lecture 28 ECON 2030

ECON 2030 PRINCIPLES OF MACROECONOMICS

INTRODUCTION

  • Instructor: Yushang Wei
  • Lecture 28

THE MEANING OF MONEY

  • Common Misconception:
    • The term "money" is often synonymous with wealth in everyday use.
  • Economic Definition:
    • Economists differentiate between money and wealth:
    • Money includes:
      • Dollar bills in circulation (cash)
    • Wealth encompasses:
      • Financial assets such as stocks, bonds, and real estate, which do not qualify as money.

WHAT IS MONEY?

  • Definition of Money:
    • Money is any asset easily used to purchase goods and services.
  • **Components of Money:
    • Currency in Circulation:**
    • Cash that is held by the public.
    • Checkable Bank Deposits:
    • Bank accounts from which individuals can write checks.
  • Money Supply:
    • The total value of financial assets in the economy considered to be money.
    • Narrow Definition:
    • Considers only the most liquid assets:
      • Currency in circulation and checkable bank deposits.
    • Broader Definition:
    • Includes the narrow definition and approximately checkable assets, such as:
      • Savings account deposits that can be easily transferred into checking accounts.

ROLES OF MONEY

  • Functions of Money:
    • Medium of Exchange:
    • Accepted by people in payment for goods and services.
    • Asset for Trading:
    • Individuals acquire money to trade it, not for personal consumption.
    • Store of Value:
    • Maintains purchasing power over time; enables saving for future consumption.
    • Unit of Account:
    • Provides a measurement standard for comparing values of various goods and services.

TYPES OF MONEY

  • Commodity Money:
    • A tangible good (e.g., gold, silver) with intrinsic value used for exchange.
    • Historical usage spans thousands of years.
  • Commodity-Backed Money:
    • Medium of exchange without intrinsic value, supported by a promise to convert it to valuable goods.
    • Advantage:
      • Reduces resource allocation; banks only need to keep enough gold/silver for note redemption, allowing them to lend out the remainder.
  • Fiat Money:
    • Money whose value is derived from its official status.
    • Advantages:
      • Minimal resource use, adjustable supply per economic needs.
    • Disadvantages:
      • Susceptibility to counterfeiting and governmental abuse.

MEASURING THE MONEY SUPPLY

  • Monetary Aggregate:
    • Overall measure of the money supply.
  • Two Measures of Money Supply:
    • M1:
    • Includes the most liquid forms of money.
    • M2:
    • Includes near-moneys—financial assets convertible into cash/checkable deposits.
    • Examples include small-denomination certificates of deposit (CDs), which aren't checkable but are withdrawable before maturity.
  • Components of M1 and M2:
    • M1 Value:
    • $18,878.8 billion
    • Breakdown:
      • Currency in Circulation (11.8%): $2,225.2 billion
      • Checkable Bank Deposits (90.1%): $18,878.8 billion
      • Other Liquid Deposits (27.4%): $5,172.3 billion
      • Money Market Funds (6.4%): $1,341.1 billion
    • M2 Value:
    • $20,823.1 billion
    • Including:
      • Time Deposits (2.9%): $603.2 billion
      • Total of Other Liquid Deposits and Money Market Funds bringing it to exceed M1.

THE MONETARY ROLE OF BANKS

  • Nature of Bank Deposits:
    • Only a fraction of M1 is currency; bank deposits are a significant part of the money supply.
  • Function of Banks:
    • They are financial intermediaries utilizing bank deposits (liquid assets) to finance the illiquid investments of borrowers.
  • Liquidity Creation:
    • Banks don’t need to maintain all funds in liquid assets; they manage depositor demands through reserves.
  • Bank Reserves:
    • Comprising cash in vaults plus deposits at the Federal Reserve.

WHAT BANKS DO

  • T-account:
    • Analytical tool displaying a business's financial position through its assets and liabilities.
  • Reserve Ratio:
    • Fraction of bank deposits held in reserves, e.g., rac100,0001,000,000=10extextpercentrac{100,000}{1,000,000} = 10 ext{ extper cent}.
  • Federal Reserve Regulation:
    • Sets minimum reserve ratios; currently, this is zero since March 2020.
  • Issue Highlight:
    • Regulation is paramount due to potential bank runs.

THE PROBLEM OF BANK RUNS

  • Bank Operations:
    • Banks keep only a fraction of deposits as reserves and loan out the remainder.
  • Definition of Bank Run:
    • A scenario where numerous depositors withdraw funds simultaneously due to fears of bank solvency.
  • Contagion Effect:
    • Bank runs can spread; panic in one bank can lead to distrust and runs on others.
  • Regulatory Response:
    • U.S. established regulations to safeguard depositors against bank runs.

BANK REGULATION

  • Principal Features:
    • Deposit Insurance:
    • A guarantee by the government, ensuring depositors are compensated even if a bank fails (currently, FDIC guarantees the first $250,000).
    • Capital Requirements:
    • Owners must maintain assets more considerable than the value of deposits.
    • Incentive Problems: Insurance may encourage risk-taking by banks.
    • Motivation for Safe Behavior:
      • Required capital ratios are 7% or more of total assets.
  • Regulations that Ensure Stability:
    • Reserve Requirements:
    • Sets the minimum reserve ratio for banks as dictated by the Federal Reserve.
    • Discount Window:
    • Facility through which the Federal Reserve lends money to banks facing short-term troubles.