Money and Monetary Policy
The Barter System: goods and services are
traded directly. There is no money
exchanged.
Money is anything that is generally accepted in payment for goods and services.
Not the same as wealth or in income
Wealth- the total collection of assets that store value.
Income is a flow of earnings per unit of time.
3 Functions of Money
A Medium of Exchange
• Money can easily be used to buy goods and
services with no complications of barter system.
2. A Unit of Account
• Money measures the value of all goods and
services. Money acts as a measurement of
value.
• 1 goat = $50 = 5 chickens OR 1 chicken = $10
3. A Store of Value
• Money allows you to store purchasing power for
the future.
• Money doesn’t die or spoil.
3 Types Of Money
Representative Money- Ex- IOUs
Commodity Money- Salt, Gold, Silver, Cigarettes, something that performs the function of money and has alternative uses.
Fiat Money- Paper money coins. Money because gov't says so.
6 Characteristics of Money
-Durability
-Portability
-Divisible
-Uniformity
-Limited Supply
-Acceptability
3 Types of Money
Liquidity- ease with which an asset can be
accessed and converted into cash (liquidized)
M1 (High Liquidity) - Coins, Currency, and
Checkable deposits (personal and corporate
checking accounts).
In general, this is the MONEY SUPPLY
M2 (Medium Liquidity) - M1 plus savings
deposits (money market accounts), time deposits
(CDs = certificates of deposit), and Mutual Funds
below $100K.
M3 (Low Liquidity) - M2 plus time
deposits above $100K.
Purpose of Financial Institutions
A. Save $$
B. Store $$
-savings acct.
-checking acct.
-CD
-Money Market acct.
C. Loan $
Interest- Price paid for the use of borrowed money.
Principal- amount that you borrow
Types of Financial Intermediaries
1. Commercial Bank
2. Savings & Loans Institution
3. Credit Unions
4. Mutual Funds companies
5. Finance companies
The Financial System
Assets- Anything of monetary value owned
by a person or business.
Financial Asset- A paper claim that entitles the buyer to future income from the seller.
Physical Asset- A claim on a tangible object (ex: house, car)
If you go to your bank and take out a loan... the bank has created a financial asset, you have created a liability.
Liability- A requirement to pay money in the future. (usually with interest.
5 major financial assets- loans, stocks, bonds, treasury bonds, and bank deposits.
The Time Value of Money- A dollar is worth more today than it is tomorrow. You are losing money every second you are not investing it.
Real Interest Rate- The intended return on an investment for lending (adjusted for inflation). The true cost of borrowing.
Real- nominal interest rate- expected inflation
Nominal Interest Rates- The rate we get at the bank. The amount of interest that lenders must charge to make a return and adjust for inflation. Nomial= Real i.r + Expected inflation
Future Value- If you invest (or lend) money to someone, it will compound (grow) according to the following equation: FV=PV (1+i)^t
Preent Value- The amount of money I need to invest now, in order to get some amount (FV is known in the futire)
Time value of Money
V= Future value of $
P= Present value of $
r- Real interest rate (nominal rate-inflation rate)
n= years
k=number of times interest is created per year
The Simple Interest Formula
v=(1+r)^n
Bonds vs. Stock
Bonds are loans, or IOUs, that represent debt that the
government or a corporation must repay to an investor.
The bond holder has NO OWNERSHIP of the company.
Stocks are owned
If a corporation sells and issues a bond it is a liability, to the buyer its a asset
If the nominal interest rate decreases the bond increases and vice versa.
Stock owners earn money by:
Dividends, which are portions of a corporation’s
profits, are paid out to stockholders.
The higher the corporate profit, the higher the dividend.
A capital gain is earned when a stockholder sells stock
for more than he or she paid for it.
A stockholder that sells stock at a lower price than the
purchase price suffers a capital loss.
Money Market
When interest rate increases the Demand for money shows an inverse
relationship between nominal interest rates
and the quantity of money demanded. Quantity demanded falls because individuals
would prefer to have interest earning assets instead
When interest rate decrease quantity demanded increases. There is no incentive
to convert cash into interest earning assets
Demand Deposits are made from a fractional reserve system
FRS is the process in which banks keep a portion of their deposits in reserves and loan out the excess.
The money that banks keep on hand is called required reserves.
Banks must keep reserve deposits in their vaut or at their district FEDs (FR bank)
Total Reserves or actual reserves (all the funds in the bank) =RR+FR
Required Reserves- Cash on hand- vault cash
Excess Reserves- loaned out
Money Creation Formula
****A single bank can create $ by the amount of its excess reserves. The banking system as a whole can.
New vs Existing $$
If the initial deposit in a bank comes from the FED or bank purchses of a bond or other money out of circulation (buried treasure), the deposit immediately increases the money supply.
The deposit then leads to further expansion of the money supply through the money supply through the money creation process total change in MS if initial deposit is new $ < deposit + $ created by banking system
If a deposit in a bank is existing $ existing $ (already counted in M!; ex: currency or checks deposited the amount does not change the MS immediately because it is already counted.
Existing currency deposited into a checking account changes only the composition of the money supply from coins/ paper $ to checking acct. deposits.
Total change in the MS if deposits is existing $= banking system created money only.
If a recession is happening RR should be decreasing
- Banks hold less money and have more ER
-Money Supply increases, interest rate decreases, AD increases, i decreases,
-Bank creates more money
Inflation- RR increases
Banks hold more money and have less ER
Banks create less money
-MS decreases, interest rate increases, AD decreases, i increases
OMO- Price of bonds will increase
**When the FEDS buy or sell bonds
-If the FED buys bonds , it takes bonds out of the economy and replaces them with money, MS increases
-If it sells- It takes money an gives the security to the investor
Discount rate- The interest rate that the FED charges commercial banks for short term loans.
Federal Fund rate- The interest rate that banks charge one another for overnight loans
*banks to banks*
Prime Rate- Interest Rate that banks charge their most credit worthy customers
**ppl with good credit scores
Loanable Funds Market
Private Sector supply and deamand
**Those who want to lend and borrow
Demand- Inverse relationship between real interest rate and quantity loans demanded.
Supply- Direct relationship between real interest rate and quantity loans supplied.
