Unit 4 Notes

Money (3/3/15)

Money: Any asset that can be used to purchase goods and services. 

3 Uses of Money:

1. As median of exchange- used to determine value (how much it is worth)
2. Unit of Account: Used to compare prices 
3. Store of Value- Some people choose to lend money or bank (bank draws interest) makes difference 

3 Types of Money:

1. Commodity Money: Has value within itself (Ex. salt, olive oil, gold) 
2. Representative Money: Represent something of value (Ex. IOU)
3. Fiat: Money because government says so (not all money is currency)

6 Characteristics of Money:

1. Durability:  How long it lasts 
2. Portability: Can take it to places 
3. Visibility:  Can be broken down
4. Uniformity: Money is same
5. Limited Supply:
6. Acceptability: People will take it 

Money Supply: Total value of financial assists available in U.S economy

M1 Money:

• Involves liquid assets (easily to convert to cash)

1. Coins
2. Currency (paper)
3. Check Deposits/ Demand Deposits
4. Travelers Check 

M2 Money:

• M1 Money + Savings Account + Money Market Account 

3 Purposes of Financial Institutions: 

1. Store money
2. Save money
3. Loan money:  Reasons- Credit Cards & Mortgages 

4 Ways to Save:

1. Through savings account
2. Checking account
3. Through Money Market Account
4. Through Certificate of Deposit (CD)

• Highest Interest Rate: Money Market Account & Certificate of Deposit (CD) 

Loans:

• Banks operate on fractional reserve system; they help a fraction of the funds & loan out the rest. 

Interest Rates:

• Principal: Amount of money borrowed 
• Interest: Price payed for the use of borrowed money
• Simple Interest: Paid on the principle
• Compound Interest: Paid on the principal plus accumulated interest 

Simple Interest:

• I = P x R x T/ 100 
• P- Principal; R- Interest Rate; T- Time
• Time (T) = I x 100/ P x R
• R = I x 100/ P x T
• P = I x 100/ R x T 

Types of Financial Institutions: 

1. Commercial Bank
2. Savings & Loan Institutions 
3. Mutual Savings Banks
4. Credit Union 
5. Financial Companies 

Investment: Redirecting resources; consume for the future 

Financial Assets: Claims on property and income of borrower (income of property) 

Yield: Annual rate of return on a bond if bond held to maturity 

Financial Intermediaries: Institution that annual funds from savers to borrowers 

• 3 Purposes:

1. To share risk: Through diversification- spreading out investments to reduce risk 
2. To provide information: Be advised 
3. Liquidity:

• Returns- Money an investor reduces above and beyond the sum of money that was initially invested (higher risk = higher return) 

Bonds: Loans/ IOU that represent debt that the government/corporation must repay to an investor

3 Components of a Bond:

1. Coupon Rate: Interest rate that a bind issuer will pay to bond holder 
2. Maturity: Time at which payment to bond holder is due 
3. Par Value: The principal- the amount an investor pays to purchase a bond

Time Value of Money (3/4/15)

Is dollar today worth more than a dollar tomorrow? 

• Yes 

Why?

• Opportunity cost and inflation. This is the reason for charging and paying interest 

Formulas:

• V: Future value of $
• P: Present value of $
• r: Real interest rate (nominal rate - inflation rate) expressed as decimal
• n: years
• k: number of times interest is creditable per year 

Simple Interest Formula: V = (1 + r) ^n x P 

Compound Interest Formula:  V = (1 + r/k) ^nxk x P

Monetary Equation of Exchange: 

MV = PQ

• M: Money supply (M1 or M2)
• V: Money's velocity (M1 or M2)
• P: Price level (PL on AS/AD diagram)
• Q: Real GDP (sometimes labeled "Y" on the AS/AD diagram) 

Functions of FED:

• issues paper currency 
• sets reserve requirements and holds reserve of banks 
• lends money to banks and charges them interest 
• it acta as personal bank for government 
• supervises member banks 
• control money supply in the economy 

How do banks "create" money?

• By lending out deposits that are used multiple times 

Where do the loans come from? 

• From depositors who take cash and place it in their banks 

How are the amounts of potential loans calculated?

