Sunday, April 14, 2013

UNIT IV

MONEY

Uses of Money

  • Medium of exchange
    • ex. trading
  • Unit of account
    • establishes worth
  • Store of money
    • money holding value over a period of time

Types of Money

  • Piat money
    • money because the govn't says so
  • Commodity money
    • ex. silver/gold coins
    • goods, no physical money exchanged
  • Representative money
    • IOU
    • backed by something tangible

Characteristics of Money

  • durability
  • portable
  • divisibility
  • uniform
  • scarcity
  • acceptability

Money Supply

  • M1 Money
    • Currency in circulation, checkable deposits (demand deposits/check), travelers check
  • M2 Money
    • consists on M1 money + savings accounts + money market accounts and deposits held by banks outside US

Fractional Reserve System

  • Process by banks upholding on small portion of their deposits in reserve and loaning out the excess
    • Banks keep cash on hand (Required reserves) to meet depositors' needs
    • Banks must keep reserve deposits in their vaults or at Federal Reserve Bank
  • Total Reserves: total funds held by a bank 
    • TR= RR+ER (required reserves + excess reserves)
  • Banks can legally lend only to the extent of their excess reserves
  • Reserve Ratio= RR/TR

Significance of 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 Fed control over how much money banks can create

Functions of FED

  1. control 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

  • Statement of assets and claims summarizing the financial position of a firm/bank at some point in time
  • must balance
  • Assets
    • what you own
    • A= L+ NW
    • Required reserves- required by FED to keep on hand to meet demand
    • Excess reserves- reserves over an above the amount needed to satisfy  the minimum reserve ratio set by Fed
    • Loans to firms, consumers, and other banks (earns interest)
    • Loans to gov= treasury securities
    • bank property- if banks fail, you could liquidate the building/ property
  • Liabilities
    • Demand deposit ($ put into the bank)
    • Times deposits (CDs)
    • Loans from Fed. 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 or failure)
    • claims of non-owners
  • Net worth: claim of the owners against the firm's assets

Reserve Requirement

  • The Fed requires banks to always have money readily available to meet consumer's demand for cash
  • Typical Require Reserve Ratio= 10%

Example RR ratio questions

  1. The Reserve Ratio is 5%. You deposit $1000 into a bank. How much is a bank required to add to its reserves?
.05 * 1000= $50

            b) How much money can they loan?
 1000-50= $950
      2. Suppose a bank holds 20% of deposits in reserves making loans w/ the rest
    • The bank will make $800 in loans
      • 1000 * .2=  200 RR
      • 1000-200= $800
  • The reserve require ratio
    • the % of DD that must be stored as vault cash or kept on Fed. Funds in the banks account with  the Fed Res
    • Determines money multiplier (1/rr)
    • Decreasing the reserve ratio increases the rate of money creation in the banking system (expansionary)
    • Increasing the reserve ratio decreases the rate of money in the banking system (contractionary)
    • Changing the require reserve ratio is the least used tool of monetary policy
  • Money Multiplier
    • shows us the impact of a change in the DD on loans and eventually the money supply
    • indicates the total number of dollars created in the baking system by each dollar addition to the monetary base (bank reserves and currency in circulation)
    • 1/RR
      • example if RR is 25, money multiplier is 4 (1/.25)

Types of Multiple Deposit Expansion Questions

  1. Calculate the initial change in excess reserves aka amount a single bank can loan from the initial deposit
  2. Calculate the change in loans in the base system
  3. Calculate the change in money supply
    1. Sometimes type 2 and type 3 will have the same results
  4. Calculate the change in demand deposit
Ex: A bank has a reserve requirement ratio of 10%, and has a purchase of government bonds of $100 mil.
  • Determine amnt that a single bank can lend
    • 100- (.2 *100)= $80 mil loans
  • Determine the max change in loans
    • 80* (1/.2) -> 80* 5= $400 mil max in new loans
  • Max change in money supply
    • 400+100= $500
    • Max change in loans + amnt of Fed Res action
  • Max change in demand deposits
    • 400+100= $500 mil
    • max change in loans+ amnt of initial deposit

Loanable Funds

  • 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, govnt, 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, govnt, and foreign sector. It is also the demand for bonds.

Changes in Dlf

  • Remember! Demand for LF= borrowing (supplying bonds)
  • More borrowing= more demand for LF, shift ->
  • Less borrowing = less demand for LF, shift <-
  • Ex. Govnt deficit spending= more borrowing= more demand for LF, shift ->
  • Ex. Less investment demand= less borrowing= less demand for LF, shift <-

Changes in Slf

  • Supply of LF= savings (demand LF)
  • More savings= more supply LF, shift ->, and vice versa
  • Ex. gov budget surplus= more saving= more supply LF, shift ->
  • Decrease in consumers' MPS= less saving= less Slf, shift <-

Let's Review!

  • Required reserve= amount of deposit * RR ratio
  • Excess reserve= TR-RR
  • Maximum amnt a single bank can loan= total change in excess reserves caused by a deposit
  • Money Multiplier= 1/RR ratio
  • Total change in loans= amount a single bank can lend * Money multiplier
  • Total change in money supply= Total change in loans +Amount of Fed action
  • Total change in demand deposits= Total change in Loans +any cash deposited
  • Fiscal policy: Made my Congress, Tax or Spend
  • Monetary Policy: by Fed
    • OMO: Open market operations, buy or sell bonds
    • RR
    • Discount rate: interest rate charged by Fed for overnight loans to commercial banks, does not change money supply directly
    • Federal Funds rate: interest rate charged by 1 commercial bank for overnight loans to another commercial bank. FOMC sets a Fed. fund rate and uses OMO to guide effective rate to target rate
Expansionary (Easy money): Buy bonds from public, decrease the RR, Discount rate, and Fed. Funds rate Contractionary (tight money): Sell bonds to public, increase the RR, Discount Rate, and Fed. Fund Rate

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