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Date Created: 08/14/14
ECN 211 Macroeconomics Dr Iohn Filer EXAM 3 Study Guide Money anything that is generally acceptable to sellers in exchange for goods and services MONEYIS WHAT MONEYDOES MONEYIS THE ONLY THING THAT ONE CAN USE TO BUYSOMETHING WITH 0 Durable Divisible Portable Easily Determined Value Easy to determine purity I Metal I Government begins to mint coins from metal OOOO Specialization or the division of labor led to a virtual explosion in the amount of output that could be produced by a society Time Saved Improvement in skills Improvement in Technology If the economy of a society is characterized by division of labor we must invent the market so that people with onlyfish and corn can get the other things that they need and want In a barter economy nothing serves as a medium of exchange No store of value bread and owers decay No set unit of accoun t These first moneys are called commodity money A commodity money serves a dual function First as an economic good and second as money salt MONEY IS ANYTHING THAT SERVES AS A MEDIUM OF EXCHANGE A STORE OF VALUE AND A UNIT OF ACCOUNT British Pound Sterling 1 pound of sterling Germany Mark Measure of weight of gold Russia the Ruble Cut a sliver of platinum from a bar US Dollar Comes from German Thaler 9 pronounced dollar We stole it Iapan Yen No one knows what it is Most of M1 is currency and checks not coins coins hard to carry around CHECKS CAME BEFORE DOLLAR BILLS Early Colonial America Tabaco stored in warehouses Checks for amount of Tabaco stored in warehouse traded for goods First Banks The Goldsmith Goldsmith Notes If had lots of gold would ask goldsmith in town to store the gold He would charge you interest and give you a receipt o These were signed over to buyer and seller numerous times Up until Great Depression used to issue silver and gold certificates Paper represents 5 worth of gold could go to bank and exchange for gold Banks began to lend out money from the currency in their vaults 0 To guard from bank failures began holding reserves Liquid Assets an asset that can easily be exchanged for goods and services cash is a car is not Coins good because durable easily transportable and equal to value of metal Money can be 1 A medium of exchange a Given in exchange for goods and services b For a barter system to work there must be double coincidence have to find a person who can do what he wants and who also wants what he can do 2 Unit of Account a We price goods and services in terms of money b In a barter economy the value of an object is always relative and subjective When using coins there39s a set standard 3 Store of Value a A durable means of storing value Don39t have to spend it right away like early Britain did with fish and bread as their currency b Currency Substitution the use of foreign money as a substitute for domestic money when the domestic economy as a high rate of in ation 4 Standard of Deferred Payment a Money what we use to pay for goods and services b Credit available savings that are lent to borrowers to spend It is debt what you owe M1 Money Supply the financial assets that are most liquid easily exchanged for goods services M1 C DD Traveler39s Checks NOW Accounts ATS Checking Accounts C Currency in the hands of the public DD demand deposits in banks M2 Money Supply M1 Liquid Assets Liquid Assets Government bonds stocks money market instruments money deposited in savings or checking account tax refunds mortgages court settlements certificates of deposits and trust fund monies 0 M2 M1 Savings Deposits Retail Money Market Mutual Funds International Reserve Asset an asset used to settle debts between governments Gold was once used as a primary international reserve asset Composite Currency An artificial unit of account that is an average of the values of several national currencies Special Drawing Rights SDR a composite currency whose value is the average of the values of the US dollar the euro the Iapanese yet and the UK pound Commercial Banks financial institutions that offer deposits on which checks can be written The first modern banks in America issued receipts in exchange for a real commodity gold Goldsmiths The first currency consisted of generalized receipts issued by the goldsmith bankers and were first called goldsmith notes The piece of paper is worthless except that it represents the ownership rights to something of real value on deposit somewhere This system only works on faith Insured by Create additional receipts checking accounts and banknotes and lend these out Know the borrower Character Capacity Collateral capital conditions to borrow Financial Intermediaries accept deposits from individuals and firms then use those deposits to make loans to individuals and firms Hopes to earn a profit through interest the price of storing savings Bank Failures banks can fail Fractional Reserve Banking System a system in which banks keep less than 100 of their deposits available for withdrawal A financial sheet is a financial statement that records a firm s assets what the firm owns and liabilities what the firm owes Assets Liabilities Required Reserves RR the cash reserves a percentage of deposits that a bank must keep