Money and Banking Lecture 2
The Four Jobs of Money • Medium of exchange • Standard of value • Store of value • Standard of deferred payment
FUNCTIONS OF MONEY (VIDEO)
Medium of Exchange • The most important job of money is to serve as a medium of exchange – When any good or service is purchased, people use money – Money makes it easier to buy and sell because money is universally accepted – Money, then, provides us with a shortcut in doing business • By acting as a medium of exchange, money performs its most important function Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 13 -5
Medium of Exchange • Money facilitates exchange by reducing the cost of trading. • Without money, we would have to barter.
Medium of Exchange • Money does not have to have any inherent value to function as a medium of exchange. • All that is necessary is that everyone believes that other people will exchange it for their goods.
Standard of Value • Money is a common denominator in which the relative value of goods and services can be expressed 13 -6
Standard of Value A job that pays $2 an hour would be nearly impossible to fill, while one paying $50 an hour would be swamped with applications Does money work well as a standard of value? You tell me 13 -6
Store of Value • Money is a financial asset that can be used to store wealth (income that you have saved and not consumed).
Store of Value • As a store of wealth, money pays no interest, but is perfectly liquid. • Money’s usefulness as a store of wealth depends on how will it maintains its value.
Store of Value • If you could buy 100 units of goods and services with $100 in 1982, how many units could you buy with $100 in 2000? ? ? ?
Store of Value • If you could buy 100 units of goods and services with $100 in 1982, how many units could you buy with $100 in 2000? Answer: you could have bought just 51 units During this period, inflation robbed the dollar of almost half of its purchasing power
Store of Value • Over the long run, particularly since World War II, money has been a very poor store of value However, over relatively short periods of time, say, a few weeks or months, money does not lose much of its value
Standard of Deferred Payment • Many contracts promise to pay fixed sums of money well into the future A couple of examples are 30 -year corporate bonds and a 20 -year mortgage
Standard of Deferred Payment • When Dave Winfield signed a 10 year, $23 million contract with the New York Yankees in 1980, he really got stuck • Because over the next 10 years the consumer price index went up by almost 59%
Standard of Deferred Payment • When Dave Winfield signed a 10 -year, $23 million contract with the New York Yankees in 1980, he really got stuck • Today when a professional ballplayer, entertainer, or virtually anyone else signs a long-term contract, she or he is generally protected by an escalator clause, which calls for increased payments to compensate for any future inflation
Standard of Deferred Payment • How well does money do its job as a standard of deferred payment? About as well as it does as a store of value Usually quite well in the short run, but not well at all over the long run of, say, three years or more
Money (VIDEO)
Money versus Barter • Without money, the only way to do business is by bartering • For barter to work, I must want what you have and you must want what I have This makes it pretty difficult to do business
Money versus Barter “Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible” Aristotle, Nicomachean Ethics
Money versus Barter VIDEO
Money in the U. S. Economy • Money Stock is the quantity of money circulating in the economy. • Different ways of measuring the money stock in the economy: – – – M 1 M 2 M 3
Measurement of Money • The most familiar form of money used includes: – Coins – Currency – Check Deposits – Travelers Checks M 1
Our Money Supply: M 1 Currency + Demand deposits + Other checkable deposits + Traveler’s checks M 1(traditionally our basic money supply)
Measurement of Money A broader measure of money than M 1, includes: – M 1 + – Savings Deposits + – Small Time Deposits + – Money Market Mutual Funds + – and other minor categories M 2
Our Money Supply: M 2 Currency + Demand deposits + Other checkable deposits + Traveler’s checks M 1 + Savings deposits + Small-denomination time deposits (less than $100, 00) + Money market mutual funds held by individuals M 2
Our Money Supply: M 3 Currency + Demand deposits + Other checkable deposits + Traveler’s checks M 1 + Savings deposits + Small-denomination time deposits (less than $100, 00) + Money market mutual funds held by individuals M 2 + Large denomination time deposits (more than $100, 00) + Money market mutual funds held by institutions + Other less liquid assets M 3
Banks and The Money Supply • The behavior of banks can influence the quantity of demand deposits in the economy and therefore, the money supply.
Banks and The Money Supply • Fractional Reserve Banking System: The practice of holding a fraction of money deposited as reserves and lending out the rest.
Fractional Reserve Banking • Deposits into a bank are recorded as both assets and liabilities. • Deposits that have been received but not lent out are called reserves.
Fractional Reserve Banking • The supply of money in the economy is affected by the amount of deposits that are kept in the bank as reserves and the amount that is lent out. • Loans become an asset to the bank.
Bank “T-Account” Example First National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets $100. 00 Total Liabilities $100. 00
Bank “T-Account” Example First National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets $100. 00 Total Liabilities $100. 00 A “T-Account” illustrates the financial position of a bank that accepts deposits, keeps a portion as reserves and lends out the rest.
Money Creation with Fractional-Reserve Banking • When a bank makes a loan (from it’s reserves) the money supply increases. • When banks hold only a fraction of deposits in reserve, banks create money.
