Unit Four

I. Uses of Money

1. Medium of Exchange (to trade)
2. Unit of Account (Establishes worth)
3. Store of Money (Money holding value over a period of time)

II. Types of Money

1. Commodity Money
1. Gold/Silver coins
2. "goods"
2. Representative Money
1. IOU
2. Backed by something tangible
3. Fiat Money
1. Money because the government says so
2. The only one used today

III. Characteristics of Money

• Durability
• Portable (Coins or Paper)
• Divisability
• Uniformity
• Scarcity
• Accept

IV. Money Supply

• M1 Money (75% used)
• Consists of currency in circulation, checkable/demand deposits, and traveler's checks
• M2 Money
• Consists of M1 money + savings account + money market accounts + deposits held by banks outside the U.S.

V. Fractional Reserve System

• A process by banks of holding a small portion of their deposits in reserve and loaning out the excess

1. Banks keep cash on hand (Required Reserves) to meet depositer's needs
2. Banks must keep reserve deposits in their volts or in the Federal Reserve Bank
3. Total reserves are total funds held by a banks (TR = RR + ER)
4. Banks can legally lend only to the extent of their excess reserves
5. Reserve 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 RR
3. Reserve Requirement gives the Fed control over how much money banks can create

Functions of the FED (Federal Reserve Bank)

1. Control the nation's money supply through monetary policy
2. Issue paper money
3. Serve as a clearing house for checks
4. Regulates banking activity
5. Serves as a bank for banks
1. Issue out loans

Balance Sheet

• It is a statement of assets and claims summarizing the financial position of a firm or bank at some point in time
• It MUST balance
• Assets = Owner's Equity

Assets + Net Worth = Liabilities

• What you own (assets)
• What you owe (Liabilities)
• Net Worth (A claim of the owner, against the firm's assets)
• Don't really own it

How Banks Work

Assets

• 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 government = Treasury securities
• Bank Property- If the bank fails, you could liquidate the building/ property)

Liability + Equity

• Demand Deposits ($ put into bank)
• Timed Deposits (CD's)
• Loans from the 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/failure
• Claims of the nonowners

*The Amount set by the Fed is the required reserve ratio
*Typically the Required Reserve Ratio=10%

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 reserves ratio
• Total change in loans= Amount single bank can lend x Money multiplier
• Total change in money supply= Total change in laons + Money amount of Fed action
• Total change in demand deposits= Total change in laons + any cash deposited
• The Fed has several tools to manage the money supply by manipulating the excess reserves held by banks, a practice known as monetary policy

Required Reserve Ratio

• The percent 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
• Decreasing the required reserves increases the rate of money creating in the banking system and is expansionary
• Increasing the required reserve decreases the rate of money creation in the banking system and its constractionary
• Changing the required reserve ratio is the elast used tool of monetary policy and is usually held constant at 10%

The Money Multiplier

• This 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 money 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

4 Types of Multiple Deposit Expansion Questions

1.       Type 1: Calculate the initial change in excess reserves

§         A.k.a. the amount a single bank can loan from the initial deposit

2.       Type 2: Calculate the change in loans in the banking system

3.       Type 3: Calculate the change in the money supply

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

4.       Type 4: Calculate the change in demand deposits

·         Ex 1.

1.       Given the required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the amount that a single bank can lend from this Federal Reserve purchase of bonds.

§         The amount of new demand deposits – required reserve =The initial change in excess reserves

§         $ 100 million (20% * 100 million)

§         $100 million - $20 million = $80 million in ER

2.       Determine the maximum change in loans in the banking system  from this Federal Reserve purchases of bonds

§         $80 million * (1/20%)

§         $80 million * 5 = $400 million max in new loans

3.       Determine the maximum change in the money supply from this Federal Reserve purchase of bonds.

§         The maximum change in loans + $ amount of Federal reserve action

§         $400 million + $100 million = $500 million max change in the money supply

4.       Determine the maximum change in demand deposits from this Federal Reserve purchase of bonds.

§         The maximum change in loans + $ amount of initial deposit

§         $400 million + $100 million = $500 million max change in demand deposits

Loanable Funds Market

• The market where savers and borrowers exchange funds at the real rate of interest
• The demand for loanable funs, 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, governmnet, and the foreign sectore
• The supply of loanable funds is also the demand for bonds

Changes in Demand for Loanable Funds

• Remember that demand for loanable funds = borrowing
• More borrowing= more demand for loanable funds
• Less borrowing= less demand for loanable funds
• Examples:
• Government deficit spending= more borrowing= more demand for loanable funds
• Less investment demand= less borrowing= less demand for loanable funds

Changes in the Supply of Loanable Funds

• Remember that the 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 loanable funds