ECON 205 1st Edition Lecture 12 Outline of Last Lecture Finance studies how participants in financial system make decisions in allocation of resources Present vs future values Risk Asset valuation Outline of Current Lecture What do we consider money What is the Federal Reserve What is the role of banks in the monetary system Current Lecture What Money is and Why It s Important Without money trade would require barter o Would require and double coincidence of wants Double coincidence of wants unlikely occurrence that two people each have a good the other wants Bartering is unnecessary with money and prevents waste of resources 3 Functions of Money Medium of Exchange an item buyers give to sellers when they want to purchase goods and services Unit of account the yardstick people use to post prices and record debts Store of value an item people can use to transfer purchasing power 2 Kinds of Money Commodity Money takes the form of a commodity with instrinsic value o i e gold coins Fiat Money without intrinsic value used as money because of government decree o i e US dollar The Money Supply Money Supply quantity of money available in the economy o A k a money stock Assets considered part of the money supply o Currency paper bills and coins in hand of public o Demand deposit checks Measures of Money Supply M1 currency demand deposits traveler s checks etc M2 everything in M1 plus savings deposits mutual funds etc The distinction between M1 and M2 will often not matter when we talk about the money supply in this course Central Banks and Monetary Policy Central bank an institution that oversees the banking system and regulate the money supply Monetary policy setting of the money supply by policymakers in the central bank Federal Reserve Fed the central bank of the US Structure of the Fed Board of governors has 7 members 12 regional Fed banks located around the US Federal Open Market Committee FOMC includes the Board of Governors and presidents of some of the regional Fed banks o FOMC decides monetary policy Bank Reserves Fractional reserve banking system and use the rest to make loans Reserve requirements established by Fed regulations on the minimum amount of reserves that banks must hold against deposits Reserve Ratio R fraction of deposit that banks hold as reserves total reserves as a of total deposits Reserve requirements are there in case many people withdraw money at the same time bank must have enough money to give Bank T account T account a simplified accounting statement that shows a bank s assets and liabilities o Liabilities include deposits o Assets include loans and reserves Banks and the Money Supply An Example No banking system public holds the 100 as currency o Money supply 100 o Currency deposits 100 100 reserve banking system public deposits the 100 at First National Bank o Money Supply 100 no effect Fractional Reserve banking system o R 10 Depositors have 100 in deposits borrowers have 90 in currency Money Supply C D 190 o Creates money but does not create wealth If borrowers continue to deposit their loans in other banks creating a pattern with the 10 Reserve Ratio then 100 of reserves generates 1000 of money o 100 90 81 The Money Multiplier Money Multiplier amount of money the banking system generates with each dollar of reserves o 1 R A More Realistic Banking Sheet Assets banks also hold securities Liabilities also obtain funds from issuing debt and equity Bank Capital resources a bank obtains by issuing equity to its owners Leverage use of borrowed funds to supplement existing funds for investment purposes Assets must always equal liabilities o This is why its called a balance sheet Leverage ratio ratio of assets to bank capital Leverage Amplifies Profits and Losses Doubles owner s equity Capital requirement a government regulation that specifies a minimum amount of capital intended to ensure banks will be able to pay off depositors and debts Leverage ad the financial crisis In 2008 2009 banks suffered losses on mortgage loans and mortgage backed securities due to widespread defaults o Securities were worth less than they thought they were o Problem many banks became insolvent all at the same time Credit crunch banks found themselves with too little capital responded by reducing lending Government s response To ease credit crunch Fed and US treasury injected capital into the banking system Temporarily made US taxpayers part owners of many banks Succeeded in easing credit crunch and restored lending to normal levels in 2009 o Recapitalized the banking system