An Overview of Money What is Money A Means of Payment or Medium of Exchange Barter direct exchange of goods and services for other goods and services alternative to monetary economy Requires double coincidence of wants for trade to take place to effect a trade you have to nd someone who has what you want and that person must also want what you have Where range of goods is small as it is in relatively unsophisticated economies it is not dif cult to nd someone to trade with and barter is often used In complex society with many goods barter exchange involves intolerable amount of effort Medium of exchange or means of payment what sellers generally accept and buyers generally use to pay for goods and services eliminates double coincidence of wants problem Under monetary system money is exchanged for goods or services when people buy things goods or services are exchanged for money when people sell things An asset that can be used to transport purchasing power from one time period to another Example if you raise chickens and at the end of the month sell them for more than you want to spend and consume immediately you may keep some of your earnings in the form of money until the time you want to spend it Other stores of value besides money antique paintings diamonds Liquidity property of money property of money that makes it a good medium of exchange as well as store of value it is portable and readily accepted and thus easily exchanged for goods Main disadvantage of money as store of value is that value of money falls when prices of goods and services rise if price of potato chips rises from 1 per bag to 2 per bag the value of the dollar bill in terms of potato chips falls from one bag to half a bag When this happens it may be better to use potato chips or antiques or real estate as a store of value A Store of Value A Unit of Account Standard unit that provides consistent way of quoting prices Commodity and Fiat Monies Commodity monies items used as money hat also have intrinsic value in some other use ex Prisoners of war making purchases with cigarettes and holding wealth in form of cigarettes but could also be smoked Fiat or token money items designated as money that are intrinsically worthless actual value of dollar bill is basically zero Paper money is accepted as means of payment because gov has taken steps to ensure that it s money is accepted Gov declares paper money to be legal tender must be accepted in settlement of debts Gov also promises public that it will not print money so fast that it loses value Currency debasement decrease in value of money that occurs when it s supply is increased rapidly can lead to serious in ation Measuring the Supply of Money in the United States M1 Transactions Money Money that can be directly used for transactions Value of all currency including coins held outside of bank vaults and the value of all demand deposits checking accounts traveler s checks and other checkable deposits Stock measure it is measured at a point in time M2 Broad Money Add near monies close substitutes for transactions money such as savings accounts and money market accounts M2 M1 savings accounts money market accounts other near monies Main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable When banks introduced new forms of interest bearing checking accounts in early 1980s M1 shot up as people switched their funds from savings accounts o checking accounts However M2 remained fairly constant because fall in savings account deposits and rise in checking account balances were both part of M2 canceling each other out Beyond M2 The Private Banking System For our purposes money will always refer to transactions money or M1 Banks and banklike institutions borrow from individuals or rms with excess funds and lend to those who need funds Ex Commercial banks receive funds in various forms including deposits in checking and savings accounts They take these funds and loan them out in the form of car loans mortgages commercial loans and so on Financial intermediaries banks and other institutions that act as a link between those who have money to lend and those who want to borrow money Main types of nancial intermediaries are commercial banks along with savings and loan associations life insurance companies and pension funds Run on a bank occurs when many of those who have claims on a bank deposits present them at the same time The fear of a run usually causes a run The Modern Banking System A Brief Review of Accounting Assets liabilities net worth Assets liabilities net worth Assets are things a rm owns that are worth something for a bank assets include bank building its furniture its holdings of gov securities cash in its vaults bonds stocks and so on Most important asset is loans it has made borrower gives bank IOU promise to repay certain sum of money on or by certain date Other bank assets include cash on hand vault cash and deposits with the u s central bank the federal reserve bank Firms liabilities are its debts banks liabilities are the promises to pay or IOU s it has issued Banks most important liabilities are its deposits debts owed to depositors because when you deposit money in your account you are in essence making a loan to the bank Net worth represents the value of the rm to its stockholders or owners Reserves deposits that a bank has at the federal reserve bank plus it s cash on hand Required reserve ratio rrr percentage of its total deposits that a bank must keep as reserves at the federal reserve If reserve ratio is 20 percent a bank with deposits of 100 million must hold 20 million as reserves at the fed Assets reserves and loans Liabilities deposits and net worth The Creation of Money Chances of run on a bank are fairly small and even if there is a run the central bank protects the private banks in various ways therefore banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction A banks required amount of reserves is equal to the required reserve ratio times the total deposits in the bank Excess reserves actual reserves required reserves Bank can only make loans if it has excess reserves When bank makes a loan it creates a demand deposit for the borrower This creation of a demand deposit causes the banks excess reserves to fall because the extra deposits created by the loan use up some of the excess reserves on hand The Money Multiplier An increase in bank reserves leads to a
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