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GWU ECON 1012 - Chapter 14: Money

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Chapter 14: Money, Banks, and the Federal Reserve SystemMoney: assets that people are generally willing to accept in exchange for goods and services or for payment of debtsAsset: anything of value owned by a person or a firmBarter and the Invention of Money- Barter economies: economies where goods and services are traded directly for other goods and services- Shortcoming- Each person must want what the other one has-double coincidence of wants- Commodity money: a good used as money that also has value independent of its use as money- Trading goods and services is much easier when money becomes available- People become much more productive specializing because they can pursue their comparative advantage- By making exchange easier, money allows people to specialize and become more productiveThe Functions of Money- Medium of exchangeo When sellers are willing to accept money in exchange for goods or serviceso People can sell goods and services for money and use the money to buy what they wanto An economy is more efficient when a single good is recognized as a medium of exchange- Unit of accounto In a barter system, each good has many priceso Once a single good is used as money, each good has a single price rather than many priceso This function of money gives buyers and sellers a unit of account A way of measuring value in the economy in terms of money- Store of valueo Money allows value to be stored easily If you do not use all your dollars to buy goods and services today, you can hold the rest to use in the futureo Financial assets (stocks, bonds, etc.) offer an important benefit relative to holding money Pay a higher rate of interest or may increase in value in the futureo Money is the most liquid asset Ease with which an asset can be converted into the medium of exchange- Standard of deferred paymento Money can facilitate exchange at a given point in time by providing a medium of exchange and a unit of accounto Money can facilitate exchange over time by providing a store of value and a standard of deferred paymento Value of money depends on its purchasing powerWhat can serve as money?- Medium of exchange helps to make transactions easier, allowing the economy to work more efficiently- 5 criteria make a good suitable for use as a medium of exchange:o The good must be acceptable to most peopleo It should be of standardized quality so that any two units are identicalo It should be durable so that value is not lost by spoilageo It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transportedo The medium of exchange should be divisible because different goods are valued differently- Commodity money’s value depends on its purity- Fiat money: money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity moneyo Paper currency is issued by a central banko Federal Reserve: the central bank of the US Legal tender which means they require that it be accepted in payment of debts and that cash or checks denominated in dollars be used in payment of taxeso Households and firms have confidence that if they accept paper dollars in exchange for goods and services, the dollars will not lose much value during the time they hold themHow is money measured in the US today?- 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- Currency has a larger value than checking account deposits, but checking account deposits are used much more often than currency to make payments- Foreign banks and foreign government hold some dollars outside the USo Most are held by households and firms in countries where there is notmuch confidence in the local currency- If enough people are willing to accept dollars as domestic currency, dollars become a second currency for the country - M2: a broader definition of the money supply: it includes M1 plus savings account balances, small denomination time deposits, balances in moneymarket deposit account in banks, and non-institutional money market fund shareso Vanguard’s Treasury Money Market Fund and Fidelity’s Cash Reserves Fund are money market mutual funds Invest in very short-term bonds- Money supplyo Consists of both currency and checking account depositso Because balances in checking account deposits are included in the money supply, banks play an important role in the way the money supply increases and decreasesCredit Cards and Debit Cards?- Not included in definitions of money supply- When you buy something with a credit card, you are in effect taking out a loan from the bank that issued the credit card- Cards themselves do not represent moneyHow do banks create money?- Most important component of the money supply is checking accounts in banks- Banks are profit-making private businesseso Role in the economy is to accept deposits and make loans by creating checking account deposits- Bank balance sheeto A firm’s assets are listed on the left and its liabilities and stockholders’equity are listed on the righto Key assets are its reserves, loans, and holdings of securities (US Treasury bills) 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 requiremento Banks make consumer loans to households and commercial loans to businesses A loan is an asset to a bank because it represents a promise by the person taking out the loan to make certain specified payments to the bank Banks largest liability is its deposits- Deposits: checking accounts, savings accounts, and certificates of deposit- Owed to the households or firms that have deposited the fundsUsing T-accounts to show how a bank can create money- A T-account is a stripped-down version of a balance sheet that shows only how a transaction changes a bank’s balance sheet- Total value of all the entries on the right side must always be equal to the total value of all the entries on the left side-Banks are required to keep 10% of deposits as reservesSimple Deposit Multiplier: the


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