Unit 4: Money, Banking, and Monetary Policy

Financial Assets

Financial Assets Money at hand, or easily accessible, in the form of cash, deposits, loans, and marketable securities (bonds, stocks, etc). Unlike physical assets, such as machinery, financial assets are “intangible” due to the fact that they regard monetary values.

Financial Assets: Stock: a claim on the ownership of the firm and is exchanged in a stock market. -In order to raise money for capital investments, firms can issue and sell stock. -Equity Financing: avoids debt by selling stock, but allows for small control over management/ profits of the firm.

Financial Assets: Bonds: financial devices through which a borrower (firm or government) is obligated to pay the principal and interest on a loan at a specific date in future. -Firms want to raise money by borrowing, which is why corporate bonds are issued. -Debt Financing: borrowing of funds in order to finance a project.

Financial Assets: Video to explain stock and equity financing vs. bonds and debt financing: Bonds and Stock

Economic Functions of Money

Economic Functions of Money: Fiat Money: name given to paper and coin money; due to the fact it has no intrinsic value (like gold) and no value as a commodity (like tobacco). However, it is serves as money because the government declares it legal tender, and assures us money performs three general functions:

Function #1: Medium of Exchange Medium of Exchange: the most common form, money, is used for buying and selling goods and services. Helped to end the “barter system” in which other goods and services were traded to gain another good or service.

Example of Function #1: You are employed at your local grocery store, and are receiving $8.50/hr. Your employer exchanges dollars for an hour of your labor. You then exchange those dollars for a grocer’s pound of bananas. The grocer exchanges those dollars for a banana plantation’s banana crop, and so on.

Function #2: Unit of Account Unit of Account: money is considered a unit of account. -society uses monetary units to measure the relative worth of goods and services. -monetary units are beneficial because: a) easily compare prices of various goods. b) easy to define debt obligations, determine taxes owed, and calculate nation’s GDP.

Example of Function #2: Prior to the monetary system, bartering was the way in which people gained the goods and services needed. In this time period, the price of cows was stated in terms of corn, crayons, cranberries, etc. Now, the monetary system allows for the value of goods and services to be compared by monetary value.

Function #3: Store of Value Store of Value: money serves as a “store of value” by allowing people to transfer purchasing power from the present to future. Money is stored in checking accounts and safes to be used at a later date. Money is the preferred store of value for short periods because it is the most liquid (spendable) of all assets; long durations of time most be analyzed considerably.

Example of Function #3: You receive a paycheck of $1,000 for two weeks of work at the local grocery store. Instead of spending it, you decided to store your money in a checking account to use at a later time. A few weeks pass before you decide that you would like to purchase a new car. You have access to the money, obtaining it instantly (liquid asset), and buying the new car.

Problem with Function #3: Store of Value Although money serves as a store of value, money can lose its value over time. For example, think of a piece of cheese. Over the course of time, this piece of cheese becomes moldy and loses its value. The same concept occurs with money over long periods of time.

Time Value of Money, Present and Future Value, and Supply and Demand of Money

Time Value of Money Time Value of Money- money may serve as a store of value, but money does lose its value over time It is the most important reason for paying interest on savings and changing interest on borrowing

Present and Future Money

Present Value and Future Value Concept of Present and Future Values (in non-Economic terms) : “If you wash the car, you can go to the movies with your friends” Present: Costs (tuition, books, etc) Future: valuable education, skills, etc.

Present and Future Values: Basic Equation Dollars today are worth more than future dollars (due to inflation that occurs) For this reason, we must convert present and future dollars to same time period: PARTS OF EQUATION: PV=present value FV=future value R= rate of interest FV=PV*(1+r)

Present and Future Values: Present Value PARTS OF EQUATION: PV=present value FV=future value R= rate of interest PV=FV/(1+r)

Present and Future Values: PARTS OF EQUATION: PV=present value FV=future value R= rate of interest n=number of years FV=PV(1+r)2

Supply and Demand for Money

Supply of Money:

Supply of Money: Government is trusted with keeping the value of money as stable as possible. -How is value guaranteed? stabilizing money supply Money Supply: the total supply of money in circulation in a country’s economy at a given time. -Important to note there are three parts to money supply: M1, M2, and M3 -Liquidity: how easy assets can be converted to cash.

Supply of Money: M1 M1: cash + coins + checking deposits + traveler’s checks. -most liquid of all the parts of money supply EXAMPLE: $5, already being cash, is as liquid as it gets. It also falls under the M1 part of money supply.

Supply of Money: M2 M2: M1 + savings deposits + small (i.e., under $100,000 certificates of deposit) time deposits + money market deposits + money market mutual funds. NOTE: M2 is slightly less liquid than M1 because converting these assets to cash immediately would incur a penalty.

Supply of Money: M3 M3: M2 + large (over $100,000) time deposits. NOTE: M3 is the least liquid of all parts of the supply of money because it takes even longer to convert these time deposits (or CDs) to instant cash.

Graphing Money Supply: The supply of money is a constant. -implies that the money supply curve is VERTICAL -when graphing money supply, focus on M1 (due to the fact other measures of money supply are based on most liquid) MS Nominal Interest Rate, i% Money

Demand for Money:

Demand for Money: Demand for Money: the sum of money demanded for transactions and money demanded as assets. People demand money for two reasons: 1) money allows for them to purchase goods/services that will satisfy their wants. 2) money is also demanded as an asset.

Demand for Money: Transaction Demand Transaction Demand: the amount of money people want to hold for use as a medium of exchange; varies directly with nominal GDP. -if output INCREASES, then money demanded INCREASES -if price level INCREASES, then money demanded INCREASES

Demand for Money: Transaction Demand We assume that Nominal Rate of Interest does NOT affect transaction demand for money. Therefore, this is plotted on y-axis as a constant. Nominal Interest Rate, i% Money

Demand for Money: Asset Demand Asset Demand: the amount of money people want to hold as a store of value; varies inversely with the interest rate. -if the interest rate on bonds INCREASES, the asset demand DECREASES -if the interest rate on bonds DECREASES, the asset demand INCREASES

Total Demand for Money: demand for money in terms of transactions + the demand for money in terms of assets. Downward sloping curve: -MD=MDt + MDa Nominal Interest Rate, i% MD Money