• Using their bank balance sheet or T-accounts that consist or assets and liabilities for banks 

Bank Liabilities (the right side of the T Account Sheet) (OWE)

1) Demand Deposits (DD) or Checkable Deposits 

• Cash deposits front eh public 
• They are liabilities because they belong to depositors 

2) Owners Equity (stock shares)

• There are values of stocks held by the public ownership of bank shares 

Key concept for AP concerning Liabilities: 

• If demand deposit come from someone's cash holdings, then the DD is already part of money supply 
• If DD comes in from purchase of bonds (by FED) then this creates new cash and therefore creates new money supply (M1)

Assets (OWN)

• RR
• ER
• Property
• Securities 
• Loans 

Liabilities (OWE) 

• DD
• Owners Equity

Bank Assets (the left side of the T Account Sheet):

1) Required Reserves (RR)

• These are the percentages of DD that must be held in vault so that some depositors have access to their money. This amount can carry, but AP usually uses 5%, 10%, or 20% for easy calculations. 

2) Excess Reserves (ER) 

• These are the source of new loans. These amounts are applied to Monetary Multiplier/ Reserve Multiplier (DD = RR + ER) 

3) Bank Property Holdings (buildings & fixtures)

4) Securities (Federal Bonds)

• These are bonds purchased by the bank or new bonds sold to the bank by the Federal Reserve. These bonds can be purchased from the bank, turned into cash, that immediately becomes available as "Excess Reserves"

5) Custom Loans 

• This can be amounts held by banks from previous transactions, owned to the bank by prior customers.

Money Creation (Using Excess Reserves) 

• Banks wants to create profit. Generate profit by lending the excess reserves and collecting interest. Since each loan will go out into customers and business accounts, more lans are created in decreasing amounts (because of RR) Rough estimate of # of loan amounts created by any first loan is the "money multiplier" 

The Monetary Multiplier (also known as):

• Checkable Deposit Multiplier 
• Reserve Multiplier 
• Loan Multiplier 

The formula is simple: 1 divided by the RR:

• RR = 10% = 1/.1 = Munetary Multiplier of 10

Excess Reserves are multiplied by the Multiplier- to create new loans for the entire baking system and this creates new money supply.

3 Types of Multiple Deposit Expansion Questions (3/5/15)

• Type 1: Calculate initial change in excess reserves. AKA the amount a single bank can loan from the initial deposit. 
• Type 2: Calculate change in loans in balancing system 
• Type 3: Calculate change in money supply. Sometimes type 2 and type 3 will have the same result. (ex. no Fed involvement) 
• Type 4: Calculate the change in DD 

Creating a Bank (3/6/15)

Vault Cash = Cash held by bank 

Reserve Ratio: Commerical Bank's RR/ Comercial Bank's CD Liabilities 

Excess Reserves: Actual Reserves - RR

RR:  CD x Reserve Ratio

ASSETS:

• Required Reserves (RR): % required by Fed to keep met demand 
• Excess Reserves (ER): % reserves over and above amount reduced to satisfy minimum reserve  ratio by Fe 
• RR + ER = DD
• Loans to firms, consumers, and other banks (earns interest)
• Loans to government: Treasury Securities 
• Bank Property:If bank funds, you could liquidate the building/property. 

LIABILITIES + EQUITY:

• Demand Deposits: $ put into bank
• Timed Deposits: CD's
• Loans from: Federal Reserves and other banks 
• Shareholders equity: to set up bank, you must invest your own money in it to have a stable in banks success or failure 

Bank Balance Sheet = Assets & Liabilities in a TALL COUNT

Liablities = 

• DD (Demand Deposits/ Checkable Deposit, Check)
• Owner's Equity (stock shares) 

Assets =

• RR
• ER
• Bank Property
• Securities 
• Loans 

Assets must Equal Liabilities: DD = RR + ER

The Money Supply is affected

• Cash from a citizen becomes DD, but does NOT change money supply; the ER from this cash becomes an "immediate loan amount"

• ER x Multiplier become new loans and DD changes money supply 

• The Fed buying bonds create new loans and change  money supply 

• IF the Fed buys the bonds on open market, this also becomes a new DD amount
• IF the Fed buys bonds from accounts already held by particular bank, then the amount only belongs to new ER

