Macro exam: Chapter 12 Money, Banking and the Financial System

money

Any good that is widely accepted for purposes of exchange and the repayment of debt.

Three functions of money

1. medium of exchange

2. unit of account

3. store of value

Medium of Exchange

Anything that is generally acceptable in exchange for goods and services; a function of money.

Unit of Account

A common measure in which relative values are expressed; a function of money.

Store of Value

The ability of an item to hold value over time; a function of money.

Barter

Exchanging goods and services for other goods and services without the use of money.

Double Coincidence of Wants

In a barter economy, a requirment, which must be met before a trade can be made. It specifies that a trader must find another trader who at the same time is willing to trade what the first trader wants and wants what the first trader has.

What constitutes money? What is included in the money supply?

M1 and M2

M1

Currency held outside banks plus checkable deposits plus traveler's checks. Referred sometimes as the narrow definition of the money supply or as transactions money. It is money that can be directly used for everyday transactions - to buy gas for the car, groceries to eat, and clothes to wear.

M1 = Currency held outside banks

+ Checkable deposits

+ Traveler's checks

Currency

Coins (minted by U.S. Treasury) and paper money (99% in circulation is in the form of Federal Reserve notes issued by the Federal Reserve District Banks (the Fed)).

Federal Reserve Notes

Paper money issued by the Federal Reserve

Checkable Deposits

Deposits on which checks can be written

M2

M1 plus savings deposits (including money market deposit accounts) plus small-denomination time deposits plus money market mutual funds (retail). Commonly referred to as the broad definition of the money supply.

M2 = M1

+ Saving deposits (including money market deposit accounts)

+ Small-denomination time deposits

+ Money market mutual funds (retail)

Savings Deposit

Sometimes called a regular saving deposit. An interest-earning account at a commercial bank or thrift institution. Normally, checks cannot be written on savings deposits, and the funds in a savings deposit can be withdrawn at any time without a penalty payment.

Time Deposit

An interest-earningdeposit with a specified maturity date. Time deposits are subject to penalties for early withdrawal, that is, withdrawal before the maturity date. Small-denomination time deposits are less than $100,000.

Money Market Deposit Account (MMDA)

An interest-earning account at a bank or thrift institution, for which a minimum balance is usually required and most of which offer limited check-writing privileges.

Money Market Mutual Fund (MMMF)

An interest-earning account at a mutual fund company, for which a minimum balance is usually required and most of which offer limited check-writing privileges. Only retail MMMFs are part of M2.

What is the benefit of money emerging out of a barter economy?

It lowers the transaction costs of making exchanges.

Fractional Reserve Banking

A banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities. Our modern-day banking operates within such a system.

Federal Reserve System (the Fed)

The central bank of the United States.

Reserves

The sum of bank deposits at the Fed and vault cash.

Reserves = Bank deposits at the Fed + Vault Cash

Required Reserve Ratio (r)

A percentage of each dollar deposited that must be held in reserve form (specifically, as bank deposits at the Fed or vault cash).

Required Reserves

The minimum dollar amount of reserves a bank must hold against its checkable deposits, as mandated by the Fed.

Required reserves = r x checkable deposits

Excess Reserves

Any reserves held beyond the required amount; the difference between (total) reserves and required reserves.

Excess reserves = reserves - required reserves

Direct Finance

Borrowers and lenders come together in a market setting, such as in the bond market. In the bond market, people who want to borrow funds issue bonds. The buyer of the bond is the lender, and the seller of the bond is the borrower. The buying and selling in a bond market are simply lending and borrowing.

Indirect Finance

Funds are loaned and borrowed through a financial intermediary. For example a commercial bank is a financial intermediary, doing business with both savers and borrowers. Through one door the savers come in, looking for a place to deposit their funds and earn regular interest payments. Through another door come the borrowers, seeking loans on which they will pay interest. The bank or the financial intermediary, ends up channeling the saved funds to borrowers.

Financial Intermediary

A financial intermediary transfers funds from those who want to lend funds to those who want to borrow them.

Asymmetric Information

Relates to an economic agent on one side of a transaction having information that an economic agent on the other side of the transaction does not have.

Adverse Selection

A phenomenon that occurs when the parties on one side of the market, who have information not known to others, self-select in a way that adversely affects the parties on the other side of the market.

Moral Hazard

A condition that exists when one party to a transaction changes his or her behavior in a way that is hidden from and costly to the other party.

Balance Sheet

A record of the assets and liabilities of a bank.

Asset

Anything of value that is owned or that one has claim to.

Liability

Anything that is owed to someone else.

Insolvency

A condition in which one's liabilities are greater than one's assets.

What the two types of finance?

Direct and Indirect finance.

It is more efficient to exchange goods and services by using

money as a medium of exchange than by bartering them directly.

