold to the bank by the Federal Reserve. These bonds can be purchased from the bank, turned into cash that immediately becomes available as "excess reserves"

#5= customer loans

• this can be amounts held by banks from previous transactions, owed to the bank by prior customers

Creating Money (using excess reserves)

• banks want to create profits. They generate profit by leading the excess reserves and collecting interest. Since each loan will go out into customer's business' accounts, more loans are created in decreasing amounts (because of reserve requirement). A rough estimate of the number of loan pints created by any first loan is the "money multiplier"

• money multiplier: checkable despisers multiplier, reserve multiplier, loan multiplier

• the formula: 1 divided by the reserve requirement (ratio)

RR=10%= 1/.1= monetary multiplier of 10

Excess reserves are multiplied by the multiplier to create new loans for the entire banking system and this create new money supply

Bank Balance Sheet

•assets and liabilities in a T account

Liabilities

•DD and Owner's Equity (stock shares)

Assets

•RR, ER, Bank Property, Securities, Loans

Assets must equal liabilities

•DD=RR + ER

Money is created through Moneyary Multiplier

• ER x 1/RR (multiplier) = new loans through the naming system

The money supply is affected

•cash from citizens becomes a DD, but does not change the money supply; the ER from this cash becomes an "immediate" loan amount

•ER x multiplier become new loans and do change the money supply

•the fed buying bonds crates new loans and changes the money supply

•if the fed buys bonds on the open market, this also becomes a new DD amount; if the Fed guys bonds from accounts already held by a particular bank, then the amount only becomes new excess reserves

•finally, bond "prices" move opposite to the changes in interest rates

-higher interest rates wil push bond prices downward (less money supply)

-lower interest rates will push bond prices upward (more money supply)

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

Creating a Bank

•Transaction #1

Vault cash: cash held by the bank

•Transaction #2

Acquiring propert and equipment

•Transction #3

Commercial bank functions

-accepting deposits

-making loans

•Transaction #4

Depositing reserves in a Federal Reserve bank

-required reserves

-reserve ratio

Reserve Ratio = (commercial bank's required reserves)/(commercial bank's checkable-deposit liabilities)

•transaction #5

Assumed the bank's deposits all cash on reserve at the Fed

Excess Reserves = Actual Reserves - Required Reserves

Required Reserves = checkable deposits x reserved ratio

Factors that weaken the effectiveness of the deposit multiplier:

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

2.) If bank customers take their loans in cash rather than in new checking 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/DM increases while IR decreases

MD/DM decreases while IR increases

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.

Changes in the Demand for Loanable Funds

•remember that demand for loanable funds = borrowing (I.e. Supply bonds)

•more borrowing = more demand for loanable funds (shift right)

•less borrowing = less demand for loanable funds (shift left)

•Examples

- government deficit spending = more borrowing = more demand for loanable funds

(Dlf) right r% increase

Less investment demand = less borrowing = less demand for loanable funds

(Dlf) left r% decrease

Changes in the supply of Loanable Finds

•remember that supply of loanable funds = saving (I.e. Demand for bonds)

•more saving = more supply of loanable funds (right)

•less saving = less supply of loanable funds (left)

•examples

- government budget surplus = more saving = more supply of loanable funds. Slf right r% decrease

- decrease in consumers' MPS = less saving = less supply of loan-able funds