Notes (3/17/15)

Key Principles:

• Single bank can create money (through loans) by the amount of excess reserves 
• Banking system as a whole create money by a multiple (deposit or money multiplier) of initial excess reserves 

INITIAL DEPOSIT      NEW/EXISTING $       BANK RESERVES      IMMEDIATE CHANGE MS

   CASH                            EXISTING                      INCREASE             NO; COMPOSITION OF M1 

                                                                                                                   MONEY CHANGES (CASH 

                                                                                                                   TO CURRENCY)

   FED PURCHASE

  OF BOND FROM 

  PUBLIC                          NEW                               INCREASE             YES; MONEY COMING 

                                                                                                                    FROM FED PUTS NEW $

                                                                                                                    IN CIRCULATION

BANK PURCHASE 

BOND FROM PUBLIC      NEW                              INCREASE             YES; B/C MONEY IS 

                                                                                                                     COMING FROM 

                                                                                                                     RESERVE WHICH PUTS

                                                                                                                     NEW $ IN CIRCULATION

Cash: Money created in banking system only 

Factors that weaken the effectiveness of Deposit Multiplier:

1. If banks fail to loan out all ER
2. If bank customers take this loans in cash rather than in new checking account deposits, it creates a cash or currency drawn 

Money Market (3/17/15)

Demand for money has an inverse relationship between nominal interest rates and quantity of money demanded. 

• MD & DM increase; ir decreases
• MD & DM decrease; ir increases 

MD: Money Demand 

DM: Demanded Money 

• If AD increases, they are buying bonds 
• If AD decreases; they are selling bonds

Money Market Graph, Loanable Funds Market Graph, and AD-AS Graph Comparison:

Notes (3/19/15)

Fiscal:

• Congress: The President 
• Tax on spend

Monetary:

• The Fed (Federal Reserve Bank)
• Benefit: FID assured
• OMO: Open Market Operation
• Discount Rate
• Federal Fund Rate
• Reserve Requirement 

                                  EXPANSIONARY                                          CONTRACTIONARY

                                   "EASY MONEY"                                              "TIGHT MONEY"

O.M.O                   BUY BONDS; INCREASE                                    SELL BONDS; DECREASE

                              MS                                                                           MS

DISCOUNT          DECREASE                                                            INCREASE

RATE

RESERVE

REQUIREMENT       DECREASE                                                       INCREASE

Recession: Money should be circulating (RR)

Required Reserves: Amount of money bank has to keep for its reserves 

Discount Rate: Interest rate that the Fed charge commercial banks for borrowing money 

DR: Recession- Lower interest rate, more money to get

Federal Fund Rate: Where FDIC member banks loan each other over night funds in order to balance account each day (simply interest rate banks charge each other for borrowing money)

Prime Rate: An interest rate bank charge to their most credit worthy customers (if you have 0-4%, your credit is good; higher than 4 = bad credit score) 

Notes (3/23/15)

Loanable Funds Market: Market where savers and borrowers exchange funds (QLF) at real rate of interest (r%)

The demand for loan bale funds/borrowing loans from households, firms, government and foreign sector. Supply of loanable funds is also the demand for bonds. 

Loanable Funds Market in Equilibrium 

Changes in Demand for Loanable Funds:

• Demand for loanable funds = borrowing (supplying bonds)
• More borrowing = more demand for loanable funds (shifts right)
• Less borrowing = less demand for loanable funds (shifts left)

Examples:

• Government deficit spending = more borrowing = more demand for loanable funds; DLF shifts left; r% increases 
• Less investment demand = less borrowing = less demand for loanable funds; DLF shifts left; r% decrease 

Change in Supply of Loanable Funds:

• Supply of loanable funds = saving (demand for loans) 
• More saving = more supply of loanable funds (shifts right)
• Less saving = less supply of loanable funds (shifts left) 

Examples:

• Government budget surplus = more saving = more supply of loanable funds; SLF shifts right; r% decreases
• Decrease in consumers' MPS = less saving = less supply of loanable funds; SLF shifts left; r% increases

When government does fiscal policy it will affect the loanable funds market 

Changes in real interest rate (r%) will affect Gross Private Investment