Transcript Money and Banking System 13.1

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What do the following words have in
common?
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Cheese
Dead Presidents
Dough
FEDS
Bones
Benjamins
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Go to Dillards and buy a winter coat—Try to
pay with a live chicken?
How about: 12 oranges, a Walrus tusk, a
coffee mug and a picture of your cousin?
Then, you try to pay with a picture of an 18th
century politician printed on green paper.
What’s the difference????
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Money—Anything that people commonly
accept in exchange for goods and services.
3 Functions of Money:
◦ A medium of exchange
◦ A unit of account
◦ A store of value
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Medium of Exchange—is any item that sellers
accept as payment for goods and services.
◦ Buyers know that sellers will accept money in
payment for goods and services.
◦ Restaurant workers are not paid in barbeque sauce.
$$$$
◦ Teachers not paid in pencils. $$$$
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Unit of Account/Standard of Value—Money
provides people with a way to measure the
relative value of goods and services. We
measure in $ and Cents.
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What is a TV worth? Bicycle? DVD player?
Helps consumers to compare prices
Helps clarify opportunity costs
Helps to compare businesses performance:
 Profit of 300,000 bags of rice
 Profit of 500,000 hamburgers
 Profit of $100,000
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Store of Value—2 things must be met
◦ Money must be nonperishable
◦ Money must keep its value over time
 If both conditions are met, people can accumulate
their wealth for later use.
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5 Major Characteristics of Money
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Durability
Portability
Divisibility
Stability
Acceptability
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Durability—the ability to be used over and
over again.
◦ Eggs? Gold/Silver? U.S. Dollars?
Portability—the ability to be carried from one
place to another.
◦ Small, lightweight
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Divisibility—the ability for money to be
divided into smaller units.
◦ Exact price comparisons can be made
Stability of Value—Must be stable in order to
encourage saving.
Acceptability—People are willing to accept
money in exchange for their goods/services.
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Go to a drive through
Ask the cashier the
following question:
◦ Will you accept a federal
reserve note in payment for
the food?
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If they say no, then
explain that federal
reserve notes are money
M1
 Coins and Paper Money—
◦ Coins minted by the U.S. Mint
◦ Bills printed by the Bureau of Engraving
◦ Paper bills are Federal Reserve Notes
Demand Deposits—Also known as checking accounts
(or Checkable Deposits-largest part of M1).
Near Money—Assets such as savings accounts, and
time deposits.
 Near money because they cannot be immediately
used to buy goods or pay debts.
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M2 (currency plus easily turned into currency)
M2=M1 plus:
◦ Savings Deposits-including money market accounts
◦ Money Market Deposit Account (MMDA)-interest bearing
account that allows direct access but may have balance
requirements and limit # withdrawals. Money is pooled
to buy short term securities.
◦ Small (less than $100K) time deposits (Certificate of
Deposit “CD”)
◦ Due to the extremely convertible nature of these funds
due to technology change, the FED has recently decided
to focus on M2 rather than M1.
M1=Paper and
*Coin in
circulation,
*Checkable
Deposits
*Traveler’s
Checks
M2=M1+Savings
Deposits & Time
Deposits<$100K
M3 not tracked by gov’t since 2006
M3=M2+other
deposits over
100K
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Commercial Banks-primary depository
institutions. Accept household and business
deposits. Use deposits to make wide variety
of loans—short term loans to business,
consumer finance, auto and other durable
goods.
Thrift Institutions- “thrifts” are Savings and
Loans and Mutual banks that take consumer
and business deposits and specialize in
financing mortgages and some other loans.
◦ Credit Unions-take deposits from and lend only to
“members” who often have a commonality (work for
same firm, profession, etc)
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Commodity Money—An item that has value of
its own as a commodity and that can be used
also as money.
◦ Diamonds, gold, silver, even salt!
Representative Money—Has value because it
can be exchanged for something else of value.
It has no intrinsic value. Bills that could be
redeemed for gold/silver/ (Specie)
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Fiat Money—Coin, paper money have been
decreed to have value by the government.
◦ The value ultimately stems from
the citizens faith in the U.S. gov’t.
 Currency—Coins, paper bills,
 used for trading
 Token Money-coins made with
 Low cost materials to keep people from melting down.
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What Backs It? FAITH and STUFF!
Paper Money and Checkable Deposits are
debts.
◦ Promise to pay
◦ Owed by the Federal Reserve Banks
◦ Debts of the commercial and thrift institutions
◦ This is a “management” solution to the money
supply.
 Try to manage right amount of currency for a
particular volume of business.
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Basing money on some commodity allows for
too much “swing”.
◦ If you back your money with gold and then there is
a huge new discover of gold then what happens?
◦ What happens if there is a long lasting decline in
gold production?