In addition to being the medium of exchange, whatever serves as

money is likely to become the standard unit of account and a popular store of value.

Throughout history, all sorts of items have served as money. Commodity money

gave way to full-bodied paper money (certificates backed percent by some commodity, such as gold), which in turn gave way to partially backed paper money. Today, our paper money has no commodity backing whatsoever; it is pure fiat money.

One popular definition of the U.S. money supply is

M1, which includes coins, paper money, and several types of checking deposits.

Most economists prefer the M2 definition, which adds

to M1 other types of checkable accounts and most savings deposits. Much of M2 is held outside of banks by investment houses, credit unions, and other financial institutions.

Under our modern system of fractional reserve banking, banks keep cash reserves equal to only a fraction of their total deposit

liabilities. This practice is the key to their profitability, because the remaining funds can be loaned out at interest. It also leaves banks potentially vulnerable to runs

Because of this vulnerability, bank managers are generally conservative in their investment strategies. They also keep a prudent level of reserves. Even so, t

the government keeps a watchful eye over banking practices.

Before 1933, bank failures were common in the United States. They declined sharply once

deposit insurance was instituted.

Some large banks and other financial institutions pose systemic risk, meaning

that their failure would threaten the entire financial system. For that reason, such systemically important institutions are often considered “too big to fail.”

required reserve ratio.

Because it holds only fractional reserves, the banking system as a whole can create several dollars of deposits for each dollar of reserves it receives. Under certain assumptions, the ratio of new bank deposits to new reserves will be

1/m where m is the required reserve ratio.

The same process works in reverse, as a system of deposit destruction, w

when cash is withdrawn from the banking system.

Because banks and individuals may want to hold more cash when the economy is shaky, the money supply would probably contract under such circumstances if the government did not intervene. Similarly,

the money supply would probably expand rapidly in boom times if it were unregulated.

Excess reserves

have proven to be a huge problem in the United States since the financial panic of September 2008.

When excess reserves increase, the deposit multiplier is

reduced, so the money supply grows less rapidly than bank reserves do.

asset

An asset of an individual or business firm is an item of value that the individual or firm owns.

A balance sheet

is an accounting statement listing the values of all assets on the left side and the values of all liabilities and net worth on the right side.

Barter .

is a system of exchange in which people directly trade one good for another, without using money as an intermediate step

Commodity money \

is an object in use as a medium of exchange that also has a substantial value in alternative (nonmonetary) uses.

Deposit creation \

refers to the process by which a fractional reserve banking system turns of bank reserves into several dollars of bank deposits.

Deposit insurance \

is a system that guarantees that depositors will not lose money even if their bank goes bankrupt.

The deposit multiplier

is the ratio of newly-created bank deposits to new reserves.

Excess reserves \\

are any reserves held in excess of the legal minimum.

Fiat money

is money that is decreed as such by the government. It is of little value as a commodity, but it maintains its value as a medium of exchange because people have faith that the issuer will stand behind the pieces of printed paper and limit their production.

Fractional reserve

banking is a system under which bankers keep as reserves only a fraction of the funds they hold on deposit.

•Medium of exchange

•The object or objects used to buy and sell other items such as goods and services

unit of acount

•Standard unit for quoting prices

•Store of value

•Store wealth from one point in time to another

•Why may money not be a good store of value?

•Commodity money

gold and silver

•An object in use as a medium of exchange that also has a substantial value in alternative nonmonetary uses

•To be useful as a medium of exchange, a commodity must be:

•Easily divisible

•Uniform or readily identifiable quality

•Storable and durable

•High value per unit of volume and weight•

•What serves as money?

•Cattle, stones, candy bars, cigarettes, woodpecker scalps, porpoise teeth, giraffe tails, cigarettes, large disk shaped boulders

•Fiat money

•Money that is decreed as such by the government

•Little value as a commodity

•Maintains its value as a medium of exchange because

•People have faith that the issuer will stand behind the pieces of printed paper and limit their production

•Evolution of money

•Commodity money → Full-bodied paper money → Partially backed money → Fiat Money

M 1:

•Narrowly defined money supply

•Coins and paper money in circulation

•Traveler's checks

•Conventional checking accounts and other checkable deposit balances

M 2:

•M 1

•Money market deposit accounts

•Money market mutual funds

•Savings accounts

Liquidity -

the ease with which it can be converted into cash

•During a recession

•Banks prone to reduce money supply

•Increase excess reserves

•Decrease lending to less creditworthy applicants

•Without government intervention contraction in money supply would aggravate recession

•Federal Reserves during the Great Depression

•and the recent financial crisis and Great Recession

•During an economic boom

•Banks expand money supply

•Undesirable momentum to economy

•Without government intervention rapid money growth could lead to inflation