Chapter 9 The Nature and Creation of Money Hossain: MSMC

Definition  Money is anything that serves as a medium of exchange  This means it is accepted as a means of payment  Therefore,  Cash  Coin  Credit card  Checks  All can be considered as Money Hossain: MSMC2

Functions  Three functions of money are:  Medium of Exchange: Purchasing goods and services  Unit of Account: A consistent means of measuring value of goods and services  Storage of Value: An item that holds value over time and therefore, expands the consumption horizon. Hossain: MSMC3

Exchange without Money  Without money goods and services can be exchanged for other goods and services  If you have Oranges and want Apples you must know the Price of Apples in terms of Oranges  Say 1 pound of Apple = 2 pounds of Oranges = 1 gallon of Milk  This is known as Barter  In a Barter economy, there will be millions of price for one pound of Apple  We will also need double coincidence of wants Hossain: MSMC4

Types of Money  Two types of money are:  Commodity Money:  Money that has its value or use apart from its use as money  Gold or Silver coins  Cigarettes in WWII prisons  Fiat Money:  Fiat money has no intrinsic value  It has value because government stands behind its value as a medium of exchange  This note is legal tender for all debts public or private Hossain: MSMC5

Measuring Money  Money Supply: Total quantity of money in an economy at any given time  Liquidity:  Not all assets are equal in terms of how quickly and easily they can be converted to currency  Liquidity is the ease with which an asset can be converted into currency  Clearly, currencies are most liquid  A U.S. treasury bond will be a little less liquid  Your home will be even less liquid Hossain: MSMC6

Measuring Money  Based on liquidity, money supply is measured in two forms.  M1 Money Supply:  The most narrowest definition of money supply by Federal Reserve or the U.S. Central Bank  It is also more liquid than M2 definition  It includes:  Currency: Cash and Coins  Checkable Deposits  Traveler’s Check Hossain: MSMC7

Measuring Money  M2 Money Supply:  A more broader definition of money supply  It includes M1 plus several other types of deposits including  All of M1  Savings account deposit  Small denomination time deposit  Money market mutual fund Hossain: MSMC8

M1 and M2 in December 2008

Financial Intermediary  Financial Intermediary  An institution that accepts funds from one group (the savers) and provides funds to another group (the borrowers) who has a better and more productive use of funds  In doing so intermediaries  Allocates resources to its best use  Reduce risks through diversification  Reduce transaction cost through specialization  Examples include Banks, Insurance company, Mutual funds, Pension funds, Investment banks. Hossain: MSMC10

Financial Intermediary  Banks  A financial intermediary that accepts deposits, offer checking account services and make loans.  Balance Sheet  A financial statement that shows an institution’s assets, liabilities and net worth.  Asset: Anything of value. For banks, loans, mortgages, cash, reserves are assets  Liability: Obligations to other parties. For banks, deposits, loans from other banks are liabilities Hossain: MSMC11

Financial Intermediary  Balance Sheet  Net worth: Refers to assets less liabilities Hossain: MSMC12 AssetsLiabilities and Net Worth Reserves$300.0Checkable deposits$604.5 Other assets1,357.8Other deposits6,306.7 Loans6,903.4Borrowings2,322.1 Securities2,466.9Other liabilities6,576.6 Total assets$11,928.1Total Liabilities9,890.9 Net worth1,137.2

Financial Intermediary  Reserves Bank’s assets in the form of vault cash and deposits with Federal Reserve in called reserve. Reserve = Cash + Deposit with Fed Hossain: MSMC13

Financial Intermediary  Required Reserve  Quantity of reserve banks are required to hold.  Required reserves cannot be loaned out.  It is usually a certain percentage of banks’ primary liability (checkable deposits) Hossain: MSMC14

Financial Intermediary  Required Reserve Ratio  Ratio of reserve to checkable deposits that all bank must maintain  For example, required reserve ratio is.10 or 10%  If Bank of America has 500 m checkable deposits, it must hold 50m worth of reserve (cash or deposit with Federal Reserve Bank)  Since reserve earns no interest, most banks maintains just the required reserve  Keep assets in the form of loans and securities. Hossain: MSMC15

Required Reserve Ratio (rrr)  Ratio of reserve to checkable deposits that all bank must maintain  Mathematically, rrr = R / D  For Bank of America rrr = 50m/500m =.10 or 10%  If rrr rises to 12%, compute the required reserve for the Bank of America. Hossain: MSMC16 Here, R= Required Reserve D = checkable deposits

Financial Intermediary  Excess Reserve  Reserve that are in excess of the required reserve  For example, required reserve ratio is.10 or 10%  If Bank of America has 500 m checkable deposits, it must hold 50m worth of reserve  However, if it has 60m reserve at hand, then what is the excess reserve.  Excess Reserve=Actual Reserve – Required Reserve  60m – 50m = 10m Hossain: MSMC17