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Money has value when:
◦ Accepted—as long as it is accepted for exchange
◦ Legal Tender —this is strengthened b/c the
government designated Federal Reserve notes so
they must legally be accepted (or else the
institution forfeits the right of charging interest).
◦ Relative Scarcity –value depends, like anything else
on Supply and Demand 
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Purchasing Power of the Dollar
◦ Amount a dollar will buy varies inversely with price
level.
◦ When CPI goes up, value of dollar goes down.
◦ When CPI goes down, value of dollar goes up!
◦ Formula:
Dollar’s Value=1/Price level = 1/P
 Note: convert CPI to a dollar equiv 120 CPI=$1.2
◦ If given a price level in base 100 form, then just
divide that into one to determine buying power.
◦ If CPI is 120, then 1/1.20=current value of dollar
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If inflation is high, demand for dollar goes
down b/c it is less acceptable to people as a
store of value and unit of account b/c not
stable.
Rapid declines may cause it to cease being
used altogether (post WWI Germany).
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Stabilization of money’s value requires:
◦ 1. Appropriate fiscal policy
◦ 2. Intelligent management of money supply
(monetary policy)
In the US Managing Money supply is three way
approach:
a. Legislation(incl. forming of Fed Reserve 1913)
b. Government Policy
c. Social Practice
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Currency and Checkable Deposits are forms
of indebtedness to you:
◦ If you buy a coat and write a check, then the check
is a transfer of banks indebtedness from you to the
merchant.
◦ The ability of the banks to honor such claims
depends on there not being too many versions.
◦ This is why banking/checking heavily regulated—to
smooth out the process.
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Monetary
Authorities make a
particular amount
of money available
given the nation’s
real interest rate.
This is Sm
◦ Vertical assumes fixed
quantity of money
available.
◦ Real Interest Rate-
Sm
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Why do people want to hold
wealth in money?
◦ 1. Make purchases
 Transactions Demand-(mortgage,
groceries, doctor, etc)
 Main Determinant for Dt is nominal
GDP.
 The larger the total money value of all
goods and services in an economy, the
larger the quantity of money needed to
negotiate transactions.
 Why nominal? Firms/households want
MORE $ if prices rise or if real output
increases. In both there is a larger
dollar volume required.
 Vertical b/c demand for it depends on
nominal GDP which is a fixed amount
of “stuff”
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2. Asset Demand for Money
◦ *Because of the store of value function
◦ People hold financial assets to:
 Increase liquidity (how easily you can convert wealth to other
forms)—money is most liquid
 Increase their buying power when prices expected to decline.
 Disadvantage-inflation eats at value, if interest doesn’t keep
up with inflation.
 Opportunity costs occur when you hold money—you give up
interest earned in exchange for liquidity.
 As interest rates fall you want more money, as they increase
you want less—so curve follows traditional demand shape.
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Money Market◦ When you combine supply of money and demand
for money on one graph you have the money
market!
◦ Just as in product markets, where supply and
demand meet is the price equilibrium (interest rate
is the price).
◦ So: A decline in money will lead to increased
interest rates
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What causes Shifts in
Demand?
◦ Change in real GDP,
◦ Change in the price level,
or
◦ Change in transfer costs
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Example
A increase the quantity of
money demanded at any
interest rate r, increasing
the demand for money
from D1 to D2. The
quantity of money
demanded at interest rate
r rises from M to M′. The
reverse of any such events
would reduce the quantity
of money demanded at
every interest rate, shifting
the demand curve to the
left
Bond prices Adjust
to Money
Supply/Demand
1. Lower bond
prices mean
higher interest
rates (returns).
2. Higher bond
prices mean
lower interest
rates (returns)
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Bond—institutions borrow money by issuing
bonds.
Maturity—the point at which a bond “comes
due”—when the interest promised will be paid.
So, if you buy a 5 year bond at $10 @5%
$10,000 bond at 5% interest will yield $50
◦ (.05x$10,000)
◦ But what if the market changes over the 5 years?
◦ What if the dollars aren’t worth what they were before?
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If Money Supply Declines:
◦ Bond prices on existing bonds will decrease so yield is
higher:
◦ $50 return/$667 price paid=7 ½ % yield
If Money Supply Increases:
$50 return/$2000 price=2 1/2 % return
So, bond prices are inversely related to interest
rates, and prices are inversely related.
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Pennies:
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Nickels:
◦ Content: 90% Zinc; 10% Copper
◦ Melted down: Penny worth @ 3 cents
◦ Content 70% Copper; 30% Zinc
◦ Melted down: Nickel worth @ 8 cents
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Penalty for melting:
◦ 10 years in prison and big fine
◦ Cannot ship out of country > $100 in
pennies/nickels