Zara Mahmood Nov 14 2013 EC102 Lecture 15 Money and Banking WHAT IS MONEY WHY DO WE NEED IT Economies can function without money Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts Asset Anything of value owned by a person or a firm Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve Required Reserves Reserves that a bank is legally required to hold based on its checking account deposits Required Reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves Excess Reserves Reserves that banks hold over and above the legal requirement Barter and the Invention of Money Barter Economies goods and services are traded for other goods and services Shortcoming each people must want what the other has o Double coincidence of wants Might need several intermediary trades before desired trade takes place o Can take considerable time and energy Commodity Money A good used as money that also has value independent of its use as money Even if you didn t have use for it you would be willing to accept it o Could use it to by other goods and services Deerskin Money allowed colonial specialization o Rather than producing everything you could sell one thing and buy others By making exchange easier money allows people to specialize ad become more productive Functions of Money Medium of Exchange Store of Value o Willing to accept it in exchange for goods and services o Money stores value of your labor o Hold to use the rest in the future o People willing to store cash so they don t incur costs when using it Unit of Account o Establishes the common denominator of all goods and services o Each good has a single price value rather than several o Way of measuring value in terms of money Standard or deferred payment Zara Mahmood Nov 14 2013 EC102 o Can facilitate exchange at a given point in time medium of exchange o Can facilitate exchange over time Store of value standard deferred Money is not wealth Liquidity How easy it is to use an asset as a medium of exchange Cheap property that money possesses that no other asset does unit of account payment M2 M1 Liquid Cash Chkg Dep Saving Deposit Time deposit Stocks Bonds Real Estate Fine Art What Can Serve as Money Which assets should be used as the medium of exchange 5 criteria make a good suitable for use as a medium of exchange Illiqui d o Acceptable Usable by most people o Standardized quality Any two units are identical o Durable o Valuable Value is not lost by spoilage Amounts large enough to be useful in trade can be easily transported o Divisible Different goods are valued differently HOW IS MONEY MEASURED IN THE US TODAY Measures of Money M1 the narrowest definition of the money supply The sum of currency in circulation checking account deposits in banks and holdings of traveler s checks o Currency and Traveler s Cecks Cash in the hands of the public o Checking Deposits Held at commercial banks S Ls Savings Banks and Credit As of Nov 4 2013 M1 2 7 Trillion Unions Zara Mahmood Nov 14 2013 EC102 M2 A broader definition of the money supply It includes M1 savings account balances skall denomination time deposits balances in money market deposit accounts in banks and noninstitutional money market fund shares o M1 Savings Deposits Time deposits o Money market mutual funds and other deposits Money supply consists of both currency and checking account deposits Balances in checking account deposits are included in the money supply banks play an important role in the way the money supply increases and decreases As of Nov 4 2013 M2 10 9 Trillion What is NOT Money Checks Credit cards o Checking deposits are money o Taking a loan have to pay it back Debit card allows you to access checking account Credit cards merely allow you to take short term loans Depository Institutions Essential activity Take deposits and make loans Commercial Banks Thrift Institutions o Savings and Load Associations o Savings Banks o Credit Unionrs Money Market Mutual Funds Bank Balance Sheet Assets A Anything you are owed Anything you own Reserves Vault cash deposits with FED Loans Bonds Other Assets Bank Capital A L Bank s wealth Individual net worth Banks are required to keep 10 of their reserves Can loan out 90 of it Liabilities L Anything you owe Deposits Saving Deposits Checking Deposits Balance sheets ends up the same whether bank loans from reserves or someone s checking deposits Zara Mahmood Nov 14 2013 EC102 Balance Sheet HAS TO Balance Bank Capital A L o A L Bank Capital Bank can loan out 900 but usually does it in the form of increasing the borrower s checking account This increases the money supply by 900 That 900 is deposited to seller s bank increasing their reserves and deposits Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves Total increase in deposits initial deposit o 10 000 1 000 10 Change in checking account deposits change in bank reserves x 1 RR Total Change in Deposits Total Deposits Initial Deposits x 1 R R of checking deposit required to keep on reserve 10 E of their deposits banks are holding as excess reserves anything ore than 10 Total Deposits Initial in reserves x 1 R E R E is called money multiplier Money Supply Total Deposits Cash held by public Money Multiplier Process Eg initial deposit of 10 000 R 10 E 0 1 1 0 10 000 X 10 100 000 100 000 10 000 money supply o 90 000 Money supply increased by 9 000 NOT wealth If E goes up then money supply goes down Reverse Money Multiplier Process EG What happens if somebody withdraws 10 000 from the bank wealth is not being destroyed money is R 10 E 0 Total Deposits Initial Deposits x 1 R E 10 000 X 10 100 000 100 000 10 000 money supply 90 000 Zara Mahmood Nov 14 2013 EC102 THE FEDERAL RESERVE SYSTEM US founded a system of 12 central banks each representing a different district decentralized structure Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves Bank Run A situation in which many depositors simultaneously decide to withdraw money from a bank Bank Panic A situation in which many banks experience runs at the same time Federal Reserve Bank Functions Clear checks o Make sure the money is transferred between banks Issue new currency ad remove damaged currency o Acts as a bank for the bank holds their reserves Lends to member banks Liaison between local