USC ECON 205 - What Money Is and Why It's Important

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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 valuationOutline of Current Lecture - What do we consider money?- What is the Federal Reserve?- What is the role of banks in the monetary system?Current LectureWhat Money is and Why It's Important- Without money, trade would require bartero 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 resources3 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 power2 Kinds of Money- Commodity Money- takes the form of a commodity with instrinsic valueo i.e. gold coins- Fiat Money- without intrinsic value, used as money because of government decreeo i.e. US dollarThe Money Supply- Money Supply- quantity of money available in the economyo A.k.a. money stock- Assets considered part of the money supplyo Currency- paper bills and coins in hand of publico Demand deposit- checksMeasures 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 courseCentral 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 USStructure 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 bankso FOMC decides monetary policyBank 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 giveBank T-account- T-account- a simplified accounting statement that shows a bank’s assets and liabilitieso Liabilities include depositso Assets include loans and reservesBanks and the Money Supply: An Example- No banking system- public holds the $100 as currencyo Money supply = $100o Currency + deposits = $100- 100% reserve banking system- publicdeposits the $100 at First National Banko Money Supply = $100; no effect- Fractional Reserve banking systemo R=10%- Depositors have $100 in deposits, borrowers have $90 in currency- Money Supply = C + D = $190o 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 moneyo 100+90+81+…The Money Multiplier- Money Multiplier- amount of money the banking system generates with each dollar of reserveso 1/RA More Realistic Banking Sheet- Assets- banks also hold securities- Liabilities- also obtain funds from issuingdebt and equity- Bank Capital- resources a bank obtains byissuing equity to its owners- Leverage- use of borrowed funds tosupplement existing funds for investmentpurposes- Assets must always equal liabilitieso This is why its called a balance sheet- Leverage ratio- ratio of assets to bank capitalLeverage 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 debtsLeverage ad the financial crisis- In 2008- 2009, banks suffered losses on mortgage loans and mortgage-backed securities due to widespread defaultso Securities were worth less than they thought they wereo Problem: many banks became insolvent all at the same time- Credit crunch- banks found themselves with too little capital, responded by reducing lendingGovernment’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 2009o Recapitalized the banking

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