Study Guide on Money Functions, Types, and Banking

Importance of Money in Market Efficiency

  • Money plays a significant role in increasing market efficiency by facilitating exchanges.

Purposes of Money

  • Money serves three primary functions:

    • Medium of Exchange: Enables transactions for goods and services.

    • Unit of Account: A standard numerical unit that provides a consistent measure for setting prices and recording debts. For instance, prices in the UK are usually expressed in pounds, while in the US, prices are expressed in dollars.

    • Store of Value: Money holds its value over time, allowing individuals to postpone consumption and save purchasing power for future expenses, like mortgages.

Types of Money

  • There are three significant types of money, with two being primarily highlighted:

    • Commodity Money: Money that has intrinsic value; examples include precious metals like gold and silver. Historically, items like gold were directly traded for goods.

    • Examples of Commodity Money:

      • Gold and silver.

      • In some historical contexts (e.g., communist Romania), cigarettes or bars of soap were used as currency due to their intrinsic value and desirability.

    • Commodity-Backed Money: Paper money that can be exchanged for a commodity (like gold or silver) at a fixed value. Historically, banks issued paper money that was redeemable for physical commodities.

    • Fiat Money: Paper currency without intrinsic value, but has value because a government maintains it. The value of fiat money comes from the trust in the government that issues it, e.g., US dollars or UK pounds.

Comparison of Money Types

  • Benefits of Commodity Money vs Fiat Money:

    • Commodity money has intrinsic value and does not suffer from inflation as fiat money might, due to government control over the money supply.

    • Fiat money can be printed in unlimited quantities, potentially leading to inflation and reduced purchasing power.

Money Supply (M1 and M2)

  • Definition: The total amount of monetary assets available in the economy at a specific time.

  • Components of Money Supply:

    • Currency: Physical notes and coins in circulation.

    • Demand Deposits: Money in bank accounts that can be quickly accessed (e.g., checking accounts).

  • Monetary Aggregates:

    • M1: Includes currency in circulation and demand deposits; older figures show M1 was significantly smaller than M2.

    • M2: Contains M1 plus savings accounts and other forms of money that are less liquid. Generally, M2 is approximately four times larger than M1, indicating a broader measure of the money supply.

Trends in Money Supply

  • Recent data and complexities of M1 and M2 trends, especially noting significant changes during economic events (like the COVID pandemic).

  • Exercises might include examining historical trends and figures for M1 and M2 to observe impacts over time (e.g. stimulus checks).

Central Banking

  • Central Banks: Institutions that manage a country's currency, money supply, and interest rates.

    • Examples:

    • US: Federal Reserve (Fed)

    • UK: Bank of England

    • EU: European Central Bank

  • The central bank holds the responsibility of monetary policy, regulating the money supply in response to economic changes.

Federal Reserve Structure and Functions

  • Board of Governors: Located in Washington DC, overseeing the Fed's operations.

  • Federal Open Market Committee (FOMC): Responsible for determining the direction of monetary policy.

Fractional Reserve Banking

  • Banks are required to hold a fraction of deposits as reserves; this reserve ratio (R) is critical in determining the money supply.

    • Reserve Requirement: Minimum percentage of deposits banks must keep as reserves. Recent policies have adjusted this ratio, particularly post-COVID.

  • Leverage Ratio: The total assets of the bank divided by its capital. A measure of how much a bank relies on debt to finance its activities.

Money Creation Process

  • Illustrated through scenarios:

    1. Without Banking System: Money supply = $100 (physical cash only).

    2. With 100% Reserve Requirement: Money supply still = $100 (bank holds all deposits).

    3. With Fractional Reserve Banking (10% Requirement):

    • Upon depositing $100:

      • Reserves = $10

      • Loans = $90

      • Money Supply = $190 (total of deposits and loans).

Money Multiplier Effect

  • The money multiplier quantifies the potential increase in the money supply resulting from initial deposits.

    • ext{Money Multiplier} = rac{1}{ ext{Required Reserve Ratio}}

    • Example: If the reserve ratio is 10%, the multiplier = 10; therefore, a $100 deposit leads to a potential increase in money supply of $1,000.

Impact of Economic Events on Money Supply

  • Analyzing how events such as the pandemic affected M1 and M2 monetary aggregates, with discussions around increased liquidity and changes in market behavior (e.g. stimulus checks leading to increased demand deposits).

Bank Runs and FDIC

  • During economic uncertainty, if too many depositors withdraw their funds simultaneously, it may lead to a bank run, affecting the solvency of banks.

  • To prevent bank runs, governments offer deposit insurance (e.g., FDIC in the US up to $250,000 per depositor).

Interest Rates and the Federal Funds Rate

  • The Fed influences interest rates and therefore affects lending rates in the banking sector, impacting economic activity.

  • The relationship between the federal funds rate and other interest rates (e.g., mortgage rates) is critical for understanding market dynamics.