The Nature of Money Money, Banking and Interest Rates

The Nature of Money What is Money Legal Tender Anything that functions as a medium of exchange, store of value, unit of account, and standard of deferred payment. Legal Tender Money that cannot be refused as payment for goods and services or for discharge of debts; consists of currency and coins.

The Nature of Money The Functions of Money Medium of Exchange or Means of Payment Standard of Value Unit of Account Standard of Deferred Payment

The Nature of Money Medium of Exchange An attribute of money that permits it to be used as a means of payment. Barter The direct exchange of one good for another without the use of money

The Nature of Money Standard of Value An attribute that allows it to be held for future use without the loss of value in the meantime.

The Nature of Money Unit of Account An attribute that permits it to be used as a measure of the value of goods, services, and financial assets.

Standard of Deferred Payment The Nature of Money Standard of Deferred Payment An attribute that permits it to be used as a means of valuing future receipts in loan contracts.

Banks Banks Are institutions that accept various types of deposits and use the funds primarily to grant loans.

Banks Central Bank The entity responsible for overseeing the monetary system for a nation (or group of nations). Central banks have a wide range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment. Central banks also generally issue currency, function as the bank of the government, regulate the credit system, oversee commercial banks, manage exchange reserves and act as a lender of last resort.

Interest Rates Inflation The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. Most countries' central banks will try to sustain an inflation rate of 2-3%.

Interest Rates Interest Rate Real Interest Rate The cost of borrowing (or the return from lending) expressed as a percent per year. Real Interest Rate Interest Rate adjusted for expected inflation.

Financial Intermediaries Financial Intermediary Institutions that serve as "middlemen" from the transfer of funds from individuals, businesses, and other entities with surplus funds to those who borrow. The classic example of a financial intermediary is a bank that consolidates bank deposits and uses the funds to transform them into bank loans.

Financail Intermediary

Financial Intermediaries Why do Financial Intermediaries exist? To address problems arising in "asymmetric information", which causes adverse selection and moral hazard problems. Financial Economies of Scale or the ability to spread costs of managing funds across large numbers of savers.

Financial Intermediaries Asymmetric Information Possession of information by one party in a financial transaction but not by the other party Adverse Selection The likelyhood that those who desire to issue financial instruments have in mind using the funds they receive for unworthy, high-risk projects Moral Hazard The possibility that the borrower might engage in more-risky behavior after a loan has been made.

Financial Intermediaries Economies of Scale The reduction that can be achieved in the average cost of managing funds of managing funds by pooling savings together and spreading the management costs across many savers.

Interest Rates Interest Rate Nominal Interest Rate Real Interest Rate The cost of borrowing (or the return from lending) expressed as a percent per year Nominal Interest Rate Rate of return that does not reflect anticipated inflation Real Interest Rate Interest Rate adjusted for expected inflation