Money and Banking - Key Concepts

Functions of Money

  • Money performs four key functions:
    1. Medium of exchange: Facilitates trade by acting as an intermediary.
    2. Store of value: Holds value over time, allowing saving and spending later; though subject to inflation.
    3. Unit of account: Standard numerical unit for measuring value, simplifying comparisons.
    4. Standard of deferred payment: Accepted for future payments, enabling credit systems.

Money Supply

  • M1 Money Supply:
    • High liquidity; includes currency in circulation, checkable deposits, savings deposits, and traveler’s checks.
    • Measured daily by the Federal Reserve; immediately spendable.
  • M2 Money Supply:
    • Broader measure including M1 plus less liquid forms of money.
    • Includes time deposits/CDs, money market funds, and other savings instruments.
    • Less liquid than M1 but still plays a role in finances.

Banks and Money Creation

  • Banks create money by lending a portion of deposits.
  • Banks contribute to money creation by holding limited reserves and issuing loans.
  • Money Multiplier:
    • Determines how much total money the banking system can generate from initial excess reserves.
    • Formula: Money Multiplier = 1 \over Reserve Requirement Ratio
  • Cautions and Limitations of the Money Multiplier:
    • Reserve requirements matter; influenced by the Federal Reserve.
    • Bank behavior influences lending; banks may hold more reserves.
    • Public behavior affects the process; impacts from people holding cash.

Importance and Risks of Money and Banks

  • Money as a Social Invention:
    • Improves efficiency of economic transactions by eliminating inefficiencies of the barter system.
  • Role of Banks:
    • Enhance the usefulness of money by facilitating easier and safer transactions.
  • Dangers and Risks of Money and Banking Systems:
    • Systemic weaknesses can harm the economy.
    • Effects of financial stress in banks, such as reluctance to lend.
    • Historical Example: The 2008–2009 Great Recession.

Open Market Operations

  • Open Market Sale:
    • Central bank sells bonds → bank reserves fall → money supply contracts → interest rates rise → slows down inflation and demand.
  • Open Market Purchase:
    • Central bank buys bonds → bank reserves increase → money supply expands → interest rates fall → stimulates borrowing and spending.

Equations

  • Velocity = Nominal GDP \over Money Supply
  • Basic Quantity Equation of Money:
    • Money Supply * Velocity = Nominal GDP
    • Nominal GDP = Price Level * Real GDP
    • Money Supply * Velocity = Nominal GDP = Price Level * Real GDP