Unit IV: Money

There are three functions of money: medium of exchange, store of value, and unit of account.
  • Medium of Exchange
    • it serves to trade one product for another
  • Store of Value
    • where money holds its value over a period of time
  • Unit of Account
    • establishes economic worth
There are three types of money: commodity money, representative money, and fiat money.
  • Commodity Money
    • gets its value from the type of material from which it is made
    • examples are gold and silver in products
  • Representative Money
    • paper money backed by something tangible that gives it value
    • examples are gold-or-silver-backed money and IOUs
  • Fiat Money
    • money because the government says so
Image result for commodity representative and fiat money
There are seven characteristics of money:
  • Durability
  • Portability
  • Divisibility
  • Uniformity
  • Scarcity
  • Acceptability
  • Limited Supply
Money supply consists of M1 money, M2 money, and M3 money.
  • M1 Money
    • consists of currency in circulation, which can be:
      • currency, which consists of cash and coins
      • checkable deposits (CD), which are also known as demand deposits (DD) and checking accounts
      • traveler's checks
    • liquidity means it is easy to convert checkable deposits and traveler's checks to cash
  • M2 Money
    • consists of M1 money + savings accounts + money market accounts
      • savings accounts - a bank account where you can store money you don't need right away but still keep it easily accessible
      • money market accounts - savings account with some checking features; they typically come with checks or a debit card and allow a limited number of transactions each month; traditionally, they've also offered higher interest rates than regular savings accounts
  • M3 Money
    • consists of M2 money + certificates of deposits (CD)
Time Value of Money
  • Variables
    • v = future value of money
    • p = present value of money
    • r = real interest rate as a decimal (nominal interest rate - inflation rate)
    • n = years
    • k = number of times interest is credited per year
  • Simple Interest Formula
    • v = P(1 + r)^n
  • Compound Interest Formula
    • v = P(1 + r/k)^nk
Balance Sheet
  • Summarizes the financial position of a bank at a certain time.
  • The value of assets must equal the value of claims.
  • Claims on a balance sheet are divided into two groups.
  • Assets, or credit, include
    • required reserves (RR)
    • excess reserves (ER)
    • loans
    • property
    • bonds (securities)
  • Liabilities, or debit, include
    • demand deposits (DD) a.k.a. checkable deposits (CD)
    • owner's equity
      • owning stock in something; investing in something
    • net worth
Image result for balance sheet
The Federal Reserve
  • Fractional Reserve Banking System
    • The banks have to hold a fraction of the total money supply as currency
  • Money Creation
    • Putting new money into circulation using two methods:
      • when the federal reserve bank buys bonds from the people or financial institutions (open market operation or OMO)
      • when banks make loans to the public
    • The money supply is increased when banks make loans
    • The more loans banks make, the more money that is in circulation
    • A bank can loan any amount that is in excess of its required reserves
    • The banking system can create loans in multiples of an original loan
  • Reserves or Total Reserves
    • The amount of deposits that a bank has accepted but not loaned out
  • Required Reserves (RR)
    • The amount of money a bank must keep on hand by law
  • Excess Reserves (ER)
    • Whatever the bank has over and above the required reserves
    • The required reserve ratio (RRR) determines this amount
  • Total Expansion of the Money Supply
    • loans x money multiplier
      • money multiplier = 1/RRR
  • Total Money Supply
    • money in circulation + money in demand deposits
The Federal Reserve System
  • Functions of the Fed
    • Issues paper currency
    • Sets reserve requirements and holds reserves of banks
    • Lends money to banks and charges them interest
    • They are a check clearing service for banks
    • Acts as a personal bank for the government
    • Supervises member banks
    • Controls the money supply in the economy
There are four types of multiple deposit expansion questions:
  • Type 1: Calculate the initial change in excess reserves (ER)
    • a.k.a. the amount a single bank can loan from the initial deposit
  • Type 2: Calculate the change in loans in the banking system
  • Type 3: Calculate the change in the money supply
    • sometimes type 2 and type 3 will have the same result (i.e. no Fed involvement)
  • Type 4: Calculate the change in demand deposits (DD)

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