Unit 4 Notes

Unit IV Notes!! This unit is a bit more rigorous than the other 3 units but if you pay attention and study these notes well you will have no problems! :)


Uses of Money

1. Medium of exchange – trade
2. Unit of account – establishes worth
3. Store of money – money holding value over a period of time

Types of Money

1. Fiat money – it is money because the government says so (like the dollar is worth a dollar because the government says so)
2. Commodity money – examples are gold and silver coins (Commodity money is a good (no physical money is exchanged))
3. Representative money – example is IOU (I owe you) backed by something tangible

Characteristics of Money

1. Durability – money is durable (physically)
2. Portability – easy to carry
3. Divisibility – you can make change in many different ways
4. Uniformity – all has the same value and looks the same
5. Scarcity – $2 dollar bill…
6. Acceptability – money is accepted everywhere (very useful and acceptable)

Money Supply: 

1. M1 money (use 75% of the time) – (M stands for money…) consists of currency in circulation, checkable deposits (demand deposits) , and travelers checks
2. M2 money (use 25% of the time)– consists of M1 money +savings accounts + money market accounts + deposits held by banks outside the US

Fractional reserve system 

1. a process by banks of holding a small portion of their deposits in reserve in loaning out the excess.
2. Banks keep cash on hand (required reserves) to meet depositors’ needs. 
3. Banks must keep reserve deposits in their vaults or at the federal reserve bank
4. Total Reserves
• Total funds held by a bank
• TR (total reserves ) = RR (required reserves ) = ER ( excess reserves)
• Excess reserve – those that are beyond required 
5. Banks can legally lend only to the extent of their excess reserves
6. Reserve Ratio = RR / TR ( how much the bank can actually lend out)

Significance of a Fractional Reserve System

1. Banks can create money by lending more than their reserves
2. The amount, set by the fed, is the Required Reserve Ratio
3. Required reserves don’t prevent bank panics because banks must keep their required reserves  (FDIC insures your money)
4. Reserve requirement gives the FED control over how much money banks can create
5. Typically the Required Reserve Ratio = 10%

Functions of the FED (Federal Reserve Bank):

1. Control the nation’s money supply through monetary policy
2. Issue paper currency
3. Serve as a clearing house for checks
4. Regulates banking activities
5. Serves as a bank for banks (they issue out loans)

Balance Sheet

1. It is a statement of assets and claims summarizing the financial position of a firm or a bank at some point in time
2. It must BALANCE

Assets vs Liabilities

1. Assets (is what you own) = Liabilities (is what you own) + Net Worth
2. Net Worth - is the claim of the owners against the firm’s assets

Multiple Deposit Expansion

How Banks Work (T chart)

1. Assets :
• Reserves:
• Required Reserves (rr) - % required by Fed. to keep on hand to meet demand
• Excess Reserves (er) - % reserves over and above the amount needed to satisfy the minimum reserve ratio set by Fed.
• Loans to firms, consumers, and other banks (earn interest)
• Loans to government = treasury security
• Bank Property – (if bank fails, you could liquidate the building/property)
2. Liabilities :
• Timed Deposits (CD’s)
• Demand Deposits ($ put into bank)
• Loans from: Federal Reserve and other banks
• Shareholders Equity – (to set up a bank, you must invest your own money in it to have a stake in the banks success or failure) 

Practice Calculating Reserve Ratios

1. The reserve ratio is 5%. You deposit $1000 into a bank. How much is the bank required to add to its reserves?
• .05 X 1000 = $50 in reserve ratio
2. How much money can the bank now loan out?
• 1000 (deposited) – 50 (reserve ratio) = $950 loaned out to next borrower
3. 100 Percent Reserve Banking
• Now suppose households deposit the $1000 at “Firstbank.”
• Firstbank’s balance sheet :
• Deposits $1000 goes under liabilities (the claim of non-owners)
• Reserves $1000 goes under assets (don’t forget each side has to balance)
• 100% Reserve Banking has no impact on size of money supply
4. Fractional-Reserve Banking
• Suppose banks hold 20% of deposits in reserve, making loans with the rest.
• Firstbank will make $800 in loans
• Firstbank’s balance sheet :
• Under assets reserves $200 and loans $800
• The money supply now equals $1800: the depositor still has $1000 in demand deposits, but now the borrower holds $800 in currency
• Thus, in a fractional-reserve banking system, banks create money

