UNIT 4

Unit 4

I.                   Uses of Money

a.       Medium of Exchange

b.      Unit of Account – Establishes worth

c.       Store of Money – Money holding value over a period of time (Bank)

II.                Types of Money

a.       Fiat money – Money because the government says so

b.      Commodity money – No physical money is exchanged, Ex. Gold & Silver coins

c.       Representative money – Money that is backed up by something tangible; Ex. IOU

III.             Characteristics of Money

a.       Durability – Money is durable

b.      Portability – Money can be carried in a multiple of ways, and it is very portable

c.       Divisibility – Many different combinations of money

d.      Uniformity – Our money is in uniform, it should not look any different from one state to another

e.       Scarcity – Scarce types of money

f.       Acceptability – Money is accepted everywhere

IV.             Money Supply

a.       M1 money

-          Consists of currency in circulation: Physical dollar as well as the coin

-          Checkable deposits

-          Travelers checks

b.      M2 money

-          Consists of M1 money plus saving accounts + money market accounts + deposits held by banks outside the US

Fractional Reserve System:

-          It is a process by banks upholding a small portion of their deposits in reserve and loaning out the excess

-          Banks keep cash on hand (required reserves)

-          Banks must keep reserve deposits in their vaults or at the federal reserve bank

Total reserves:

-          Total funds held by a bank

-          TR (Total reserves) = RR (Required reserves) + ER (Excess reserves)

-          Banks can legally lend only to the extent of their excess reserves

Reserved Ratio = RR / TR

Significance of a Fractional Reserve System

1.      Banks can create money by lending more than their reserves

2.      Required reserves don’t prevent bank panics because banks must keep their required reserves (FDIC)

3.      Reserve requirements give the Feds control over how much money banks can create

Function of the FED (Federal Reserve Bank):

1.      Control the nation’s money supply through monetary policy

2.      Issue paper currency

3.      Serve as a clearing house for checks

4.      Regulates banking activities

5.      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

Assets – what you own

Liabilities – what you owe

Net Worth – a claim of the owners against the firm’s assets

Assets + Net Worth = Liabilities

Multiple Deposit Expansion

How Banks Work

Assets

Liabilities + Equity

·         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 (earn interest) ·         Loans to govt. = treasury securities ·         Bank property – (if bank fails, you could liquidate the building/property)

·         Demand Deposits ($ in the bank) ·         Timed Deposits ·         Loans from: Federal Reserve & 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

·         The Fed requires banks to always have some money readily available to meet consumers’ demand for cash.

·         The amount, set by the Fed, is the Required Reserve Ratio.

·         The Required Reserve Ratio is the % of demand deposits (checking account balances) that must not be loaned out.

·         Typically the Required Reserve Ration = 10%

Practice Calculating Reserve Ratios

The reserve ratio is 5%. You deposit $1000 into a bank. How much is the bank required to add to its reserves?

0.5 * $1000 = $50 in reserve ratio

How much money can the bank now loan out?

$1000 (deposited) – 50 (reserve ratio) = $950

100% Reserve Banking has no impact on size of money supply.

Thus, in a fractional-reserve banking system, banks create money.

·         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 & currency in circulation)

·         To calculate the money multiplier, divide 1 by the required reserve ratio.

o   Money Multiplier = 1/ Reserve Ratio

o   Ex. If the reserve ratio is 25%, then the multiplier = 4

The Four types of Multiple Deposit Expansion Question

·         Type 1: Calculate the initial change in excess reserves

o   a.k.a. 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

o   Sometimes type 2 and type 3 will have the same result (i.e. no Fed involvement

·         Type 4: Calculate the change in demand deposits

·         We built this city. We built this city on rock & roll - BU

Review

·         Required Reserve = 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	Monetary Policy
·         Congress ·         Tax ·         Spend	·         Fed ·         OMO (Open Market Operations) ·         Required Reserves ·         Discount Rate ·         Federal funds rate

Monetary policy option	Expansionary (“easy” $)	Contractionary (“tight” $)
Open market operation (OMO)	Buy bonds from the public	Sell bonds to the public
Required Reserves	Decrease reserve ratio	Increase reserve ratio
Discount Rate	Decrease discount rate	Increase discount rate
Federal funds rate	Decrease federal funds rate	Increase federal funds rate

Monetary policy options

Open Market operation (OMO)

Required Reserves - Vault cash, reserve banks, percentage of the banks total deposits that they must hold on to. Government has control of.

Discount Rate – The interest rate charged by the Feds for overnight loans to commercial banks, and does not change money supply directly

Federal funds rate – The interest rate charged by one commercial bank for overnight loans to another commercial bank, FOMC sets a federal fund rate and then uses OMO to guide the effective rate to the target rate

Loanable Funds Market

-          The market where savers and borrows exchange funds (Q_lf) 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. supplying bonds)

-          More borrowing = more demand for loanable funds

-          Less borrowing = less demand for loanable funds

-          Examples

1.      Government deficit spending = more borrowing = more demand for loanable funds: D_LF→.:r%↑

2.      Less investment demand = less borrowing = less demand for loanable funds: D_LF←.:r%↓

Changes in the Supply of Loanable Funds

-          Remember that supply of loanable funds = savings (i.e. demand for bonds)

-          More saving = more supply of loanable funds (→)

-          Less saving = less supply of loanable funds (←)

-          Example

1.      Government budget surplus = more saving = more supply of loanable funds: S_LF→.:r%↓

2.      Decrease in consumers’ MPS = less saving = less supply of loanable funds: S

3.       _LF←.:r%↑