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UNC-Chapel Hill ECON 101 - Money and the Banking System

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ECON 101 1st Edition Lecture 9Money: the Money Market and the Banking SystemDefinition of Money: why do people hold and use money?-Money is a medium of exchangeo The definition of money has varied a great deal over the past 7-8decades. In order to be usable as a medium of exchange an asset must be (1) acceptable, (2) protected from counterfeiting, and (3) divisible (for small transactions)-Money is a store of valueo Allows one to store up purchasing power until you need it;  Cash is a store of value but its not as desirable because it doesn’t allow the collection of interest, its not protected against inflation and it subject to theft. - Money is a unit of accounto valuable as a measure of the relative value of different commodities; provides a way of recording receipts, expenditures, assets, and liabilitiesDemand for Money:- Money is a very valuable commodity but in order for you to physically hold money in your possession, there involves an opportunity cost. o *If you hold cash, or put your money in a checking account you forego the interest you could earn if you put the funds into a savings account or into a money market fund or lent it so someone.- Speculative motive: holding less money when interest rates are highand more when they are low. Consequently, the higher the interest rate, the higher the opportunity cost of holding money, the less you are likely to want to hold.These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.o If the interest rate is the “price” of holding money, the demand curve with respect to the interest rate will be downward sloping- Transactions demand: We need to hold money simply to make transactions on a daily, weekly or monthly basis. Generally, the higher our incomes, the more transactions we are likely to make and the higher our transaction demand for money.- Precautionary motive: we hold money to protect us in case of an emergency. Also individuals hold money due to precarious banking given the history of the economy. How the Quantity of Money is measured: - The two most important definitions of money are "M1" and "M2". M1 corresponds most closely to the definition of money as a medium of exchange, while M2 contains assets that have "store of value" characteristics.M1 o Currency: including coins and paper currency ranging in denomination from $1.00 to $100.00o Transactions accounts: demand deposits (non interest bearingchecking accounts) at commercial banks, and other deposits upon which checks can be written (e.g., NOW accounts, "Super NOW accounts, automatic transfer (ATS) system, etc.)o Traveler’s checks: outstandingM2 includes all of M1 plus:o Savings Deposits: Passbook savings accounts, and statement savings accounts that allow withdrawal and deposit by mail.o Savings certificates, less than $100,000 in denomination.o Money-market mutual funds: Funds that invest only in short-term securities (usually maturing in less than 90 days) and allowthe writing of an unlimited number of checks over a specific minimum value (e.g., $500).Ambiguities over the definition of "money" clearly cause problems formonetarists and others who advocate a “constant-growth-rule” for themoney supply. The question is "Which Money Supply?"The Banking System and How it Began: - Banking developed out of a service offered by early Renaissance goldsmiths, who offered their customers a safe place to store their precious gold, which was the universally accepted means of exchangeand store of value. As long as their sole function was to store gold, this service of goldsmiths was of little interest to economists.- The tension between profits and safety comes in the decision as to how much more than the bank's reserves is actually lent. As long as not everyone attempts to get cash from the bank at once, the bank can lend out a high multiple of its reserves. This is called fractional reserve banking, and many banks historically have gotten too greedyand lent out too much money or made loans that could not be repaid, thus not being able to withstand "runs" on the bank. This can cause the very banking crises that the Federal Reserve was established to prevent. Example: Economic crisis of 2008The Deposit Multiplier:- How a monopoly bank creates money: Assume that in our economythere is only one bank. Assume further that this bank is required to keep a certain proportion of its reserves (cash) on hand:reservesdeposits ≥ RRr where RRr is the required reserve ration - The reciprocal of the required reserve ratio is the deposit multiplier.The Need For Monetary Control:- Banks have a vast amount of power in over the money supply therefore:- Small changes in their behavior can cause the money supply to expand (or contract) greatly. In a boom, banks are tempted to lend to the limit of their capacity; this can be inflationary. On the other hand, in a recession banks might be very cautious and keep high excess reserves; this can prolong and deepen the recession.- money supply is an important determinant of aggregate demand for goods and services, regulation of the money supply is important in order to keep the demand for goods and services stable.We will see later how the Fed uses its power over the supply of money to affect not only the money market but the market for real goods and services(and the entire economy) as


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