Money Creation with Fractional-Reserve Banking • The creation of money through loans does not create any wealth, but allows banks to charge interest several times on the same bit of wealth.
The Demand for Money • The amount of money people hold is called money balances • John Maynard Keynes noted that people had three reasons for holding money – People hold money to make transactions – People hold money for precautionary reasons – People hold money to speculate
The Demand for Money Economists have since identified four factors that influence three Keynesian motives for holding money – The price level – Income – The interest rate – Credit availability
The Keynesian Motives for Holding Money The transaction motive – Individuals have day-to-day purchases for which they pay in cash or by check – Individuals take care of their rent or mortgage payment, car payment, monthly bills and major purchases by check – Businesses need substantial checking accounts to pay their bills and meet their payrolls
The Keynesian Motives for Holding Money The precautionary motive – People will keep money on hand just in case some unforeseen emergency arises • They do not actually expect to spend this money, but they want to be ready if the need arises
The Keynesian Motives for Holding Money The speculative motive – When interest rates are very low you don’t stand to lose much holding your assets in the form of money – Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise • You would be locked into very low rates – This motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise
Four Influences on the Demand for Money 1) The price level – As the price level rises, people need to hold higher money balances to carry out day-to-day transactions – As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth – Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances
Four Influences on the Demand for Money 2) Income – The more you make, the more you spend – The more you spend, the more money you need to hold as cash or in your checking account – Therefore as income rises, so does the demand for money balances
Four Influences on the Demand for Money 3) Interest rates – The quantity of money demanded (held) goes down as interest rates rise • The alternative to holding your assets in the form of money is to hold them in some type of interest bearing paper • As interest rates rise, these assets become more attractive than money balances
Four Influences on the Demand for Money 4) Credit availability – If you can get credit, you don’t need to hold so much money • The last three decades have seen a veritable explosion in consumer credit in the form of credit cards and bank loans • Over this period, increasing credit availability has been exerting a downward pressure on the demand for money
Four Influences on the Demand for Money • Four generalizations – As interest rates rise, people tend to hold less money – As the rate of inflation rises, people tend to hold more money – As the level of income rises, people tend to hold more money – As credit availability increases, people tend to hold less money Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 13 -27
The Demand Schedule for Money The Three Demands for Money
Total Demand for Money This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide
Total Demand for Money and the Supply of Money The interest rate of 7. 2 percent is found at the intersection of the total demand for money and the supply of money (M) Since at any given time the supply of money (M) is fixed it can be represented as a vertical line Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 13 -30
Determination of the Interest Rate The Prime Rate of Interest Charged by Banks on Short-Term Business Loans, 1978 -2001 Although the prime rate is set by the nation’s largest banks, it is strongly influenced by actions of the Federal Reserve Board of Governors Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 13 -31
Who Controls the Interest Rates? • People who borrow money – players • Banks – referee • National bank – coach
The Money Multiplier • When one bank loans money, that money is generally deposited into another or the same bank thus creating more deposits and more reserves to be lent out. • The Money Multiplier is the amount of money that the banking system generates with each dollar of reserves.
The Money Multiplier First National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets $100. 00 Total Liabilities $100. 00
The Money Multiplier First National Bank Second National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans Deposits $90. 00 Loans $90. 00 Total Assets $100. 00 Reserves $9. 00 Liabilities $81. 00 Total Liabilities $100. 00 Total Assets $90. 00 Total Liabilities $90. 00
The Money Multiplier First National Bank Second National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans Deposits $90. 00 Loans $90. 00 Total Assets $100. 00 Reserves $9. 00 Liabilities $81. 00 Total Liabilities $100. 00 Total Assets $90. 00 Total Liabilities $90. 00
The Money Multiplier First National Bank Second National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Reserves $9. 00 Liabilities Deposits $90. 00 Total Money Supply = $190. 00! Loans $90. 00 Total Assets $100. 00 $81. 00 Total Liabilities $100. 00 Total Assets $90. 00 Total Liabilities $90. 00
What determines the size of the money multiplier? • The money multiplier is the reciprocal of the reserve ratio. – With a reserve requirement (R) of 20% or 1/5. . . – The multiplier will be 5. 1 M =R
Tools of Monetary Control The National Bank has three instruments of monetary control: • Open-Market Operations: – Buying and selling bonds. • Changing the Reserve Ratio: – Increasing or decreasing the ratio. • Changing the Discount Rate: – The interest rate the Fed charges other banks for loans.
Problems in Controlling the Money Supply • Two problems that the National Bank must “wrestle” that arise due to fractionalreserve banking: ¬does not control the amount of money that households choose to hold as deposits in banks. does not control the amount of money that bankers choose to lend.
What “Backs” the Money Supply? • Money as Debt • Value of Money – Acceptability – Legal Tender – Relative Scarcity
What “Backs” the Money Supply? • Money & Prices – The Purchasing Power of the Dollar NOTES: Reciprocal relationship between the price level and the value of the dollar D = 1 P
What “Backs” the Money Supply? • Money & Prices – The Purchasing Power of the Dollar – Inflation & Acceptability
Conclusion (VIDEO)