on hand or on deposit with the Federal Reserve From 1785 1837 9 50 Now 9 10 Equation RR Percentage in decimal form Total Deposits 0 RR 011000100 kept in bank other 900 loaned out Legal Reserves LR the combination of cash in the vault of the bank and cash reserves stored in the local Fed district bank Excess Reserves ER the cash reserves beyond those required which can be loaned A bank can loan out more than the required reserves Banks loan out more when the economy good more likely to be paid back Hold onto more recession Equation ER LR RR Required reserves are the minimum level of reserves that a bank must hold today against deposits Banks are allowed to hold more reserves against deposits than the minimum When banks maintain a reserve ratio against deposits greater than the minimum the bank is said to hold EXCESS RESERVES How the Fractional Reserve Banking System Creates Money A town has no banks One person comes into town and deposits 1000 in cash into the bank And as the bank loans and saves the 1000 grows Carry on this process for the over 72 rounds This is a mathematical progression 1000 x 1 100 from 1000 900 x 1 90 from 900 810 x 1 81 from 810 729 x 1 7290 from 729 65610 and so on If we sum the factors we get 1000 900 810 729 65610 1 10000 0 So 1000 cash in vault acting to back demand deposits acting as reserves will support 10000 in total demand deposits which have been created by the bank making 9000 in loans to borrowers NOTE THAT THE OPERATION OF THE FRACTIONAL RESERVE BANKING SYSTEM RESULTS IN A SIGNIFICANT INCREASE IN THE MONEYSUPPLY OF THE COMMUNITY AS WELL AS A SIGNIFICANT INCREASE IN THE CREDIT LOANS AVAILABLE IN THE COMMUNITY o Formula What money deposited in the bank could potentially be 0 MONEY MULTIPLIER 3 DD H 1rr Where DD demand deposits H high powered money rr reserve ratio of banks High powered money is the coin and currency issued by the US Treasury and the Fed respectively High powered money serves as currency in the hands of the public and bank reserves H C R Equation 212 Where H High powered money C Currency in the hands of the public R Reserves held by banks The level of high powered money that exists in the economy is determined by the Fed Currency in the hands of the public is some fraction of the level of demand deposits C c DD Equation 213 Where C Currency in the hands of the public c The currency to demand deposit ratio CDD DD Demand deposits in banks The currency to deposit ratio is determined by the public It is the fraction of demand deposits that individuals wish to hold as cash M1 1 c 1c rr H 1 cc rr H Equation 2111 This is our expression for the money suppb M1 It states that the money suppbl is a function of three variables the level of high powered money H which is determined by the Fed the reserve to deposit ratio rr which is determined by banks and the currency to deposit ratio c which is determined by the public The expression 1 c c rr is the new money multiplier that takes account of currency leakage Bank Panic the cause of 32 out of 33 business cycles in the history of US Throughout the history of the fractional reserve banking system frequent bank runs on individual banks occurred If a bank held illiquid assets such as loans to farmers to plant crops the bank often failed as a result of the run If the bank run spread to other banks and became wide spread a bank panic occurred The panic was often called a LIQUIDITY CRISIS 1893 1908 4 Bank Panics People got tired Government do something The Panic of1893 the Richman 39s Panic 1902 and the Panic of1907 and another not listed 1908 Two solutions to these liquidity crises were enacted by Congress after the severe Panic of 1907 IN 1908 CONGRESS PASSED THE ALDRICHVREELAND ACT THE PURPOSE OF THE ACT WAS TO SUPPORT THE BANKING SYSTEM DURING BANK PANICS OR LIQUIDI TY CRISES Worked perfectly Idea during a bank panic a bank facing a bank run could go to one of ten large banks around the US or go to the US Treasury and borrow the currency needed to stem the bank run Never tested but would have been perfect Instead passed IN 1913 CONGRESS PASSED THE FEDERAL RESERVE AC T THE PURPOSE OF THE ACT WAS TO SUPPORT THE BANKING SYSTEM DURING BANK PANICS OR LIQUIDI TY CRISES Country divided into 12 federal reserve districts During bank run bank goes to local federal reserve bank and borrow money o Discount Window go here to borrow money to stem bank panic but have to pay interest during duration of loan Federal Reserve System accepts deposits from and making loans to commercial banks acts as a banker for the federal government and controls the money supply Board of Governors chairman appointed by President Considered 2nd most powerful person in US Each of the 12 District banks is directed by a 9 person board of directors and a district bank president Monetary Policy the objective is economic growth with stable prices nolittle in ation Money Supply controlled by interest rates and reserve requirements Fiscal Policy money supply controlled by government spending and taxes Federal Deposit Insurance Corporation FDIC created in 1933 a federal agency that insures deposits in commercial banks for up to 250000 Bank Panic occurs when depositors become frightened and rush to withdraw their funds