The Required Reserve Ratio

1. The % of demand deposits that must be stored as vault cash or kept on reserve as Federal funds in the bank’s account with the Federal Reserve.
2. The Required Reserve Ratio determines the money multiplier (1/reserve ratio)
• Decreasing the reserve ratio increases the rate of money creation in the banking system and is expansionary
• Increasing the reserve ratio decreases the rate of money creation in the banking system and its contractionary
3. Changing the required reserve ratio is the least used tool of monetary policy and is usually held constant at 10%

The Money Multiplier

1. The money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply
2. The money multiplier indicates the total number of dollars created in the banking system by each $1 addition to the monetary base (bank reserves & currency in circulation)
3. To calculate the money multiplier, divide 1 by the required reserve ratio.
• Money multiplier = 1/reserve ratio
• Ex. If the reserve ratio is 25%, then the multiplier = 4.

The four types of multiple deposit expansion question

1. Type 1: Calculate the initial change in excess reserves
• A.k.a. the amount a single bank can loan from the initial deposit
2. Type 2: Calculate the change in loans in the banking system
3. Type 3: Calculate the change in the money supply
• Sometimes type 2 and 3 will have the same result (i.e. no Fed involvement)
4. Type 4: Calculate the change in demand deposits

Ex 1.

1. Given the required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the amount that a single bank can lend from this Federal Reserve purchase of bonds.
• The amount of new demand deposits – required reserve =The initial change in excess reserves
• $ 100 million (20% * 100 million)
• $100 million - $20 million = $80 million in ER
2. Determine the maximum change in loans in the banking system  from this Federal Reserve purchases of bonds
• $80 million * (1/20%)
• $80 million * 5 = $400 million max in new loans
3. Determine the maximum change in the money supply from this Federal Reserve purchase of bonds.
• The maximum change in loans + $ amount of Federal reserve action
• $400 million + $100 million = $500 million max change in the money supply
4. Determine the maximum change in demand deposits from this Federal Reserve purchase of bonds
• The maximum change in loans + $ amount of initial deposit
• $400 million + $100 million = $500 million max change in demand deposits

Fiscal Policy vs. Monetary Policy

1. Fiscal Policy:
• Congress
•  Tax or Spend
2. Monetary Policy:
• Fed
• OMO (Open Markey Operations): Buy or Sell bonds/securities
• Required Reserves: The amount of money the bank is required to keep on hand
• Discount Rate: the interest rate charged by the Fed for overnight loans to commercial banks. Does not change the money supply directly
• Federal Funds Rate: the interest rate charged by one commercial bank for overnight loans to another commercial bank. FOMC sets a federal fund rate and then uses open market operations to guide the effective rate to the target rate

The Fed has several tools to manage the money supply by manipulating the excess reserves held by banks, a practice known as monetary policy.

Loanable Funds Market

• The market where savers and borrowers exchange funds (Q_LF) at the real rate of interest (r%)
• The demand for loanable funds or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.
• The supply of loanable funds or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds.

Changes in the Demand for Loanable Funds

• Remember that a demand for loanable funds = borrowing (i.e. supplying bonds)
• More borrowing = more demand for loanable funds (shift right)
• Less borrowing = less demand for loanable funds (shift left)
• Examples
• Government deficit spending = more borrowing = more demand for loanable funds: D_LF shift right, r% increase
• Less investment demand = less borrowing = less demand for loanable funds: D_LF shift left, r% decrease

Changes in the Supply of Loanable Funds

• Remember that supply of loanable funds = saving(i.e. demand for bonds)
• More saving = more supply of loanable funds (shift right)
• Less saving = less supply of loanable funds (shift left)
• Examples
• Government budget surplus = more saving = more supply for loanable funds: S_LF sight right, r% decrease
• Decrease in consumers’ MPS = less saving = less supply of loanable funds: S_LF shift left, r% increase