Week 14 Money Sum Pt 1

Introduction to Fiscal and Monetary Policy

  • Definition of Fiscal Policy:

    • Changes in government spending and/or taxation to achieve particular macroeconomic goals.

    • Jointly driven by Congress and the President in the U.S.

  • Definition of Monetary Policy:

    • Changes to the money supply to achieve particular macroeconomic goals.

    • Controlled by the Federal Reserve (the central bank of the U.S.).

Understanding Money

What is Money?

  • Definition of Money:

    • Any good that is widely accepted for exchange and in the repayment of debts.

  • Historical Forms of Money:

    • Items such as quins, paper, shells, furs, cigarettes have all been used as money.

Functions of Money

  • Money must fulfill three basic functions:

    1. Medium of Exchange:

    • Facilitates transactions.

    • Example: Bartering without money requires a double coincidence of wants.

      • Barter Example:

        • A wants to learn economics, and B provides that service, while A provides babysitting for B.

        • If A offers a service not desired by B (like golf lessons), the swap fails without money.

    1. Unit of Account:

    • Provides a common measurement for values.

    • Example: If instructors charge in various non-standard ways, it complicates price comparison. Money standardizes this.

    1. Store of Value:

    • Maintains its value over time, allowing saving, lending, and borrowing.

    • An economy could technically function without money, but efficiency is significantly improved with it.

Understanding Money Supply

Definition and Structure of Money Supply

  • What is Money Supply?

    • The amount of money available in an economy.

  • Multiple Official Versions of the Money Supply:

    • M1:

    • The narrowest definition: most liquid assets, including currency held outside banks, checkable deposits, and traveler's checks.

    • M2:

    • Includes M1 plus assets that are slightly less liquid: small denomination time deposits (CDs), savings deposits, money market accounts, etc.

    • M3:

    • Includes M2 plus longer-term CDs and financial agreements (even less liquid assets).

Creation of Money

Fractional Reserve Banking System

  • Definition:

    • Banks hold reserves that are a fraction of their total deposit liabilities.

  • How Reserves Work:

    • A bank's total reserves consist of vault cash and deposits with the Federal Reserve.

    • Required Reserve Ratio (r):

    • The legally mandated percentage banks must keep as reserves.

    • Total required reserves:

    • extRequiredReserves=rimesextTotalDepositsext{Required Reserves} = r imes ext{Total Deposits}

    • Excess Reserves:

    • extExcessReserves=extTotalReserves−extRequiredReservesext{Excess Reserves} = ext{Total Reserves} - ext{Required Reserves}

Process of Money Creation

  • Lending Money: Banks lend out excess reserves.

  • Example of Money Creation:

    • A deposits $500 in Wells Fargo; reserve ratio is 10%.

    • Required reserves = 10 ext{ ext{%}} imes 500 = 50

    • Excess reserves = 500−50=450500 - 50 = 450

    • Wells Fargo lends $450 to a customer, and that repeats in the banking system.

  • Money Multiplier Effect:

    • Maximum change in money supply = rac1rimesextChangeinReservesrac{1}{r} imes ext{Change in Reserves}

    • With a reserve ratio of 10%, the multipliers imply maximum change is 10 times the initial deposit.

    • In this example:

    • Maximum change = 10imes500=500010 imes 500 = 5000

The Roles of Reserves in Banking

Definitions: Reserves, Required Reserves, Excess Reserves

  • Reserves:

    • Total cash banks hold, including cash in vaults and deposits at the Federal Reserve.

  • Required Reserves (RR):

    • Minimum reserves mandated by law, based on checkable deposits.

    • extRequiredReserves=rimesextCheckableDepositsext{Required Reserves} = r imes ext{Checkable Deposits}

  • Excess Reserves (ER):

    • Any reserves held beyond required reserves.

    • extER=extTotalReserves−extRequiredReservesext{ER} = ext{Total Reserves} - ext{Required Reserves}

Example Calculations

  1. Bank A Reserves Calculation:

    • Bank deposits at the Fed = $4,000,000, Vault cash = $1,000,000.

    • Total Reserves = 4,000,000+1,000,000=5,000,0004,000,000 + 1,000,000 = 5,000,000

  2. Required Reserves Calculation:

    • Checkable Deposits = $100,000,000, Required Reserve Ratio = 10%.

    • Required Reserves = 0.1imes100,000,000=10,000,0000.1 imes 100,000,000 = 10,000,000

  3. Excess Reserves Calculation:

    • Total Reserve = $5,000,000, Required Reserves = $1,000,000.

    • Excess Reserves = 5,000,000−1,000,000=4,000,0005,000,000 - 1,000,000 = 4,000,000

Functions of Money Summarized

  • Money has three functions:

    1. Medium of Exchange:

    • Used for transactions of goods and services.

    1. Unit of Account:

    • Provides a basis to measure and compare values.

    1. Store of Value:

    • Retains value over time, allowing for future purchases.

Conclusion with Applications

  • Examples of Functions in Action:

    • Paying for a hamburger uses money as a medium of exchange.

    • Comparing prices of different items uses money as a unit of account.

    • Saving money in a bank relates to its role as a store of value.

  • Understanding these concepts is essential for grasping monetary policy and its implications for the economy.