The Fed and President Roosevelt during the worst parts of the banking system collapse often declared bank holidays locking their doors and going home for weeks at a time The lender of last resort was not at home There was a light on however IN 1929 THERE WERE 24000 BANKS IN THE US BETWEEN 1929 AND 1933 9000 BANKS FAILED 8000 BANKS OR 13 OF THE BANKS IN EXIS TENCE AT THE TIME NEVER REOPENED THEIR DOORS DURING THE SAME PERIOD THE MONEYSUPPLYFELL BY 13 DURING THE SAME PERIOD NOMINAL GNP FELL BY 12 FROM 96 BILLION TO 48 BILLION DURING THE SAME PERIOD REAL GNP FELL BY 13 FROM 96 BILLION TO 64 BILLION The FED s Policy Tools 1 The Federal Reserve Discount Window the interest the fed charges banks who borrow loans from it 2 Reserve Requirements they have the right to set the reserve requirement within boundaries set by Congress a It is currently 10 b The Monetary Control Act of 1980 regardless of whether a bank was a member of the Fed or not the bank had to follow the rules of the Fed especially concerning reserve requirements c ER LR RR 3 Open Market Operations OMOMost important Monetary policy available the buying and selling of government and federal agency bonds by the Fed to control the bank reserves the federal funds rate and the money supply 0 To lower the federal funds rate and increase the money supply the FED buys US Government bonds 0 To raise the federal funds rate and increase the money supply the Fed sells government bonds Federal Funds Rate the interest rate charged by a commercial bank for a loan to another commercial bank happens in the Fed but not controlled by it Discount rate the interest rate the federal reserve charges for a loan to a commercial bank The Federal Open Market Committee the official policy making body of the Federal Reserve System 1 Banking Services and Supervision It supplies currency to banks holds their reserves and clears checks a banker39s bank 2 Controls the Money Supply through its ability to in uence bank reserves and the money creating power of commercial banks to achieve its policy goals Foreign Exchange Market Intervention the buying and selling of currencies by a central bank to achieve a specified exchange rate 1 Graph on page 299 Demand curve the demand for dollars produced by the demand for US goods They are exchanging yen for dollars Supply Curve the supply of dollars generated by US residents demand for the products and financial assets of other countries The supply dollars to the dollar yen market comes from the US demand to buy Iapanese products You are supply dollars to get Iapanese products 0 Appreciate to increase in value versus another currency It takes fewer dollars to get the same product 9 value of dollar increase 0 Depreciate to decrease in value versus another currency It takes more dollars to buy the same amount gt value of dollar down In 1980 Paul Volker cited above made the decision that the FED would no longer monetize the federal debt MV Py Equation 242 Where M the money supply say M1 V the velocity of circulation of the money supply P the price level as before y real GDP or real income AM AV AP Ay Equation 247 How does this work Since Equations 241 and 242 are always true by definition then equation 247 also must always be true In other words The percentage change in M plus the percentage change in Vequals the percentage change in P plus the percentage change in y K is the fraction of one year39s worth of GDP held by the public It reveals the demand for money Precautionary demand for money the demand for money to cover unplanned transactions or emergencies Speculative Demand for Money the demand for money created by uncertainty about the value of other assets Determinants of the Demand for Money 1 The Market Rate of Interest the demand for money is inversely related to the market rate of interest a If interest is high the demand for money is low considering if it sits in a bank with high interest more money will be aggregated to your deposit Thus velocity is high b When interest is low the demand for money is high people will want to get rid of it Velocity is low 2 The Rate of In ation the demand for money is inversely related to the rate of in ation a When in ation is high people demand for money is low and the velocity is high b When in ation is low people demand lots of money to spend it all 3 The level of Income the demand for money is directly related to the level of income a As income rises people demand more money b As income falls people demand less money 4 Expectations a People tend to save hold more liquid assets when the future is uncertain b People spend more when the future is stable Potential Reserves Excess Reserves Reserve Requirement Ex A man deposits 1000 in a bank with a Reserve Requirement of 10 The money supply in the whole banking system could now potentially be RR Deposits 9 011000 100 ER LR RR 9 1000 100 900 Potential Money Supply 9 90001 9000 High Powered Money All money circulating in the public the portion of reserves that are maintained in bank accounts Demands Deposits funds held in deposit accounts in commercial banks DD H 1rr Equation 211 Where DD demand deposits H high powered money rr reserve ratio of banks
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