Macro Final Exam Review Ch 14 Ch 15 04 21 2014 Ch 14 Money Banking and Financial Institutions Usable for buying goods and services any of the items available in Allows society to escape the complications of barter Enables society to gain advantage of geographic and human The Functions of Money Medium of Exchange the market place specialization Unit of Account Society uses monetary units dollars euros etc to measure the worth of a variety of goods Easy to compare the prices of goods Defines debts and obligations Enables people to transfer purchasing power from the present to the Store of Value future Store wealth as money Anything that is accepted as a medium of exchange can serve as money Money Definition M1 Consists in 1 Currency 51 coins and paper money Provided by Government and government agencies 2 All checkable Deposits 49 Provided by Commercial Banks and Thrifts savings institutions like Savings and Loans Association Mutual Savings Bank Credit Union The currency of the US is token money because the value of the material out of which that piece of currency is made is less than the face value M1 Currency Checkable deposits We exclude currency held by banks when determining the total supply of money so we avoid the problem of double counting Also excluded are any checkable deposits of the government of the Federal Reserve Broader definition of money because it includes M1 near monies Money Definition M2 Near Monies Highly liquid financial assets 1 Saving accounts can be easily transferred to a checkable account 2 Small denominated time accounts become available at maturity 3 Money market mutual funds Depositor can easily redeem shares M2 M1 Saving Accounts Small denominated time accounts Money Market mutual funds What Backs the money The money is backed by government s ability to keep the value of money supply If the government backed the currency with let s say gold the supply of money would depend on the supply of gold By not baking the money the government can easily manage money What gives money its value Acceptability people accept currency and checkable accounts as money Legal Tender given by the government Relative Scarcity the supply of money will determine the purchasing power of a monetary unit Purchasing Power of the dollar If the price level increases the purchasing power decreases now you need more money to buy the same product if the price level decreases the purchasing power increases Ex Price level doubles the value of the dollar declines by 50 If the government issues to many pieces of paper currency the purchasing power of each of those units is undermined In order to stabilize the purchasing power of a nation s money we need to stabilize the nation s price level This can be done through management of the monetary policy and fiscal policy The Federal Reserve and the Banking System Federal Reserve System the Fed Directs the activities of the 12 Federal Reserve Banks which control the lending activity of thrifts and banks MAJOR GOAL control money supply Fed consists in a Board of Governors 7 members The 12 Federal Reserve banks act as the Central Bank they are quasi public banks blend private ownership and public control and banker s banks perform same functions for thrifts and banks as those institutions perform for the public Fed Functions and the Money Supply 1 Issuing Currency 2 Setting Reserve requirements fractions of checking account balances that banks must maintain as a reserve 3 Lending to financial institutions and serving as an emergency lender makes short term loans to banks 4 Providing for check collection Ex check of a Miami bank can be 5 Acting as Fiscal agent for the federal government form the money 6 Supervising Banks asses banks profitability and makes sure banks 7 Controlling the money supply this enables it to control interest rates collected at a Dallas bank collected from taxes etc obey regulations makes policy decisions Ch 15 Money Creation The fractional Reserve System currency in bank vaults Only a portion of checkable deposits are backed up by reserves of The Goldsmiths 16th Century people started to store their gold with the Goldsmiths for a fee the depositor received a receipt first type of paper money Goldsmiths backed their circulating paper money receipts fully with the gold they held people accepted the receipt as money so they would rarely redeem the gold in the vaults Goldsmiths realized that the receipts could be issued in excess and put into circulation by making interest earning loans First fractional reserve system in which reserves in bank vaults are a fraction of the total money supply 2 CHARACTERISTICS OF FRACTIONAL RESERVE BANKING Banks can create money through lending Banks with fractional reserves are vulnerable to Panics or runs Everyone withdraws money at the same time bank goes bankrupt because it runs out of reserves How is money made and to make loans Commercial banks have 2 basic functions to accept deposits of money All commercial banks and thrift institutions that provide checkable deposits must by law keep required reserves specified of checkable deposit liabilities that a commercial bank must keep in reserve Reserve Ratio Ex citizen deposits 100 000 Reserve Ratio 20 the commercial bank deposits 20 000 100 000 x 0 2 in the Federal Reserve Bank the minimum amount Excess Reserve actual reserves required reserves Ex commercial bank deposits 80 000 in the Federal Reserve Bank Excess reserve 80 000 20 000 60 000 What is the purpose of reserves It is not to provide commercial bank liquidity it is for Control required reserves help the Fed control the lending ability of commercial banks Reserves are an asset to commercial banks and a liability to the Fed Transaction 6 Granting a Loan A commercial bank grants a loan of 50 000 in return the person borrowing the money gives the bank a IOU promissory note assuring the bank that he will pay back The person has now a 50 000 in a checkable account When a bank makes a loan it creates money because the person went to the bank with something that is NOT money the IOU and walked out with something that is money the checkable account There is a change in the total supply of money This checkable deposit money may be thought as debts of Commercial Banks and thrifts The lending ability of a bank is limited to the excess reserves amount if it lends more than that the additional amount would lower the banks reserve The money created is destroyed when borrowers pay off the loan