Macroeconomics Module 12 Money and Banking What is

Macroeconomics Module 12: Money and Banking

What is Money? • • • Barter: literally, trading one good or service for another, without using money Commodity Money: an item that is used as money, but which also has value from its use as something other than money Commodity-Backed Currencies: dollar bills or other currencies with values backed up by gold or another commodity Double Coincidence of Wants: a situation in which two people each want some good or service that the other person can provide Fiat Money: something used as money, but which has no intrinsic value besides that Medium of Exchange: whatever is widely accepted as a method of payment

Defining Money by its Functions • • Money solves the double coincidence of wants problem • • • First, since money is generally accepted as a means of payment (or medium of exchange) Second, people are willing to sell something for money Third, money serves as a unit of account Money is anything that can serve all of these functions— it is a medium of exchange, a store of value, a unit of account, and a standard of deferred payment

Commodity versus Fiat Money • • • Money has taken a wide variety of forms in different cultures Examples of commodity money is gold, silver, cowrie shells, cigarettes, and even cocoa beans Fiat money has no intrinsic value, but is declared by a government to be the legal tender of a country

Measuring Money: Currency, M 1, and M 2 • • • Coins and Currency in Circulation: the coins and bills that circulate in an economy that are not held by the U. S Treasury, at the Federal Reserve Bank, or in bank vaults Credit Card: immediately transfers money from the credit card company’s checking account to the seller, and at the end of the month the user owes the money to the credit card company; a credit card is a short-term loan Debit Card: like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller Demand Deposit: checkable deposit in banks that is available by making a cash withdrawal or writing a check Liquidity: how quickly and easily an asset can be converted to a means of payment to make a purchase M 1 Money Supply: a narrow definition of the money supply that includes currency and checking accounts in banks, and to a lesser degree, traveler’s checks.

Measuring Money: Currency, M 1, and M 2 cont. • • • M 2 Money Supply: a definition of the money supply that includes everything in M 1, but also adds savings deposits, money market funds, and certificates of deposit Money Market Fund: the deposits of many investors are pooled together and invested in a safe way like short-term government bonds Savings Deposit: bank account where you cannot withdraw money by writing a check, but can withdraw the money at a bank—or can transfer it easily to a checking account Smart Card: stores a certain value of money on a card and then one can use the card to make purchases Time Deposit: account that the depositor has committed to leaving in the bank for a certain period of time, in exchange for a higher rate of interest; also called certificate of deposit

M 1 and M 2 M 1 • M 1 is the most narrow definition of the money supply • Includes coins and currency in circulation M 2 • A broader definition of money, M 2 includes everything in M 1 but also adds other types of deposits • Includes savings deposits, money market funds, certificates of deposit, etc.

M 1 and M 2: Image

Credit • • • When you make a purchase using money that you don’t have, you are using credit Credit is someone else’s money that they have lent to you Typically you use credit to buy something like a car, a house, or college expenses, “big-ticket items” that will benefit you for a long time Instead of saving up and only then paying for them, credit allows you to buy now and pay for them over time Sometimes people obtain credit in advance so that in the future when opportunities or needs arise they will be able to buy something

Credit cont. • • • Credit comes in many forms, including loans, bonds, notes, or lines of credit (like home equity loans) All are essentially IOUs: that is, promises to repay with interest Debt is accumulated credit, less what has been repaid If you look at a credit card statement, each purchase you make using a credit card is a loan from the credit card company to you Your total debt is the sum of money you have borrowed from all your creditors

Financial Markets and Assets • • Bills: short term (less than one year) debt instruments Bonds: long term (greater than 10 years) debt instruments Debt Instruments: IOUs Equities or Stocks: Ownership in a private company (unlike debt which conveys no ownership) Initial Public Offering (IPO): original sale of stock by a corporation Notes: intermediate term (1 -10 year) debt instruments Securities: synonym for financial assets

Financial Markets and Assets cont. • • Where do individuals put their savings, and where do businesses obtain the funding for investment expenditure? The answer to both of these questions is financial markets. Financial markets include the banking system, equity markets like the New York Stock Exchange, or the NASDAQ Stock Market, bond markets, commodity markets and more. Financial markets are global, Americans put their savings into foreign as well as domestic bank accounts, foreign and domestic stocks and foreign and domestic bonds. All financial assets are called securities.

Financial Markets, Supply and Demand, and Interest • • Interest Rate: the “price” of borrowing in the financial market; a rate of return on an investment. Intertemporal Decision Making: the study of how people make choices about what and how much to do at various points in time; when choices at one time influence the possibilities available at other points in time. Financial markets are made up of a large number of markets for different types of securities: equities, bonds, credit cards, etc. Each financial asset is a substitute for every other financial asset (to greater or lesser extent), and thus, all financial markets are linked, directly or indirectly.

The Commercial Banking System • • • Checking Account: a bank account that typically pays little or no interest, but that give easy access to money either by writing a check or by using a “debit card” Credit Union: a nonprofit financial institution that its members own and run Debit Card: a card that lets the person make purchases, and the financial institution immediately deducts cost from that person’s checking account Depository Institution: institution that accepts money deposits and then uses these to make loans Financial Intermediary: an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return Payments System: system by which buyers and sellers exchange money for goods, services and financial capital.

The Commercial Banking System cont. • • Savings Account: a bank account that pays an interest rate, but withdrawing money typically requires a trip to the bank or an automatic teller machine Transaction Costs: the costs associated with finding a lender or a borrower for money

The Role of Banks as Financial Intermediaries • Banks play two key roles in the functioning of the economy, • Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets Banks lower transactions costs • • • first by facilitating the payments system and second by serving as financial intermediaries.

Banking Assets and Liabilities • • Asset: item of value that a firm or an individual owns Asset—Liability Time Mismatch: customers can withdraw a bank’s liabilities in the short term while customers repay its assets in the long term Balance Sheet: an accounting tool that lists assets and liabilities Bank Capital: a bank’s net worth Diversify: making loans or investments with a variety of firms, to reduce the risk of being adversely affected by events at one or a few firms Liability: any amount or debt that a firm or an individual owes Net Worth: the excess of the asset value over and above the amount of the liability; total assets minus total liabilities Reserves: funds that a bank keeps on hand that it does not loan out or invest in bonds

Banking Assets and Liabilities cont. • • T-Account: a balance sheet with a two-column format, with the T-shape formed by the vertical line down the middle and the horizontal line under the column headings for “Assets” and “Liabilities” Treasury Securities: government debt obligations in which the government sells short term bills, intermediate term notes and long term bonds to raise money The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right All firms use T-accounts, though most are much more complex

How Banks Create Money • • • Banks create money through making loans. Money Multiplier: ratio of total money in the economy divided by the amount of reserves, or the ratio of change in the total money in the economy divided by a change in the amount of reserves; formula for the money multiplier is 1/(required reserve ratio) Required Reserve Ratio: percentage of total deposits a bank must hold as reserves

Quick Review • • What are the functions of money? Contrast commodity money and fiat money Contrast and classify monies as either M 1 money supply and M 2 money supply What is credit? What are financial markets and their assets, including securities? What are the types of financial markets and how they are linked How are market forces determined by interest rates in financial markets?

More Quick Review • • • How do banks act as intermediaries between savers and borrowers? What is the difference between banks and credit unions? What is a bank’s assets and liabilities in a T-account Analyze the causes of bankruptcy and recessions How do banks create money? How do you calculate how banks create money using the money multiplier formula?