Econ 201 1st EditionExam #3 Study Guide Lectures: 20 - 28Lecture 20 (March 2)Money and Its Functions in an EconomyBarter systems are where people exchange goods for other goods they want; however,this system only works when there is a double coincidence of wants. Money is anintermediate good that people use to buy goods and services from other people. Moneyhas three main functions in an economy: that of a medium of exchange, a unit ofaccount, and a store of value. A medium of exchange is an item buyers give to sellerswhen they want to purchase goods and service. It also acts as a unit of account, which isthe “yardstick” that people use to post prices and record debts. Finally, it functions as astore of value, an item that people can use to transfer purchasing power from thepresent to the future.Types of MoneyThere are three different types of money in an economy: commodity money,representative commodity money, and fiat money. Commodity money is money that is acommodity but also has intrinsic value (i.e. gold). Representative commodity money ismoney that represents a commodity; an example of this is the U.S. dollar from 1945-1973 or a gold exchange. Fiat money is money without intrinsic value, used as moneybecause of a government decree. An example of this is the current U.S. dollar we havenow. One problem with fiat money though is that if the government issues money andthe people do not believe in the new system of money, then it is not of value. The Money SupplyThe money supply, or money stock, is the quantity of money available in an economy.Both currency and demand deposits are considered part of the money supply. Currencyis the paper bills and coins in the hands of the (non-bank) public. Demand deposits, orcheckable deposits, are balances in bank accounts that depositors can access ondemand by writing a check. There are two measures of the U.S. money supply: M1 andM2. M1 is the first measure and includes currency, demand deposits, and traveler’schecks as the money supply. M2 is the second measure supply and includes everythingin M1 along with savings deposits, small time deposits, money market deposits, moneymarket mutual funds, certificates of deposits, and other time deposits. The Banking SystemIn the process of exchanging money between savers and borrowers, banks create moneyby using a fractional reserve banking system, which is a system where banks keep afraction of deposits as reserves and use the rest to make loans. However, banks cannotgive money as they please: the Federal Reserve (Fed) sets reserve requirements, orregulations on the minimum amount of reserves that banks must hold against deposits.The reserve ratio, or R, is a fraction of deposits that banks hold as reserves and showsthe total reserves as a percentage of total deposits. Lecture 21 (March 4) Bank ReservesThere are three types of reserves in a bank: required reserves, actual reserves, and excess reserves. Required reserves are the amount of reserves the bank must hold; actual reserves are the amount of reserves that banks really hold, and excess reserves are the amount beyond what the bank must hold. The formula for these three reserves is actual reserves = required reserves + excess reserves. The key to making money in a banking system is to have excess reserves to be able to lend money to borrowers and make a profit from the interest. T-Account and ExamplesA T-account is a simplified accounting statement that shows a bank’s assets and its liabilities. An example T-account of First National Bank’s assets and liabilities is shown below. First National Bank – Statement 1Assets LiabilitiesReserves: $1,000 Deposits: $1,000Loans: $0Using the example above, suppose that the required reserve ratio is 10%. What will First National Bank’s T-account statement look like if they choose to loan all but the required reserves out to borrowers? Well, if the ratio is 10% and the amount of deposits is $1,000, then the amount of required reserves is (0.10)(1000) = $100. First National Bank would then keep $100 in its reserves and loan $900 out to borrowers; its new T-account statement will look like the following. First National Bank – Statement 2Assets LiabilitiesReserves: $100 Deposits: $1,000Loans: $900Now, the money supply has $1,000 in deposits and $900 in currency from the loans, so the total amount of the money supply is $1,900. This process of loaning all but the required reserve rate can continue indefinitely and increase the money supply. Here, we are assuming that there are no other leakages other than reserve requirements. The Money MultiplierThe money multiplier is the amount of money the banking system generates with each dollar of reserves. To calculate the money multiplier, find the inverse of the requiredreserve ratio, or 1/R. For the example above, if the required reserve ratio is 10%, then the money multiplier is 1/R = 1/0.1 = 10. The first deposit was worth $1,000, so multiplying this by the money multiplier gives us $10,000, the total change in the moneysupply. 1R=1.1=10Extended Bank Balance SheetThe bank capital is the resources a bank obtains by issuing equity to its owners. This is also known as the bank’s assets minus the bank’s liabilities. Leverage is the use of borrowed funds to supplement existing funds for investment purposes. The following new balance sheet is shown below.Balance SheetAssets LiabilitiesReserves: $200 Deposits: $800Loans: $700 Debts: $150Securities: $100 Capital: $50The leverage ratio is the ratio of assets to bank capital. In the example above, the leverage ratio is $1,000/$50 = 20. This means that for every $20 the bank has in assets, $1 is from bank owners while $19 is financed with borrowed money. Lecture 22 (March 6)Appreciation and DepreciationBalance SheetAssets LiabilitiesReserves: $200 Deposits: $800Loans: $700 Debts: $150Securities: $100 Capital: $50In the T-Account statement above, the bank’s total assets are worth $1,000. Suppose that the assets appreciate by 5% from $1,000 to $5,000. This increases the bank’s capital from $50 to $100, doubling the owner’s equity. Now, suppose a bank’s assets decrease by 5%, so that the bank capital falls from $50 to $0. If this bank’s assets decrease by more than 5%, the bank capital will be negative and the bank is insolvent. LeverageLeverage amplifies profits and losses. A capital requirement is a government