Money and Banking System 13.1
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Transcript Money and Banking System 13.1
What do the following words have in
common?
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Cheese
Dead Presidents
Dough
FEDS
Bones
Benjamins
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????
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
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.
$$$$
◦ Teachers not paid in pencils. $$$$
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
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.
5 Major Characteristics of Money
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Durability
Portability
Divisibility
Stability
Acceptability
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
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.
Go to a drive through
Ask the cashier the
following question:
◦ Will you accept a federal
reserve note in payment for
the food?
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.
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
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)
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)
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.
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.
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?
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
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
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).
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
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.
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
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”
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.
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
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)
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?
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.
Pennies:
Nickels:
◦ Content: 90% Zinc; 10% Copper
◦ Melted down: Penny worth @ 3 cents
◦ Content 70% Copper; 30% Zinc
◦ Melted down: Nickel worth @ 8 cents
Penalty for melting:
◦ 10 years in prison and big fine
◦ Cannot ship out of country > $100 in
pennies/nickels